Contents

Cover

Series

TitlePage

Copyright

Introduction

Chapter1:“AllSensibleInvestingIsValueInvesting”

WHATITMEANSTOBEAVALUEINVESTORDOESQUALITY

MATTER?THEVALUEOFGROWTHTHEVALUEMINDSET

PartOne:FieldofPlay

Chapter2:Circleof

CompetenceTHERIGHTSIZEINDUSTRYPREFERENCEWHEREINTHEWORLD?

Chapter3:DeficientMarketHypothesis

THEHUMANELEMENTIT'SAMATTEROFTIME

Chapter4:FertileGround

INSEARCHOFUNCERTAINTYSPECIAL

SITUATIONSOPERATINGTURNAROUNDS

Chapter5:GeneratingIdeas

BEHINDTHESCREENFOLLOWTHELEAD

RELIABLESOURCES

PartTwo:BuildingtheCase

Chapter6:CuttingThroughtheNoise

SECOND-

LEVELTHINKINGMACROVERSUSMICROBUSINESSFIRSTWHATQUALITYMEANS

CRUNCHINGTHENUMBERSWHATCOULDGOWRONG?FROMTHETOPCATALYSTSGETTINGITDONEORGANIZINGPRINCIPLES

Chapter7:GettingtoYes

CASH(FLOW)ISKINGMULTIPLEANGLESTHEINFORMEDBUYERMODEL

BEHAVIORPLAYINGTHEODDSTHEORIESOFRELATIVITYPULLINGTHETRIGGER

PartThree:

ActiveManagement

Chapter8:ThePortfolio

CONCENTRATIONVERSUSDIVERSIFICATIONTHESIZETHAT

FITSCOGNIZANCEOFCORRELATION

Chapter9:PlayingtheHand

TRADINGMENTALITYDEALINGWITH

ADVERSITYTAKINGASTANDATTRACTINGACTIVISTS'ATTENTION

Chapter10:GuardingAgainstRisk

MARGINOF

SAFETYBUILDINGAPOSITIONCASHMANAGEMENTMIDASTOUCHHEDGINGBETS

Chapter11:MakingtheSale

WHYTOSELLSELLINGBYTHENUMBERSGETTINGTHETIMINGRIGHTSALEPROCESS

PartFour:OfSoundMind

Chapter12:OfSoundMind

COMPETITIVESPIRITINDEPENDENTTHOUGHTPERPETUALSTUDENTTOERRISHUMAN

BEEVERSOHUMBLE

TheFinalWord

AbouttheAuthors

Index

Foundedin1807,JohnWiley& Sons is the oldestindependent publishingcompanyintheUnitedStates.With offices in NorthAmerica, Europe, Australiaand Asia, Wiley is globallycommitted to developing andmarketingprintandelectronicproductsand services forourcustomers' professional andpersonal knowledge andunderstanding.

The Wiley Finance seriescontains books writtenspecifically for finance andinvestment professionals aswell as sophisticatedindividual investors and theirfinancial advisors. Booktopics range from portfoliomanagement to e-commerce,risk management, financialengineering, valuation andfinancial instrument analysis,aswellasmuchmore.

Foralistofavailabletitles,visit our Web site atwww.WileyFinance.com.

Cover image: ©iStockphoto.com/CandiceCusackCoverdesign:Leiva-SposatoCopyright © 2013 by ValueInvestor Media, Inc. Allrightsreserved.Published by John Wiley &Sons, Inc., Hoboken, NewJersey.Published simultaneously inCanada.

No part of this publicationmaybe reproduced, stored ina retrieval system, ortransmittedinanyformorbyany means, electronic,mechanical, photocopying,recording, scanning, orotherwise, except aspermitted under Section 107or 108 of the 1976 UnitedStatesCopyrightAct,withouteither the prior writtenpermission of the Publisher,

or authorization throughpayment of the appropriateper-copyfeetotheCopyrightClearance Center, Inc., 222Rosewood Drive, Danvers,MA 01923, (978) 750-8400,fax(978)646-8600,orontheWeb at www.copyright.com.Requests to the Publisher forpermission should beaddressed to the PermissionsDepartment, John Wiley &Sons, Inc., 111 River Street,

Hoboken, NJ 07030, (201)748-6011, fax (201) 748-6008, or online athttp://www.wiley.com/go/permissionsLimit of Liability/Disclaimerof Warranty: While thepublisher and author haveused their best efforts inpreparing this book, theymake no representations orwarrantieswithrespecttotheaccuracy or completeness ofthecontentsof thisbookand

specifically disclaim anyimplied warranties ofmerchantability or fitness fora particular purpose. Nowarranty may be created orextended by salesrepresentatives or writtensales materials. The adviceand strategies containedhereinmaynotbesuitableforyour situation. You shouldconsult with a professionalwhere appropriate. Neither

thepublishernorauthorshallbeliableforanylossofprofitor any other commercialdamages, including but notlimited to special, incidental,consequential, or otherdamages.For general information onour other products andservices or for technicalsupport, please contact ourCustomer Care Departmentwithin the United States at

(800) 762-2974, outside theUnited States at (317) 572-3993orfax(317)572-4002.Wiley publishes in a varietyof print and electronicformats and by print-on-demand. Some materialincluded with standard printversionsofthisbookmaynotbe included in e-books or inprint-on-demand.Ifthisbookrefers tomediasuchasaCDor DVD that is not included

intheversionyoupurchased,you may download thismaterial athttp://booksupport.wiley.com.For more information aboutWiley products, visitwww.wiley.com.Library of CongressCataloging-in-PublicationData:ISBN 978-0-470-47977-3(Hardcover)

ISBN 978-1-118-22029-0(ePDF)ISBN 978-1-118-25863-7(Mobi)ISBN 978-1-118-23396-2(ePub)

Introduction

When we launched thenewsletter Value InvestorInsight in early 2005, ourmotivationwasnottotoutthe“10BestStockstoBuyNow”or peddle a proprietarysystem that would “TripleYourMoneyinSixMonths!”Primarily through two in-

depth interviews with highlysuccessful money managers,ourgoals foreach issuehavebeen to deliver not onlytimely investment ideas, butalso timeless wisdom aboutthecraftofinvesting.Tothatend, our Value InvestorInsightinterviewsexplorethefull spectrum of stockinvesting: from thedefinitionof an underlying philosophy,to the identification of

potential ideas, the researchand analytical process, thediscipline around buying andselling, all aspects ofportfolio management and,maybe the most important,keeping emotion andcommon behavioral biasesfrom ruining the best effortsofalloftheabove.As befits the title of our

newsletter,we'reunrestrainedproponentsofthecorevalue-

investing philosophy firstespoused by BenjaminGrahamandthenembellishedand popularized by WarrenBuffett. Value investingmeans different things todifferentpeople(moreonthatlater), but value investors'core belief is that equitymarketsregularlyoffer—foravariety of different butpredictable reasons—opportunitiestobuystakesin

companies at significantdiscounts to conservativeestimates of what thosebusinessesareactuallyworth.Ifyoucanconsistentlygetthevalue of the underlyingbusinesses right, pay deepdiscounts to those values inbuyingthecompanies'stocks,andmaintainyour convictionand discipline whileconventional wisdomregularly goes against you,

youcanbeatthemarket.While the core precepts of

value investing strike us aseminently sound, age andexperience have alsomade itequally clear that, likefingerprints, no two value-investing strategies areexactly alike. So manyelements make up a givenstrategyanditsexecutionthatwhen combined withinevitable differences in

judgment, it's perfectlynormal for equally talentedandaccomplishedinvestorstoassess the landscape ofinvestment opportunities or aspecific idea and come todiametrically opposedconclusions. That's whatmakes investing—andmaking judgments aboutinvestors—so difficult . . .andendlesslyfascinating.As encouraging as it may

be that there are a multitudeof paths to investmentsuccess,thatinnowayarguesfortryingtopursueseveralatthe same time. The bestinvestors, in our experience,can articulate in a clear andfocused way what they'relooking for, why they'relooking for it and wherethey're trying to find it.Theyhave a well-defined andconsistently applied process

for research and analysis.They follow specificdisciplines for buying, forselling, for diversification,and for managing risk. Theyare well-versed in thebehavioraltrapsinvestorscanfall into and take concretesteps toavoid them.Obviousas that all should be, we'reconstantly surprised by thenumber of professionalmoney managers who can't

credibly argue why and howtheyexpecttooutperform.Our goal with The Art of

Value Investing is to offer acomprehensivesetofanswersto the questions every equitymoney manager should havethought through clearlybefore holding himself orherself out as a worthysteward of other people'smoney. Because there is notjust one credible answer to

eachofthesequestions,we'veprovided a full range ofpotential answers and thejustifications for each. Whatmarket inefficiencies will Itry to exploit? How will Igenerate ideas?Whatwill bemy geographic focus? WhatanalyticaledgewillIhopetohave? What valuationmethodologies will I use?What time horizon will Itypicallyemploy?Howmany

stocks will I own? Howspecifically will I decide tobuyorsell?WillIhedge,andhow? How will I keep myemotions from getting thebestofme?We'vedelegatedthetaskof

providing answers to suchquestions to the experts: themarket-beating moneymanagers who have gracedthe pages of Value InvestorInsight. Hedge-fund

superstars such as JulianRobertson, Seth Klarman,Lee Cooperman, DavidEinhorn, Bill Ackman andJoel Greenblatt. Mutual fundluminaries including MartyWhitman, Mason Hawkins,Jean-Marie Eveillard, BillNygrenandBruceBerkowitz.Lower profile but no lessaccomplished moneymanagers such as MaverickCapital's Lee Ainslie,

Highfields Capital's JonJacobson, Ralph Whitworthof Relational Investors, andJeffrey Ubben of ValueActCapital. We hope to provideuseful context andorganization to thediscussion,butwe leave it tothese superior investors anddozens more like them todescribe how they practicetheircraftandwhy.Wecan'timagine more credible

sources of information andinsight.We should emphasize that

our goal is not to present asingleanswertoanystrategicquestion an investor faces.Any investor's givenperformance is a function ofthousands of individualdecisions about the strategyhe or she employs and howit's executed over time. Oneinvestor may invest only in

large-cap stocks, whileanother may never touchthem. One may considerspending time withmanagement to be the mostimportant component ofresearch, while another mayfind it a complete waste oftime. One may specialize inenergy stocks, while anotheravoids them like the plague.What we will do is presentthe conclusions that a set of

uniquely qualified investorshave reached on a widevarietyofsubjects,aswellastheir explanations for whythey've chosen the strategyand methods they have.While their conclusions willfrequentlydiffer,wehopethediversity of opinion helpsinform the decisions youultimately will have tomakeasaninvestor.WhoshouldreadTheArtof

Value Investing? Ouraspiration is for it to be asvital a resource for the just-starting-outinvestorasforthesophisticated professionalone.Theformerareprovideda comprehensive guidebookfor defining a soundinvestmentstrategyfromAtoZ; the latter are providedchallenges to all aspects oftheir existing practice andprovocations to potential

improvements.We also want the book to

be a must-read for anyinvestor—institutional orindividual—charged withchoosing the best managersfor the money they areallocating to equities.Choosing the right managersfor you consists of knowingall the right questions to askaswellastheanswersworthyof your respect and attention

—both of which we aim todeliver.Ourorganizingprinciplefor

the content roughly matchesthechronologicalprogressiononewouldfollowindefiningand executing an investmentstrategy. In Chapter 1 weexplore the core principlesinvestors rely on to guidetheir strategies. While thoseprinciplesforalltheinvestorswe hear from fall under the

value-investingumbrella,thatumbrella covers a diversespectrum of thought andopinion. In thesection“FieldofPlay,”thebestinvestorsinthe business describe howthey define their circle ofcompetence, the types ofsituations and inefficiencieson which they look tocapitalize, and how theygenerate ideas. In the section“Building the Case,” we

examinehowtopinvestorsgoabout their research, wherethey focus their analyticalefforts, how they valuecompanies, and thedisciplines they follow indeciding what to buy andwhen.Whilemostoftheliterature

on stock investing stops atgetting to the buy decision,the final two sections ofTheArtofValueInvestingaddress

equally importantcontributors to investmentsuccess. The section titled“Active Management”describesbestpractices inallaspects of portfoliomanagement, includingposition sizing,diversification, responding tochanging circumstances, andthe decision to sell. In thesection“OfSoundMind,”wehear how superior managers

learn from mistakes, whatmotivatesthem,andhowtheyface the many threats torational thinking thatinvestingservesup.Allofthequotesusedhave

appeared in the pages ofValue Investor Insight, withthe vast majority comingfrom first-person interviewswe have conducted over thepast eight years. In a smallnumber of cases—most

prominently the timelesswisdom from The BaupostGroup's Seth Klarman andOaktree CapitalManagement'sHowardMarks—certain quotes have comefrom investorcommunications that wereeither publicly available orfor which we were grantedpermission to use. In allcases, we offer our sincerethanks to everyone we've

interviewed, whosegenerosity in sharing theirexperiences and insights istrulyaninspiration.Thequest forknowledge is

a never-ending process forinvestors and is what helpsseparatethebestfromtherestof the pack. To contribute ineven a modest way to thatlearning process is truly ourhonor.

JohnHeinsWhitneyTilson

CHAPTER1

“AllSensibleInvestingIs

ValueInvesting”

A walk down anysupermarket aisle makes itclear we live in a world ofincreasing productspecialization.Tobreakintoanew market or grab more ofan existing one, companieslaunch a dizzying array ofnew products in ever-more-specific categories. Wantyoursodawithmorecaffeineor less? You've got it. Moresugar? Less sugar? Six

ounces, 10 ounces, 20ounces?Whateveryoulike.Thistrendhasnotbeenlost

on marketers of investmentvehicles. Specialized mutualfunds and exchange-tradedfunds exist for almost everyimaginable combination ofmanager style, geographicreach, industry sector, andcompany marketcapitalization size. If you'relookingforamid-capgrowth

fund focused on thecommoditysectorinso-calledBRIC countries (Brazil,Russia, India and China),you'relikelytofindit.We understand the

marketing reality ofspecialization, but we arguethatthemostimportantfactorin judging an investor'sprospectivegainsor losses ishis or her underlyingphilosophy. As you might

guess from the fact that weco-founded a newslettercalledValueInvestor Insight,we agree 100 percent withBerkshire Hathaway's ViceChairman Charlie Munger,who says simply that “allsensible investing is valueinvesting.”But what exactly does it

mean to be a value investor?At its most basic level itmeansseekingoutstocksthat

you believe are worthconsiderably more than youhave topayfor them.Butallinvestorstrytodothat.Valueinvesting to us is both amindsetaswellasa rigorousdiscipline, the fundamentalcharacteristicsofwhichwe'vedistilled down to a baker'sdozen.Valueinvestorstypically:Focusonintrinsicvalue—whatacompanyis

reallyworth—buyingwhenconvincedthereisasubstantialmarginofsafetybetweenthecompany'ssharepriceanditsintrinsicvalueandsellingwhenthemarginofsafetyisgone.Thismeansnottryingtoguesswheretheherdwillsendthestockpricenext.Haveaclearlydefinedsenseofwherethey'll

prospectforideas,basedontheircompetenceandtheperceivedopportunitysetratherthanartificialstyle-boxlimitations.Pridethemselvesonconductingin-depth,proprietary,andfundamentalresearchandanalysisratherthanrelyingontipsorpayingattentiontovacuous,minute-to-minute,cable-

news-styleanalysis.Spendfarmoretimeanalyzingandunderstandingmicrofactors,suchasacompany'scompetitiveadvantagesanditsgrowthprospects,insteadoftryingtomakemacrocallsonthingslikeinterestrates,oilprices,andtheeconomy.Understandandprofit

fromtheconceptthatbusinesscyclesandcompanyperformanceoftenreverttothemean,ratherthanassumingthattheimmediatepastbestinformstheindefinitefuture.Actonlywhenabletodrawconclusionsatvariancetoconventionalwisdom,resultinginbuyingstocksthatare

out-of-favorratherthanpopular.Conducttheiranalysisandinvestwithamultiyeartimehorizonratherthanfocusingonthemonthorquarterahead.Considertrulygreatinvestmentideastoberare,oftenresultinginportfolioswithfewer,butlarger,positionsthanis

thenorm.Understandthatbeatingthemarketrequiresassemblingaportfoliothatlooksquitedifferentfromthemarket,notonethathidesbehindthesafetyofclosetindexing.Focusonavoidingpermanentlossesratherthanminimizingtheriskofstock-pricevolatility.Focusonabsolute

returns,notonrelativeperformanceversusabenchmark.Considerstockinvestingtobeamarathon,withwinnersandlosersamongitspractitionersbestidentifiedoverperiodsofseveralyears,notmonths.Admittheirmistakesandactivelyseektolearnfromthem,ratherthan

takingcreditonlyforsuccessesandattributingfailurestobadluck.

WHATITMEANSTOBEAVALUEINVESTOR

Elaborating in detail on allaspects of the bare-bones list

above isessentiallywhat thisbook is about. We begin byturning to the uniquelysuccessful investors we'veprofiledovertheyearsasco-editors of Value InvestorInsight toexaminewhat theyconsider to be the keycomponents of a value-investing philosophy, fromgeneral fundamentalprinciples to the overarchingmindset needed to make it

work.

***

Ourentireprocessisrootedin Ben Graham's simplephilosophical frameworkfor investing. He believedthere were two values forevery stock, the firstbeingthe current market price,and the second what thesharewouldbeworthifthe

entire company wereacquired by aknowledgeable buyer or ifthe assets were liquidated,the liabilities paid off andthe proceeds paid tostockholders. He calledthat the intrinsicvalueandarguedthatthetimetobuywaswhentherewasalargespreadbetween thecurrentprice and that value, andthe time to sell was when

thatspreadwasnarrow.Overtimewe'vedevelopeddifferent ways of applyingthat —by valuing incomestreams rather than justassets, by calculatingprivate market values, byinvesting internationally—buttheessenceofwhatwedohasremainedconsistent.Our work every day isessentially directed atvaluing what businesses

areworth.—WillBrowne,Tweedy,

BrowneCo.

At the heart of being avalue investor is having acontrarian bent. Beyondthat, though, there aremany different flavors ofvalue investing. TweedyBrowne is a great deep-value investment firm.Chuck Royce at Royce

Funds is a wonderfulGARP [Growth At aReasonable Price]practitioner—he's focusedon value but definitelydoesn't like to own badcompanies. MasonHawkins at SoutheasternAsset Management andMarty Whitman of ThirdAvenue are orientedtoward stocks trading atsignificantdiscounts tonet

asset value. Bill Miller isprobably best described asan all-out contrarian. Thefact that all these peoplehave been successfulproves that there's nosingle way to do it. Whatthe market offers up asopportunity is constantlychanging, so being able todeploy a variety ofstrategies as the situationwarrants allows us great

flexibility to go almostanywhere and never getshut out of the market.That's important becauseour investors don't ask ustomoveinandoutofcashdepending on howovervalued or undervaluedwe think the market is.And frankly, having aneclectic view makesinvesting a lot moreinteresting.

—PrestonAthey,T.RowePrice

We've found that to earnrepeatable, excellentreturns over time withreasonable risk exposurerequires being able toassign somethingapproximating a fair valueto a business, makingconservative estimates.Then it's a question of

looking at the price. Ifpriceissignificantlybelowthatfairvalue,you'relikelytohaveagoodoutcomebyinvesting in it. If the priceis significantly above thatfair value, you can makegoodmoneybyshortingit.

—ZekeAshton,CentaurCapital

There'snothingparticularlyearth-shatteringaboutwhat

we try to do. We believethemarket oftenmispricesstocks due to neglect,emotion, misinterpretationor myopia, so our value-addcomesfrombottom-upstock selection. We'retrying tobuyat lowpricesrelative to our currentestimate of intrinsic valueandwewanttobelievethatintrinsicvaluewillgrow.—SteveMorrow,NewSouth

Capital

When I got much moreinterested in individualsecurities analysis in theearly 1990s I read aswidely as I could and alightbulb just switchedonwhen I read everythingMarty Whitman wrote. Iwasthinkingitwascriticalto understand the ins andouts of how the stock

market really worked, buthis basic message was toignore the market, whichwasjustthebazaarthroughwhich you had to maketrades. He was all aboutvaluing what a companywas worth—independentof what the market wassaying it was worth at thetime—and buying whenthemarketwasgivingyoua big discount and selling

when it was paying you apremium.Asobviousas that sounds,it was very liberating tocome across such astraightforward approach.Using whatever analyticaltools I want, whether it'svaluing net assets,calculating private-marketvalues or discountingfuture cash flows, I canarriveataclearestimateof

whatacompanyisactuallyworth. From there, theactual buying and sellingdecisionsaren'tthathard.

—JimRoumell,RoumellAssetManagement

I've heard it said manytimes that value investingisnotasmuchaboutdoingsmart things as it is aboutnot doing dumb things.Avoiding mistakes,

resisting market fads, andfocusing on allocatingcapital into ideas that arehighly likely to producesatisfactoryreturnsandthatoffer a margin of safetyagainst permanent capitalloss – these are thedominant themes of thevalue investing approach.Contrary tohow it sounds,these elements don't makevalue investing easier than

other approaches. In fact,cultivatingthedisciplinetoavoid unproductivedecisions,refiningthecraftof valuing businesses andassessing risk, anddeveloping the emotionaland mental equilibriumrequired to thinkindependently in a field inwhich there is tremendouspressure to conformrequires constant diligence

andeffort.—ZekeAshton,Centaur

Capital

Long-term-oriented valueinvestors have greaterscope to produce superiorrisk-adjusted returns whenthe seas are rocky. Thevalidresponsewhenthere'schopistofocusontheenddestination—what valueinvestors call intrinsic

value—and not worryabout whether the nextwave is going to push theboat up or down. If youdon't invest with a veryclear notion of underlyingvalue, how do you do it?Nothingelsemakessense.Your ability to maintainfocus on the long termcomes from experience.You go through a couplecycles where everybody

elseisscreamingatyounotto try to catch a fallingknife, and then when youdo so and make somemoney,itdoeswondersforyou...andforyourabilitytodoitnexttime.—HowardMarks,Oaktree

Capital

We make no heroicassumptions in ouranalysis, hoping, instead,

that by compoundingmultiple conservativeassumptions,wewillcreatesuch a substantial marginof safety that a lot can gowrong without impairingourcapitalmuchorevenatall.Weneverinvestjusttoinvestanddon'tbetblindlyon mean reversion or onhistorical relationshipsholding up. Our settingsare permanently turned to

“riskoff.”—SethKlarman,TheBaupost

Group

In traditional-value ideaswe're looking for a largediscount toourestimateofvalue based on acompany'snormalearningspower, where normalmeans that generalbusinessactivity isnot toohotandnottoocold.These

tend to be more average-quality businesses, whichcan get very cheap in thedown part of a cycle orwhen dealing with a self-inflictedproblem.The priority in these ideasis on margin of safety,which we look at in twoprimary ways. The first isby making sure thepotential downside is asmall fraction of the

upside. That means weavoidstocksthatarecheapon an equity-value basisprimarily because there's amountain of debt. Thesecond important way tohave amargin of safety istohavemorethanonewayto win, through earningsgrowth,multipleexpansionor free options in thebusiness.—LeeAtzil,PennantCapital

Whenever Ben Grahamwasaskedwhathethoughtwould happen to theeconomy or to companyX's or Y's profits, healways used to deadpan,“The future is uncertain.”That'spreciselywhythere'sa need for a margin ofsafety in investing, whichismorerelevanttodaythanever.

—Jean-MarieEveillard,FirstEagleFunds

People should be highlyskeptical of anyone's,includingtheirown,abilityto predict the future, andinstead pursue strategiesthat can survive whatevermayoccur.[Nassim]Talebadvises us to be “anti-fragile” – i.e., to embracethose elements that benefit

from volatility, variability,stressanddisorder.This isexactly what we strive todo.

—SethKlarman,TheBaupostGroup

The person with thehighest probability ofoutperformingover time istheonewhoknowshowtovalue companies and buysat a significant discount

fromthat.I'veheardfor45years why all these otherthings have become moreimportant. You knowwhat?It'sallcrap.—RobertOlstein,Olstein

CapitalManagement

Much of what we do isfocused on the concept ofmeanreversion.Forawidevariety of inputs, such asP/E ratios, profit margins,

sales growth and dividendyields, we assumeeverything will end up inseven years at normal.There's obviouslyjudgment involved indefiningwhat'snormal,butwe're pretty faithfulhistorians who are alsotryingtouseourbrainsandtrying desperately not tolose money. For a longtime we used 10-year

forecasts, but haveconcludedthroughresearchthatsevenyearsisclosertothe average time it takesfor a financial series tomeanrevert.—JeremyGrantham,GMO

Price is perhaps the singlemost important criterion insoundinvestmentdecision-making. Every security orasset is a “buy” at one

price, a “hold” at a higherprice, anda “sell” at somestillhigherprice.Yetmostinvestors in all assetclasses love simplicity,rosy outlooks, and theprospectofsmoothsailing.They prefer what isperforming well to whathas recently lagged, oftenregardless of price. Theyprefer full buildings andtrophy properties to fixer-

uppers that need to befilled, even though emptyor unloved buildings maybethefarmorecompelling,and even safer,investments. Becauseinvestors are not usuallypenalized for adhering toconventional practices,doing so is the lessprofessionally riskystrategy, even though itvirtuallyguaranteesagainst

superiorperformance.—SethKlarman,TheBaupost

Group

IfIhadtoidentifyasinglekey to consistentlysuccessful investing, I'dsay it's “cheapness.”Buying at low pricesrelative to intrinsic value(rigorously andconservatively derived)holds the key to earning

dependably high returns,limiting risk andminimizing losses. It's notthe only thing thatmatters—obviously—but it'ssomething for which thereis no substitute. Withoutdoing the above,“investing”movescloserto“speculating,” amuch lessdependableactivity.—HowardMarks,Oaktree

Capital

Whenyoulookbackasfaras 80 years for which wehave data, rather thanmoving about withoutrhymeor reason, the stockmarket methodicallyrewards certain investmentstrategies while punishingothers.There'snoquestionthe value-based strategiesthatworkoverlongperiodsof time don't work all the

time,buthistoryshowsthatafter what turn out to berelatively brief periodswhen other things seem tobe all that matter, themarket reasserts itspreference for value, oftenwith ferocity. My basicpremise is that given allthat,investorscandomuchbetter than the market ifthey consistently use time-tested strategies that are

basedonsensible, rational,value-based methods forselectingstocks.—JamesO'Shaughnessy,

O'ShaughnessyAssetManagement

Warren Buffett has madethe point many times thatbeingcontrarianreallyisn'tthefullanswer—it'shavingconviction in your ownopinion and filtering out

the noise. If the markethappenstoberight,beingacontrarian for the sake ofbeing a contrarian isn't avery good strategy. Youhave tohave thedisciplineto stick to the situationswhere you have an edgeandsitouttherestofthem.—JonJacobson,Highfields

Capital

There isn't really a strong

value-investing culture inEurope—at least thatoperates the way we do.Mostofthebiginstitutionshere define value in termsofhighdividendyieldsandlow P/E multiples onreported earnings. That'swhy so many of them didpoorly in 2008, becausethey owned too manybanks and cyclicalcompanies.Themajorityof

European hedge funds aretraders who care littleabout valuation but areinvesting based on short-term news or momentum.Some are very good at it,butthat'snotatallwhatwedo. We tell our investorsthat while they're bettingon our skill in identifyingcorporate assets to investin, in the end, they ownhigh-quality assets. That's

very different thaninvesting in a tradinghedge fund, where you'reinvesting in the tradingskill of the portfoliomanager. If I have a badday,that'snotgoingtohurtthe future prospects of thecompanies I own. If atraderhasabadday,itcanbeadisaster.

—RichardVogel,AlatusCapital

In a rising market,everyone makes moneyand a value philosophy isunnecessary. But becausethere is no certain way topredict what the marketwill do, onemust followavalue philosophy at alltimes. By controlling riskand limiting loss throughextensive fundamentalanalysis, strict discipline,

andendlesspatience,valueinvestors can expect goodresults with limiteddownside.Youmaynotgetrich quick, but you willkeepwhatyouhave,andifthe future of valueinvesting resembles itspast, you are likely to getrich slowly.As investmentstrategies go, this is themost that any reasonableinvestorcanhopefor.

—SethKlarman,TheBaupostGroup

Do those things as ananalyst that youknowyoucandowell,andonlythosethings. If you can beat themarket by charts, byastrology, or by some rareand valuable gift of yourown, then that's the rowyou should hoe. If you'regood at picking the stocks

most likely to succeed inthe next twelve months,base your work on theendeavor. If you canforetell the next importantdevelopment in theeconomy, or in thetechnology, or inconsumers' preferences,andgaugeitsconsequencesfor various equity values,then concentrate on thatparticular activity. But in

each case you must proveto yourself by honest, no-bluffing self-examination,and by continuous testingof performance, that youhave what it takes toproduce worthwhileresults.If you believe—as I havealways believed—that thevalue approach isinherently sound,workable, and profitable,

thendevoteyourselftothatprinciple. Stick to it, anddon'tbeledastraybyWallStreet's fashions, itsillusions, and its constantchase after the fast dollar.Let me emphasize that itdoes not take a genius orevenasuperiortalenttobesuccessful as a valueanalyst. What it needs is,first, reasonable goodintelligence;second,sound

principles of operation;third, and most important,firmnessofcharacter.

—BenjaminGraham,CommonSenseInvesting

Consultants in theinvestment world work sohard to pigeonholeinvestors that I think eventhe word “value” ismisconstrued to just meanlow multiples of book

value or earnings. EvenBen Graham early ontalkedabouthowgrowthisof great value, it's justriskierandmoredifficulttoquantify. I'm alwaysamazed that someonewould say they weren't avalue investor—I wouldn'tadmit itevenifIwasn't. Itjust seems silly to thinkabout investing any otherway.

—ThomasGayner,MarkelCorp.

DOESQUALITYMATTER?

No less an authority thanWarrenBuffetthasdescribedhis evolution as a valueinvestor from being moreinterested early on in “cigar-

butt” types of companies—distinguished by little morethan how inexpensive theirstocks were relative to theirtangible assets—to anemphasis on less-cheap, buthigher-quality businesseswith a sustainable ability tocompound shareholder valueover long periods of time.The relative importance oneplaces on business qualityremains a central element of

justaboutanyvalue-investingapproach.

***

Istartedoutin1974withaBen Graham valuestrategy, which suited mypersonality.Foreightyearsthemarketdidnothing,butit was a great time forstock pickers and valueinvesting, so things went

very well. Around 1982 ithitmethattherewerealotof lousy stocks in myportfolio and I startedwondering why. While itsounds like an obviousconclusion now, thecommon denominator ofthe losers was that theywere in lousybusinesses. Irealized I should be moreofabusinessanalystthanastockanalyst,meaningthat

to create value as aninvestor I had to betterunderstandhowcompaniesthemselvescreatedvalue.Imoved more away fromclassical stock metrics ofP/E and book value tobusiness metrics of returnoncapitalandcashflows.

—AndrewPilara,RSInvestments

Value to me often derives

from competitively strongcompanies in structurallyattractive industriessupported by seculargrowth. In financial termsit'seasytodescribeahigh-quality business. Theygenerate high returns onunlevered capital and highreturns on equity on anafter-tax basis. Theyproduce free cash flow orhave attractive enough

reinvestment opportunitiesto investcash flowathighreturns.Greatbusinesses areworthmore, so I would ratherown that type of companyatareasonablepricethanamediocre company at areallycheapprice.ButI'vealso learned the hard waynever to disregardvaluation—you can easilyoverpay for even the best

business.—MorrisMark,MarkAsset

Management

As a value investor, Iwasinitially almost exclusivelyfocusedoncompanieswithgoodbalancesheetssellingat lowvaluationmultiples.There's nothing inherentlywrong with that, but I'velearned from experiencethatwhencheapnessblinds

you to not-so-hotbusinesses or poormanagement, it's a recipefor disaster. We still onlybuybargains,butwepayalotmoreattentiontothingslikewhetherthecompany'sreturns on capital are asgoodastheyshouldbeandat how adept anddisciplined management isat allocating cash flow.When returns are

inadequate or capital isallocatedrecklessly,equityvalueisusuallydestroyed.

—DavidHerro,HarrisAssociates

Our view is simply thatsuperior long-terminvestment performancecan be achieved whenfinancially strong,competitively entrenched,well-managed companies

are bought at pricessignificantly below theirbusiness value and soldwhen they approach thatcorporate worth. Thequantitativepieceofthatisthat we only want to buywhenwecanpayless than60 percent of aconservative appraisal of acompany's value, based onthe present value of futurefree cash flows, current

liquidation value and/orcomparablesales.

—MasonHawkins,SoutheasternAsset

Management

I began as a traditionalvalue investor in the BenGraham mold, looking fornet-nets [companiestrading for less than theircurrent assets minusliabilities], discounts to

bookvalueandallofthat.Iwould say, though, that Ihave graduated over timetobemorefocusedonverygood companies selling atfairprices.

—PremWatsa,FairfaxFinancial

I have come to theconclusion, asothershave,that in general you findbetter investments in

businesses with goodeconomics, seculartailwinds, and sustainablecompetitive advantagesthanyoudointryingtogetone last puff out ofproverbial cigar butts.When everything's out offavor and you can buybusinesses with brightfutures without having topay for that future, that's awonderfulthing.

—DavidWinters,WintergreenFund

I've learned that to meetmyreturngoalsIcan'thavebiglosers.Soregardlessofhowcheapsomethingisorhowmuchpotentialupsidethere is, that meansavoiding companies thatcan wipe out—with toomuch debt, unprovenbusiness models, secularly

challenged end markets orno durable competitiveadvantages.

—ZekeAshton,CentaurCapital

What I'm looking for aresteady cash flows,reinvested on owners'behalf by honest and ablemanagement. Steady cashflows come frombusinesses that, for one

reason or another, enjoythe perception ofindispensability for theirproducts. This perceptionof indispensability oftencomes from a brand, butcan also be from realbarriers to competition. Ifyouhavetheonlyquarryintown, it's hard forcompetitors to ship intoyour market becausetransportation costs are so

high.—ThomasRusso,Gardner

Russo&Gardner

Forthepast30yearswe'vesort of floated in stylebetween Ben Graham andWarren Buffett. Graham'sapproach is static,quantitative, and focusedon the balance sheet.There's no attempt to lookinto the future and judge

the more qualitativeaspectsofthebusiness.Buffett'smajorideawastoalso look morequalitatively for those fewbusinesses with apparentlysustainable competitiveadvantages,wheretheoddswere fairly high that thebusiness would be assuccessful ten years fromnowasitistoday.Inthosesituations, one makes

money not so much fromthe elimination of thediscount to intrinsic value,but more from the growthinthatintrinsicvalue.WhenIstartedoutin1979,both in the U.S. andEurope, there were manyBenGraham-typestockstouncover after the dismalstock performance of the1970s. As we grew andmarkets changed, we've

movedmore to theBuffettapproach, but not withouttrepidation.Ifoneiswrongin judging a company tohave a sustainablecompetitive advantage, theinvestment results can bedisastrous. With theGrahamapproach,theverylarge discount to staticvalue minimizes that risk.Overall, I'd like to believewe've learned well from

both Graham and Buffettand thatweownsecuritiesthat would attract each ofthem.

—Jean-MarieEveillard,FirstEagleFunds

Wehavemovedmorefroma pure Benjamin Grahamstyle of value investing toone closer to Phil FisherandWarrenBuffett, in thesense that we're putting

even more weight on thequality of the business. Idon't know, maybe whenyou're younger you justcare about getting thingsthat are cheap andmakingmoney fast. But as youbecome old you see thatbuying companies withhigh and sustainablereturns on capital atreasonable prices tends toworkalittlebitbetter.

—FranciscoGarciaParames,BestinverAssetManagement

What we've tried to do ismarry the Graham-and-Dodd type emphasis onmargin of safety with themore modern version ofvalueinvestingthatfocusesonacompany'ssustainableability to generate returnson investedcapital (ROIC)that exceed its cost of

capital. For ROIC we useearningsbeforeinterestandtaxes, divided by the sumof networking capital andproperty, plant andequipment, less cash. Thatmeasure consistentlyexceeding the cost ofcapitalmeans thenet assetvalueis likelytogrowandthe business can be worthconsiderablymorethanthenetvalueofthoseassets.

—AriLevy,LakeviewInvestmentGroup

Speakingbroadly,probably10 percent of thebusinesses out there arelousy, such as selling purecommodities where themarginalcostofproductiondrives the pricing andcompaniesfinditveryhardto earn even the cost ofcapital over time. I may

ownsuchacompany fromtimetotime,butit'srare.At the other end of thespectrum are anothermaybe 10 percent ofbusinesses which are ofexcellentquality.Aperfectexample would be moneymanagement firms, whichin aggregate earn obscenereturnsonequity.We loveto own these types ofcompanies, but the

opportunities to buy themcheaply are relatively fewandfarbetween.So that leaves us mostoccupiedwith theother80percent, in which there's achanging roster ofwinnersand losers. Those changesin fortunes are typicallytied to cycles and howindividual companies aremanaged, which are thetypes of things we believe

we can analyze and judge.In a lot of our companies,justgettingbacktoaverageoperating performance canresult in excellentinvestmentresults.—PrestonAthey,T.Rowe

Price

We would love to owngreat businesses as muchas the next guy, but theproblem is finding themat

the right price. We'reperfectlyhappylookingforthe average company,where we think there'ssomething going onwhichthe market hasn'trecognizedthatcanmakeitbetter thanaverage.You'rerewarded asmuch for thatas for a good companybecomingverygood.Wedomakeeveryefforttounderstand what edge the

company has in facingcompetitive threats ormaintainingpricingpower.When that edge isn't clear,youhavetobeverycarefulabout the valuation youassign to the earnings andcash flow stream. Butbusiness quality, in and ofitself, isn't paramount toourdecisiontobuy.

—VincentSellecchia,DelafieldFund

We aren't obsessed withperfectionandquality. I'vemade some very niceinvestments in companiesthat were going fromterrible to bad or bad tofair.We're just looking forthe biggest mismatchbetween value and price—where those occur on thequality scale can changeovertime.

—CarloCannell,CannellCapital

Everything doesn't have tobe thenextMicrosoft—wemay invest in a companybecause the market thinksit's going to fail, and wedon't.

—LeeAinslie,MaverickCapital

When I talk about the

companies I invest in,you'll be able to rattle offhundreds of bad thingsaboutthem—butthat'swhythey're cheap! The mostcommon comment I get is“Don't you read thepaper?” Because if youread the paper, there's noway you'd buy thesestocks.They're priced where theyare for good reason, but I

invest when I believe theconditions that are causingthemtobepricedthatwayare probably notpermanent. By nature, youcan'tbeshort-termorientedwith this investmentphilosophy.Ifyou'regoingto worry about short-termvolatility, you're just notgoingtobeabletobuythecheapest stocks. With thecheapest stocks, the

outlooksareuncertain.Inmywhole career I haveyet to find the greatbusiness with a wonderfulmanagement team, highmargins, a dominantmarketpositionandall theconditions everybodywants, at a low price. Thestocks of such companiesdon'tsellatalowprice.IfIfind one, I'll cheer, but ithasn'thappenedyet.

—RichardPzena,PzenaInvestmentManagement

People often say theyemphasize the quality ofmanagement or thecompetitive moat of acompany, but the problemwith some of thosegeneralizations is thatcompanies with thoseattributesareveryoftennotattractively priced. Procter

& Gamble may today beconsidered one of best-managed companies in theworld, with some of thebest brand franchises andwith very low-risk equity,but if the stock is notattractive at the currentprice, none of the restmatters.—RicDillon,DiamondHill

Investments

I'm generally not obsessedwith quality. Good assetsbought at the wrong pricecanbeterribleinvestments,just as lousy ones boughtvery cheaply can generateexcellentresults.That anything is attractiveat a price might seemintuitively obvious, butmany investorsconsistently ignore it.People feel better in our

business when prices aregoing up, so youconsistently see buyerscomeinaftermarketshavebeen good, while peopletend to move to thesidelines and watch whenmarkets are bad. Peopleare, ingeneral,momentuminvestors, which iscompletely at odds withbeing a value investor andwhich can create

opportunitiesforthosewhoaredisciplinedandpatient.—JonJacobson,Highfields

Capital

THEVALUEOFGROWTH

A corollary issue to businessquality is the emphasis valueinvestors place on a

company's ability to grow.Distinctions tend to bemadein how heavily weightedgrowthisintheassessmentofvalueandintheconservatismwith which future estimatesare made, but avowed valueinvestors typically resistbeing labeledasunconcernedwith growth in assessing acompany'sintrinsicvalue.

***

Positioning value versusgrowth sets up a falsecomparison. They are notopposite ends of thespectrum—value investingand momentum investingare at opposite ends. Allelse equal, after a stockprice falls with no changein its estimated value, avalue investor will find itmore attractive. Amomentum investor reacts

intheoppositeway;apricedecline makes the stockless attractive, and viceversa.A value investor needs tobe able to assess thevalueof many businesscharacteristics, such asbalance sheet strength,cash-generating ability,franchisedurability,andsoon. Growth is also one ofthosefactors.Theabilityto

grow organically is almostalwaysapositive.Itwouldbe a negative only if thatgrowth required so muchinvestment that it had anegative present value.Thatalmostneverhappens.Ten to 15 years ago,investors were paying averyhighpriceforgrowth.Many stocks traded atbarely double-digit P/Es,but large-cap companies

that had above-averageexpected growth weretrading at 50 timesearnings and higher. Atthat spread, we believedgrowth was way tooexpensive, and it was aneasy choice to avoid it.More recently, valuationshave compressed,meaningthe price of growth hassharply fallen. When wecan get more growth

without having to pay forit, the choice againbecomesveryeasy.I see value investing asapplying a consistentdiscipline to a changingmarketplace. As the priceinvestors pay for growthbecomes excessive,applying our pricediscipline moves us awayfrom growth. As the pricefor growth declines, our

disciplinemovesustowardhigher-growthbusinesses.

—BillNygren,HarrisAssociates

I don't get overlyconcerned with how myportfolios are categorized.Our mutual fund wasoriginally called a valuefund, then it was a “core”fund,andnowitshowsupsometimes as a growth

fund. Through all that, wehaven't changed anythingwe do since day one—thenotion that growth is acreator of value is animportant part of how weinvest.—ChuckAkre,AkreCapital

Management

Peopleoftenmakeitsoundcomplicated, but investingis really all about

estimatingwhat somethingisworthandthenbuyingitatanattractiveprice.Eventhoughwehaveaclassicalvalueapproach—analyzingstocks as an ownershipstake in a business,calculatingintrinsicvalues,requiring a margin ofsafety—we don't callourselvesvalueinvestorsinany of our marketing orother communications.

Borrowing from WarrenBuffett, aswesooftendo,weseegrowthandvalueasall part of the sameequation—toseparatethemstrikesusaskindofdumb.There should be fairlybroad agreement thatwhatconstitutes value are acompany's discountedfuture cash flows—thegrowthinthosecashflowsis obviously central to

figuringthatout.—RicDillon,DiamondHill

Investments

We believe the mostimportantcontributortothelong-term investmentperformance of thecompanies we own isearnings growth, not achange in valuation.Because growth is drivenby earninghigh returns on

capital and successfullyreinvesting cash flow, wetend to be very long-terminvestors—our averageholding period runs aboutseven years—in order forthis virtuous process tobear fruit. Because of thatorientation,weputprimaryemphasis on marketstructure, the sustainabilityof the business'scompetitiveadvantage,and

management's track recordin creating shareholdervalueovertime.If you step back and thinkabout the basics of whatwe're doing, we'reinterested in companiesthat are better than theircompetitors and whichhave shown the ability totakethecashtheyearnanddosomethingsmartwithit.There's nothing earth-

shatteringaboutthat,buttotheextentyoucanapplyit,understand the businessdynamics and not payfoolish prices for things,there's no reason youshouldn't get the attractivelong-term returns webelieve we and ourpredecessors haveproduced.—EricEnde,FirstPacific

Advisors

When I started in thebusiness and for a longtime,my concept of valuewasabsolutevalueintermsof a price-earnings ratio.But I would say myconcept of value haschanged toamore relativesense of valuation, basedon the expected growthrate applied against theprice of the stock.

Something trading at 30×earnings that isgrowingat25 percent per year—where Ihaveconfidence itwill grow at that rate forsome time—can be muchcheaper than something at7× earnings growing at 3percent. Some people callthat GARP (Growth-at-a-Reasonable-Price)investing,I'dcallitvalue.Ithinkthat'sjustsemantics.

We'vealwayshadexcellentanalysts, and a goodanalyst is more adept atmaking judgments ongrowth. That's their job—based on the business andthe company's position init,howfastisthecompanygoing to grow? It's prettyhard to lose if you're righton the growth rates whenthe growth rates are high.In that 30× P/E company

growing 25 percent peryear, you'll be bailed outpretty quickly because inabout 21/2 years theearnings will double andthemultipleonthatwillgotoonly15×.—JulianRobertson,Tiger

Management

I'mavalueinvestor,whichsays Iwant tobuy50-centdollars,butgivenmyfirm's

predilectionforservingtheneeds of taxable investors,I also want that dollar totax-efficiently compoundin value over long periodsof time. That means thebusinesses I find attractivemusthavegreatcapacitytoreinvest, which is not allthatcommon.—ThomasRusso,Gardner

Russo&Gardner

In such a value-focusedworld,weneedtobeallthemore contrarian in ourviews. It also requiresadditional research focuson unique, future-potentialsituations that mighttraditionally have beencalledgrowthideas.Thisisjust a practical response.As defined in classicalGrahamandDoddterms,abargain-basementstockhas

a market capitalizationlower than its networkingcapital—current assetsminus current liabilities.The approximate numberof companies selling at adiscount to net workingcapitaltodayiszero.—MurrayStahl,Horizon

AssetManagement

Inmyexperience, it'sbeenmore important to be

involved with a powerfultrend with acceleratingpotentialreturnsthantogettoo hung up on valuation.That's not at all to sayvaluation doesn't matter,but there have been manytimeswhen I've been rightabout the trend but didn'tbuyaleaderbecauseitwas20 percent too expensiveand that turnedout tobeamistake.

—JohnBurbank,PassportCapital

Tome,investingsuccessis50 percent analyticalability and 50 percentunderstanding and playingoff the market'spsychology.Weareseriousstudentsofmacroeconomicinfluences and trends, andare most interested whenindustrysectorsthatshould

benefit from majordemographic,technological,oreconomicshiftsareoutoffavor.

—RalphShive,WasatchAdvisors

If you're looking, as weare, for extraordinaryreturns—from companieswhose stocks can go up10×ratherthan2×—it'sfarmore likely to happen

because the company'searnings turn out to be somuch better than anyoneexpected than because youfound a temporary 50-centdollar.—JohnBurbank,Passport

Capital

I'm looking foropportunities in which Ihave a differentiated viewon forward earnings,

preferably revenue-driven.Yougenerallymakemoneyin three ways on the longside: your estimates arehigherthantheStreet'sandthe consensus moves toyournumbers,theearningsgrow, or the earningsmultiple expands. By andlarge, themultipleis likelyto expand the most insituationswhererevenueisaccelerating.

—JedNussdorf,SoapstoneCapital

I tend to look atmultiplesin absolute terms and amquite comfortable with 12to 13× multiples of netincome when I believethere's an opportunity forfastergrowthinearnings—for clearly defined reasons—thanthemarketexpects.Idothinkit'sdangerousto

lockyourselfintorules.Somany people miss out ongreatopportunitiesbecausea stock only gets within aquarter point of their pricetarget. I try to avoid beingoverlyrigid.—ThomasRusso,Gardner

Russo&Gardner

While price obviouslymatters, if we're right onthebigpicture,Idon'tneed

a screaming bargain to dowell—compounding valuecancoverupalotofsins.—ThomasGayner,Markel

Corp.

We have learned fromexperiencethatthecredibleexpectation of intrinsic-value growth is a helpfulguard against value traps.We'd rather own a full-priced business with

potential 15 percent peryear intrinsicvaluegrowththan something at a 30percent discount that hasnogrowth.Themathworksin your favor. Ideally, ofcourse, we're shooting forboth the growth and thediscount.—SteveMorrow,NewSouth

Capital

I've read that the average

holdingperiodontheNewYork Stock Exchange isninemonths,which Idon'teven consider investing.Oversuchashortperiodoftime you're just betting ontheoveralldirectionof themarket or on the nextquarterly earnings. Itypically don't even makequarterly projections, butget excited when I seeexcellent growth potential

over time for which I'mpaying next to nothingbecause the market isignoringit.—AaronEdelheit,Sabre

ValueManagement

Many value investors areprimarily focused on priceand valuation, which weobviously think areimportant, but we alsobelieve that when

constructing a portfolioyoushouldhavecompanieswith promise beyond justgoing fromundervalued tofairlyvalued.Basic-value stocks makeupabout40percentof theportfolio [and] consistentearners, blue-chipcompanies that tend tohavelongrecordsofsteadyorganic revenue and profitgrowthbuteveryonceina

whilebecomeoutoffavor,also make up around 40percent of the portfolio.Thelastcategorywetrytoown are emergingfranchises, which aretypically youngercompanies with excellentgrowth prospects. Becausethey often have a narrowproduct lineup, they falloutoffavorwhenoneorafew important products

suffer from inevitablehiccups in growth. I oftensay the only smallcompanywewanttobuyisone that can become a bigcompany—that's whatwe're looking for inemergingfranchises.—WilliamFries,Thornburg

InvestmentManagement

We tend to like equityideas that have almost

bond-like qualities, wherecashisbeinggeneratedinafairly predictable way andbeing used to pay downdebt or return capital toshareholders throughdividends or stockbuybacks. Companies ingrowth mode, reinvestingall of their cash, are morelikezero-couponbondsandaremoredifficult forus toget our hands around. It's

not thatwenever invest ingrowth ideas, but it's notourfocus.—MitchellJulis,Canyon

Capital

We expect to generate thevastmajorityofourreturnsnot from thegrowth in thevalue of the business, butfrom the unwinding of thevaluediscount.We'remorethan happy to see growth

potential andwe recognizehowvaluableitcanbe,buthigher-growth businessestypicallyexposeustomorevaluation risk than we'recomfortablewith.

—DavidSamra,ArtisanPartners

THEVALUE

MINDSETWhile the success of anyinvestment strategy bearsheavily on the intelligenceand technical skill of itspractitioners, value investorsalsobelieve theircompetitiveadvantage rests upon theuniqueandmultifacetedvaluemindset they possess. It's anattitudeasmuchasastrategy,born more than bred, and

indispensible to their abilitytooutperformovertime.

***

Starting with the firstrecorded and reliablehistorythatwecanfind—ahistory of thePeloponnesian war by aGreek author namedThucydides—andfollowing through a broad

array of key historicalglobal crises, you seerecurringaspectsofhumannature that have gottenpeopleintotrouble:hubris,dogma, and haste. Thekeys to our investingapproach are thesymmetrical opposite ofthat: humility, flexibility,andpatience.On the humility side, oneof the things that Jean-

Marie Eveillard firmlyingrained in the culturehere is that the future isuncertain. That results ininvesting with not only apricemarginof safety, butin companies withconservativebalancesheetsand prudent and provenmanagement teams. If youacknowledge your crystalball is at best foggy, youfollow the advice of Ben

Grahamandinvesttoavoidthelandmines.In terms of flexibility,we've been willing to beoutofthebiggestsectorsofthemarket,whether itwasJapan in the late 1980s,technology in the late1990sorfinancialsthelate2000s. That wasn'tnecessarily because of anyparticular gift of foresight,but reflected a recognition

that each of those areasembodied very widelyaccepted and highexpectations. It's painfulandnotsociallyacceptableto be out of the mostrevered sectors of themarket, but those types ofactsofomissionhavebeena key contributor to thestrongperformance.The third thing in termsoftemperament we think we

valuemorethanmostotherinvestors is patience. Wehave a five-year averageholdingperiod.Particularlyin a volatile market liketoday's,peoplearetryingtozigandzagaheadofeverymarket turn that they'rehoping they can forecastwith scientific precision.We like toplant seedsandthenwatch the trees grow,and our portfolio is often

kind of a portrait ofinactivity. That's kept usfrom making sharp andsometimes emotionalmoves that we eventuallycometoregret.—MatthewMcLennan,First

EagleFunds

The key to the success ofvalue investing is that it isbasically contrarianinvesting. How can you

buy something at a valueprice if it's desired by theworld? Investors goout oftheir way to look forcompanies with certaincash flow characteristics,returns on assets that arestable and that haveobjectively verifiabletangible assets that couldbeliquidatedatsomepoint.If that's going to be thefocus for literally

thousandsoffunds...howcould you possibly haveoutstanding results by justdoingthesamething?—MurrayStahl,Horizon

AssetManagement

It's important to play toyour strengths. As aninvestor, I'm not a home-runhitterandcan'tthinkofalotofsecuritiesonwhichI've made 10 times my

money. But I also can'tthinkof a lot of securities,post-1970, on which I'velost a meaningful amountof capital. Success ininvesting is not reallymuch more complicatedthanthat.

—SpencerDavidson,GeneralAmericanInvestors

It'shardformostpeopletograspthatagreatcompany

isnotalwaysagreatstock,andthatagreatstockisnotalways a great company.Value works becauseyou're consistently payinglesstogetmore.Overtimethatworksalotbetterthanpayingmoretogetless.—JamesO'Shaughnessy,

O'ShaughnessyAssetManagement

Going against the grain is

clearly not for everyone—and it doesn't tend to helpyouinyoursociallife—butto make the really largemoney in investing, youhave to have the guts tomake the bets thateveryone else is afraid tomake.—CarloCannell,Cannell

Capital

Our worst mistakes have

been far more likely aresult of our being afollower rather than aleader. We've been muchless successful buying intostories that are out therealready than ones thatwe're anticipating inadvance.

—SamIsaly,OrbiMedAdvisors

It's important to remember

asacontrarianinvestorthatthe consensus is oftenright. My colleagueFrançoisSicartlikestosay,“Just because everyonesays it's raining outside isno reason not to take anumbrella.”Butbecausewebelieve the consensus ispriced into any giveninvestment, going alongwith that is a very hardplace fromwhich tomake

money.—RobertKleinschmidt,

TocquevilleAssetManagement

Value investors tend tohave a different defaultquestion in looking at apotentialopportunity.Mostinvestment managers ask“Can I own this?”—towhich the answer isgenerally yes. Value

investors put a differentburden of proof on everyidea by asking, “Whyshould I own this?” Thatdegree of skepticism is avaluabletrait.—JamesMontier,Société

Générale

We do tend to be a littledour at times and wedefinitely take a skepticalview of the facts. Warren

Buffett once said, “Youpayaveryhighpriceforacheery consensus.” Valueinvestors simply don'tbelieve in cheeryconsensus. That's not acriticism—I'd consider it abadgeofhonor.

—DanielBubis,TetremCapital

Most investors takecomfort from calm,

steadily rising markets;roiling markets can driveinvestor panic. But theseconventional reactions areinverted. When all feelscalm and prices surge, themarketsmayfeelsafe;but,in fact, they are dangerousbecause few investors arefocusingonrisk.Whenonefeels in the pit of one'sstomach the fear thataccompanies plunging

market prices, risk-takingbecomes considerably lessrisky,because risk isoftenpricedintoanasset'slowermarket valuation.Investment successrequires standing apartfromthefrenzy—theshort-term, relative performancegame played by mostinvestors.

—SethKlarman,TheBaupostGroup

Whatyoushoulddoistakea dimviewofwhat's beenappreciating and beinterested in what hasn'tbeen good to you. Youcertainly want tounderstand why any assetclasshasbeengoingdown,but you should celebratethe fact that it has beengetting cheaper. To saypricegoingdownisagood

reason to look the otherway is like saying you'dnever go shopping whenstoresarerunningsales.—HowardMarks,Oaktree

Capital

We're classic valueinvestors in the sense thatwhensharepricesare low,we think risk is low aswell. Most people canunderstand that in theory

but don't believe it inpractice and even act as ifit's heresy. It's actuallywhen prices are rising andstocksare convergingwithour share-price targets thatwe find risk far moreuncomfortable.—SarahKetterer,Causeway

Capital

Someone asked me theother day whether

watching what was goingon [in troubled markets]felt lousy, and of course itdoes.Butyoucanonlybuyquality cheapwhen peopleare afraid. We earn ourkeep much more indifficultmarketsthanwheneverybody's serene andhappy.

—DavidHerro,HarrisAssociates

I'm perfectly fine if Mr.Market wants to go downanother15to20percent—we'll justbuymore stocks.It'snotduringupyearsthatgreat investment trackrecordsaremade!

—CharlesdeVaulx,InternationalValueAdvisers

The market is extremelynoisy,butyoujustcan'tletthatdistractyoufromyour

discipline and yourframework.We'vesaidthissince we started out: Themarket is really just apendulum that foreverswings betweenunsustainable optimism,which makes stocks tooexpensive, and unjustifiedpessimism, which makesthem too cheap. All we'retryingtodoiskeepalevelhead, sell to the optimists,

and buy from thepessimists.—JonathanShapiro,Kovitz

InvestmentGroup

Warren Buffett is rightwhen he says you shouldinvest as if the market isgoing to be closed for thenext five years. Thefundamental principles ofvalue investing, if theymake sense to you, can

allow you to survive andprosper when everyoneelseisrudderless.Wehavea proven map with whichtonavigate. It soundskindof crazy, but in times ofturmoil in themarket, I'vefelt a sort of serenity inknowing that if I'vecheckedandrecheckedmywork, one plus one stillequals two regardless ofwhere a stock trades right

afterIbuyit.—SethKlarman,TheBaupost

Group

When you have a modelyou believe in, that you'veused for a long time andwhich is more empiricalthanintuitive,stickingwithit takes the emotion awaywhen markets are good orbad. That's been a centralelementofoursuccess.It's

the emotional dimensionthat drives people tomakelousy,irrationaldecisions.

—WillBrowne,Tweedy,BrowneCo.

I like to say that changinginvestment styles to thelatest fad produces thesame results as changinglanes during rush-hourtraffic jams: You increasetheriskofanaccidentwith

little chance of achievingbetter results. Thepsychological pain ofsticking to your guns,though, is tough. Iwas up35percentin1999buthadpeople telling me I didn'thaveenoughtechnologyinmy fund and they weretaking money out. This isnot nuclear physics, but[it's] hard to stick to yourguns when the crowd's

runningoveryou.Wedon'tbelieve value investing isever out of style—it justdoesn't work all of thetime.—RobertOlstein,Olstein

CapitalManagement

Therealsecrettoinvestingis that there isnosecret toinvesting. Every importantaspect of value investinghasbeenmadeavailableto

the public many timesover, beginning with thefirst edition of SecurityAnalysis. That so manypeople fail to follow thistimeless and almostfoolproofapproachenablesthose who adopt it toremain successful. Thefoibles of human naturethat result in the masspursuit of instant wealthand effortless gain seem

certain to be with usforever. So long as peoplesuccumb to this aspect oftheir natures, valueinvestingwill remain, as ithas been for 75 years, asound and low-riskapproach to successfullong-terminvesting.

—SethKlarman,TheBaupostGroup

It is occasionally possible

for a tortoise, content toassimilate proven insightsofhisbestpredecessors, tooutrun hares which seekoriginalityordon'twish tobe left out of some crowdfolly which ignores thebestworkof thepast.Thishappens as the tortoisestumbles on someparticularly effective wayto apply the best previouswork, or simply avoids

standardcalamities.Wetrymore to profit by alwaysremembering the obviousthan from grasping theesoteric. It is remarkablehow much long-termadvantage people like ushavegottenbytryingtobeconsistently not stupid,insteadoftryingtobeveryintelligent.—CharlieMunger,Poor

Charlie'sAlmanack

In a world in which mostinvestors appear interestedin figuring out how tomakemoney every secondandchasetheideadujour,there's also somethingvalidating about themessagethatit'sokaytodonothing and wait foropportunities to presentthemselves or to pay off.That's lonely and contrary

a lot of the time, butreminding yourself thatthat'swhat it takes isquitehelpful.

—SethKlarman,TheBaupostGroup

One investor who hasgreatlyinfluencedmefroma conceptual standpoint isHoward Marks, theChairman of OaktreeCapital.He's not an equity

investor, but he describesthis notion of running acore strategy, focused onbeating themarket throughthe accumulation of smallbut high-probabilityadvantages over a longperiod of time. Thealternative,which can alsobe a legitimate strategy, isto swing for the fenceswith the goal of hittingenoughhomerunstodrive

outstanding performance.The high-probabilityapproachisconsistentwithmypersonality.

—ZekeAshton,CentaurCapital

I feel strongly thatattempting to achieve asuperior long-term recordbystringing togethera runof top-decile years isunlikely to succeed.

Rather, striving to do alittle better than averageevery year, and throughdiscipline to have highlysuperior relative results inbadtimes,is:(1)lesslikelyto produce extremevolatility; (2) less likely toproducehuge losseswhichcan't be recouped, and (3)most importantly, morelikelytowork.—HowardMarks,Oaktree

Capital

Oneofthetemptationsofaprofessionalinvestoristhatoneisoftendrawntowardsdifficult analyticalproblemsinsearchofabigpayoff. If anything, thistemptation has beenamplified in recent yearsby the acclaim andfinancial rewards thathaveaccrued to those who end

up on the right side of abig, dramatic bet – themore complex, the better.The problem is that suchsuccessishardtomaintain,hard to predict, andgenerally creates furtherpressure to find similarlydifficult, large-scalemispricingopportunities toexploit in the future. Suchopportunities may not beavailablemostof the time,

which may explain whymany of those investorswho get thingsdramatically rightoneyearfind themselves getting itdramatically wrong thenext.Attheendoftheday,being consistently smarterthan the rest of themarketis probably next toimpossibletodo.

—ZekeAshton,CentaurCapital

I don't think being a valueinvestor is something youcan learn. You can learnhow to be better at it andtheanalyticalsupportforit,but you can't sit there andsay,“I'mgoingtomakeanintellectual decision thatI'm going to become avalue investor.” Mypersonal belief is thatyou're either born as a

bargain-hunter type oryou're born as a bright-eyedoptimist.Youhavetobe skeptical andpessimistic, and you havetoreallyenjoythebargain-huntingprocess, and ithasto be part of your wholelife. I find that the peoplewhoarethebestatthisarethetypeofpeoplewhoareabsolutelythrilledtofindapair of shoes for $20 that

they couldhavepaid$150foratadepartmentstore.

—RichardPzena,PzenaInvestmentManagement

Some of the best earlyadvice I got was to forgetall I'd learned in businessschool about efficientmarkets and instead readBen Graham. You eithertaketoitoryoudon't,andIknew right away that this

washowIwantedtodoit.—PremWatsa,Fairfax

Financial

We consistently articulatetwo goals—to achievepositive returns and tooutperform the market. Ifyou aren't going to makemoney owning our mutualfund, then there's no pointin buying it. And if youaren't going tomakemore

money than you wouldhave in an index fund,we'renotworthourfees.Attheendof2010Ilookedat the previous decade forthe Oakmark Fund, to seein how many quarters wecouldtellourinvestorsthatwe both made money andthatwemademeaningfullymore—which I defined as100 basis points—than theS&P 500. Of the 40

quarters, only eightqualifiedaswinners.That'slike hitting .200 inbaseball,justoneoutawayfrom a ticket to the minorleagues.For those 10 years,however,thefundreturned74 percent, versus 15percent in total return forthe S&P 500. So eventhoughweweremostoftenfrustrated because we lost

money or didn't make asmuch as somebody else,overthatperiodwebeat96percentofcompetingfundsand did more than 400basispointsbetterperyearthanthemarket.Thattomeis kind of the essence ofvalue investing. We oftendon't keep up with strongmarkets,butmakeupforitby losing less duringmarket declines.

Expectations forcompanies we own aretypically quite low, whichmeans they don't usuallyfall asmuchas themarketdoeswhentimesgettough.Itisalimitedsetofpeoplewho have the personalityand discipline tosuccessfully invest thisway.Iguessthat'swhywecancontinuetoputfoodonthetable.

—BillNygren,HarrisAssociates

Value investing strategieshaveworked foryearsandeveryone's known aboutthem. They continue towork because it's hard forpeopletodo,for twomainreasons. First, thecompaniesthatshowuponthe screens can be scaryand not doing so well, so

people find them difficultto buy. Second, there canbeone-, two-or three-yearperiods when a strategylikethisdoesn'twork.Mostpeople aren't capable ofstickingitoutthroughthat.—JoelGreenblatt,Gotham

Capital

Ifyouareavalueinvestor,you'realong-terminvestor.If you are a long-term

investor, you're not tryingto keep up with abenchmarkonashort-termbasis. To do that, youaccept in advance thatevery now and then youwill lag behind, which isanotherwayof sayingyouwillsuffer.That'sveryhardto accept in advancebecause, the truth is,humannatureshrinksfrompain. That's why not so

many people invest thisway.But if you believe asstrongly as I do that valueinvesting not only makessense, but that it works,there's really no crediblealternative.

—Jean-MarieEveillard,FirstEagleFunds

PARTOne

FieldofPlay

CHAPTER2

CircleofCompetence

In a 1989 Fortune articleprofiling 10 young moneymanagers—under the title

“Are These the NewWarrenBuffetts?”—MarshallWeinberg, of the brokeragefirmGruntal&Co., recallsadinner in Manhattan he hadwithBuffetthimself:“Hehadan exceptional ham-and-cheesesandwich.Afewdayslater, we were going outagain and he said, ‘Let's gobacktothatrestaurant.'Isaid,‘Butwewere just there,' andhesaid, ‘Precisely.Whytake

ariskwithanotherplace?Weknow exactly what we'regoingtoget.'AndthatiswhatWarren looks for in stockstoo. He only invests incompanieswheretheoddsaregreat that they will notdisappoint.”This anecdote says a great

deal about a core tenet ofsuccessful investing:combining an understandingof what Buffett calls your

“circle of competence” withthe discipline to remainwithin itsboundaries.There'scertainly no one right circleof competence to have, norshould it remain static overtime. But when successfulinvestorstalkaboutideasthathave gone awry, one keyreason often cited has beenventuring into an industry,company,ormarket situationwith which they don't have

experienceordon'tyethaveafullcommand.Enoughcangowrong even when you're inthe center of your circle ofcompetence,whyincreasethechance of mishap byoperatingoutsideofit?Regardlessofhowbroador

narrowtheirfieldofplay,thebest equity investorsareableto articulate clearly wherethey expect to find investingopportunity and why. This

circle-of-competencedefinition includes thecharacteristics of companiesof interest, with respect tosuch things as their size,where they operategeographically,theirbusinessmodels, and the industry orindustries in which theycompete. It also includes thesituations that the investorhas found can lead topotential share mispricing,

such as where a company isin its evolution, where anindustry is in its cycle, andwhen a company or industryis likely to be neglected ormisunderstood. All of thisinforms where the investorwill—and won't—look forideas, and the tactics he orsheusestogeneratethem.Inan interview in2009we

asked Julian Robertson, thefounderofTigerManagement

and one of the mostsuccessful hedge fundmanagers of all time, whatadvice he might have forstudents interested inpursuing an investing career.He spoke about them gettingexperience working with thebest investors possible, andaboutlearningtofocus:A baseball player neverreally gets paid, nomatterhow many homeruns he

hits or what his battingaverage is, unless he getsto the big leagues. Thenhe's guaranteed tomake alot of money. But in thefundbusinessyoucan findaminor league where youcan hit for a betteraverage, because that'swhatyou'repaidon.IrememberoneofourguystakingusintoKoreaintheearly 1990s, and the

market was so inefficientthat it was a gold mine ifyou knew what you weredoing. One of our Tigerfunds today focuses ongold—a league that isinhabited by some of thecrazier investors out there—and it just has aphenomenal record. Theyknowmoreaboutgoldthananyone else in the worldand they just kill all the

rest.My point is that to besuccessful in this business,youdon'thavetobebetterthan everybodyeverywhere, just betterthan everybody in theleague in which you play.It's maybe today moredifficult to find thoseinefficient areas, but it'snotimpossible.This section assembles the

myriad answers the bestinvestors givewhen asked toexplain where they look foropportunity and to justifywhythey'vechosenthefocusthey have. Again, it'simportant to keep in mindthat there isnonarrowsetofright answers here. Whatmatters is that some level ofclearfocusexistsandthattherationale behind it is sound.From there, it's all about

execution.

THERIGHTSIZE

One of the most basicdistinctionsinvestorsmakeindefining their field of playconcernscompany size.Howbigacompanyiscansayalotabout its complexity, thesustainability of its business

model,howactivelyfolloweditis,thevolatilityofitsstockprice, and why it might bemispriced. Practical concernscanobviouslycomeintoplay:Amanagerwith$5billion inassetswill find itmuchmoredifficulttoinvestinmicrocapstocks—where he or shemight have to own 100percent of the company inorder to take a position sizethat is material to his

portfolio—thanwill someonemanaging $50 million. Butmanagers typically canidentify their sweet spot interms of market cap, or,alternatively, should be ableto explain why they'reagnosticonthepoint.

***

Our strategy from thebeginning has been to

focus on areas where webelieve we can have someadvantage,wherethereisagreater prevalence ofirrationality and higherlikelihood of mispricedassets. For us, that's notgoing to be investing inMicrosoft or in somequantitative strategyagainst a room full ofGoldman Sachs' PhD'swithCray supercomputers.

We have to be guerrillainvestors, lying in theweeds and picking offopportunities among theobscureandmundane.That usually means small,ignored companies that noone else is talking about.We'll invest in companieswithup to$1billionor soin market cap, but havebeen most successful inideas that start out in the

$50millionto$300millionrange. Fewer people arelooking at them and theindustries the companiesare in can be quite stable.Given that, if you find acompany doing well, it'smore likely it can sustainthat advantage over time.We can also take asignificant-enough stake inany company that, ifnecessary,we can have an

impactonhowit'srun.—JamesVanasek,VNCapital

My basic premise is thatthe efficient marketshypothesis breaks downwhen there is inconsistent,imperfect dissemination ofinformation. Therefore itmakes sense to direct ourattention towards the14,000 or so publiclytraded companies in the

U.S. for which there islittle or no investmentsponsorshipbyWallStreet,meaning three or fewersell-side analysts whopublishresearch.Money ismade in the dark, not thelight.You'dbeamazedhowlittlecompetitionwehaveinthisneglected universe. It isjustnot in thebest interestof the vastmajority of the

investing ecosphere tospend 10 minutes on thecompanies we spend ourliveslookingat.IconsidermyselfbetteroffbuyinganindexfundoranETF rather than trying tofigure out how to ownJohnson & Johnson orCoca-Cola or Exxon, veryhigh-quality companieswith dozens of analystsfine-tuning their estimates

bythepennyeveryweek.IloveCoca-Colaandfinditsfinancial characteristics tobe outstanding, but howcan I have an edge inbuying and selling itsstock?Howcansomethinglikethateverbeafatpitch?Iwouldpointoutthatmostignored companies are notinvestable, either becausethey're not really public orare just complete garbage.

Butwithinthatfleamarketis where you find thegreatest bargains, so wetroll through it to find thesmall percentage ofcompanies thatare ignoredforimproperreasons.—CarloCannell,Cannell

Capital

I accept the propositionthat public markets aremost of the time efficient

in pricing large-capcompanies, but I've neverbelieved there wassufficient trading volumeor research coverage ofvery small companies tomake their prices similarlyefficient. So it ought to atleast be theoreticallypossible for an investor inmicrocaps to have aninformational advantage.We focus on companies

withanaveragemarketcapof $400 million, whicheither don't have WallStreet coverage or thevalue-added of thatcoverage is, shall I say,modest. It can turn yourstomach,butwealsoseeitas an opportunity thatfrequent imbalances ofsupply and demand in thestocks we follow arecapable of producing

enormouspriceswings.WefoundRogerIbbotson'srecent study of the impactof investors'preferenceforliquidity to be quiteconsistent with ourexperience. He's doneseminal research on thesuperior performance overtime of small-caps overlarge-caps and of valueinvesting over growthinvesting, but in this case

he found going back over40 years that investorsoverpay so much for theperceived safetyand lowerfrictional costs of liquidstocks that theopportunities to earn gainsin the less-liquid stockstheyneglectaresignificant.One could certainly arguethattheextremeincreaseinmarket volatility thatstarted in 2008 has

exacerbated thisinefficiency.—DavidNierenberg,D3

FamilyFunds

The potential value addedby the research into amicrocap company issubstantiallygreater.Ihavea lot less competition. I'malso much more able tospeak directly with theCFOorCEO,whomaynot

beaspolished in thewaysofWallStreetandmightbemore open andforthcoming about theirbusiness.Allofthatmakesit easier to uncover newand previously unknownfacts, which can be animportantedge.

—PaulSonkin,HummingbirdValueFund

We focus on smaller-cap

companies that are largelyignoredbyWallStreetandface some sort of distress,oftheirownmakingorduetoanindustrycycle.Thesecompanies are more likelyto be inefficiently pricedand ifyouhaveconvictionand a long-term view theycan produce not 20 to 30percent returns, butmultiplesofthat.—RobertRobotti,Robotti&

Co.

Our process is meant toidentify where short-termfears have createdinefficiencies in pricing,and as you go down inmarket cap, the marketreactions get moreextreme.Because somanypeopleare lookingat largecaps, when a stock getseven a little undervalued

the market tends to takeadvantageofthat.Ifyou'reinvesting on bad news, it'sbest to look where theoverreaction on thedownside is the biggest,and that's more often insmallcaps.—CanonColeman,Invesco

I'malsonotgoingtospendany time trying to figureout what a conglomerate

like General Electric isworth. Too many movingparts, and there are somany other people whohavetoownitthatit'sveryunlikely it will bedramatically mispricedanyway.

—ZekeAshton,CentaurCapital

In the same year I startedmy firm, 2000, I read

David Swensen'sPioneering PortfolioManagement. He talked alot about how institutionsusing a multi-managerapproach ought to findmanagers who concentratecapital in their best ideasand who look off thebeaten path to produceabove-averageresults.Thatdovetailed perfectly withwhat we thought made

sense anyway: Themarketgetslessefficientasyougodown the market-capspectrum, so running aconcentrated portfolio ofaround 12 stocks in theleast-efficient segmentswould offer the bestopportunity to produceabove-average returns.Westarted out primarily inmicrocaps, which wedefine as $300 million in

market value or less, andhave since started a small-cap strategy as well,investing in companieswith up to $2 billion inmarketcap.

—BrianBares,BaresCapital

We believe we cangenerate alpha in smallercompanies in part becausethemarketoveremphasizesthe income statement and

underemphasizes thebalance sheet in valuingthem. We try by focusingfirstonthebalancesheettotake out some of the riskthat comeswith relying soheavily on inherentlyunpredictable futureprospects.—BruceZessar,Advisory

Research,Inc.

Maybe the biggest reason

small companiesoutperform is just theirentrepreneurial nature.We're almost alwaysmorecomfortable investingbehind management withsignificant ownership inthe business than in bigcompanies where that'srarelythecase.

—WilliamNasgovitz,HeartlandAdvisors

We stick primarily tosmallercompaniesbecauseif we can't speak withsenior management on aregular basis, we aren'tinterested.Otherwisewe'rejust playingwith numbers.We've always focused onsmallcaps,butwhatmakesthemevenmoreinterestingtoday is thatsell-sideWallStreet research has neverbeen worse. Everyone has

cut back on research staff,which means more andmore companies areignored or getting verysuperficial work done onthem. I was reading ananalyst report over theweekend where the pricetargeton thecompanyhadgonefrom$6to$16,butasfarasIcouldtellnothingatallhadchanged.Theworsethe research, the better the

chance we find somethingthat'sbeingoverlooked.—CandaceWeir,Paradigm

Capital

Multiples tend to contractfurther when smallcompanies mess up thanwhen large ones do, sothere's more room on theupside when a smallcompany grows out of aturnaround. I'd also argue

that it's generally quickerand easier for a smallcompany to be turnedaround, which improvesyourchancesofinvestmentsuccess.—KevinO'Boyle,Presidio

Fund

In my second year atColumbia I took BruceGreenwald's valueinvesting class, and on the

first day he showed us atable from Eugene Famaand Kenneth French'sfamousJournalofFinancepaper called “The Cross-Section of Expected StockReturns.” The tableshowed how low-price-to-bookstocksandsmallcapstendedoverlongperiodsoftime to outperform themarket as a whole. Thewhole idea made so much

sense tome that I decidedthatwasthebasicdirectionIwantedtogo.

—PaulSonkin,HummingbirdValueFund

I'm never going to run $1billion while sticking withthese teeny-weenycompanies. That suits me,because I much prefermanaging a portfolio tomanagingthestaffI'dneed

with a lot more assets.Most important, though, isthat I just love the thrillofthe hunt involved withthese types of companies.Whygivethatup?

—PaulSonkin,HummingbirdValueFund

Small-cap investingcanbemorelaborintensiveduetothe sheer number ofcompanies,butatthesame

timeyoucanmorequicklyknowjustabouteverythingyou need to know about acompany to make aninvestment judgment. Ican't say that in lookingata company like AIG, forexample.—PhilipTasho,TAMRO

Capital

We're looking for theprospectof anaccelerating

rate of positive change.Thatmeanswe'renaturallydrawn to managementchanges, turnarounds, or,more generally, tosituationsinwhichchangesin the macroeconomic,competitive or regulatorylandscape require acompanytoremakewhatitdoesorhowitdoesit.Thatstrategyisparticularlytailored to small caps.

Simpler business modelsare easier to analyze andcross-check, while at thesame time change happensfaster in small companies,makingformoreinvestableinflection points. One ortwopeoplecanalsomakeabigdifference,quickly.—MarikoGordon,Daruma

CapitalManagement

The traditional reason for

looking at a small-capstock,which is less liquid,less known, and thereforetheoretically riskier, isbecause it cangrow faster.Whathappensasaresultisthat people crowd into thesame 200 names that arerock-star growers, leavingaside a large number ofsmaller companies thatmay still have excellentprospects but fall between

thecracks.Wehavealwaysbeen about finding thosetypes of companies andlearned throughexperienceearly on that (1) youwanttoinvestincompanieswithgreat balance sheets; (2)you want to take a long-term view; (3) the priceyou paymatters a lot; and(4) you have to bediversified. To be good atit you have to focus on it,

so we believe our edge isin bringing a formidableamount of knowledge andexperience to a part of thestock market that is notalways well understood oreffectivelyfollowed.—WhitneyGeorge,Royce&

Associates

For quality-of-businessreasons, we now focus oncompanies with between

roughly $1 billion and $8billion in market cap. The$500 million company isunlikelytohaveasglobalafootprintandasdiversifieda customer base as wewant, and the businessgenerally is less matureand more volatile. We'veinvested successfully insmallercompaniesovertheyears, but it can be morehair-raising than I'm

comfortable with at ourcurrentassetsize.We avoid the biggestcompanies because wewanttoeliminatethe“whatyoudon'tknow”risk.Withbiggercompaniestherecanbemanydifferentbusinessunits with distinctlydifferent trajectories,makingithardertoidentifythe core engine that trulydrives the bottom line.

There's also just a greaterpossibility that you misssomething important, likeenvironmentalliabilities,orunderfunded multi-employerpensionplans,orwork rules ina region thatlimit your ability to sellbusinesses.—JeffreyUbben,ValueAct

Capital

I do believe mid caps to

some extent offer the bestof both worlds. They'reusually not as wellfollowedas largecapsandby the rule of largenumbers can have longergrowth runways. At thesametime,they'rebroader-based and therefore lessvolatile than small caps,withbetter liquidity. I alsothinkit'sbeenanadvantagethat the investing world

seems more focused onsmall-cap or large-capexposure,leavingmid-capsrelativelyneglected.

—TomPerkins,PerkinsInvestmentManagement

Oursweetspot tends tobein small and mid-sizecompanies thatoftenaren'tparticularly well followedbyWallStreet.Itwouldbeillogical for us to knowor

uncover something aboutProcter&GambleorTexasInstruments before 100smart analysts did. I'd addthat as brokerage firmshave gone out of businessor cutbackon thenumberof companies they follow,it's not as if we need tofocus on tiny or newcompanies to find thosethat are relatively ignored.You can find plenty of

established, decent-sizedcompanies that just don'tgettheattentionfromWallStreetthattheyoncedid.

—DennisDelafield,DelafieldFund

We try to be cap-agnostic,butwedowantbusinessesthat are easier tounderstand, and smaller tomid-size companies aregenerally easier to

understand. They havefewerdivisionsandwecanusually get more of ourquestions answered. Ourmedian market cap in thefundisaround$5billion.

—StevenRomick,FirstPacificAdvisors

Wegenerallywant to ownonly those things that canbe bought out. Thatnumber keeps getting

bigger, but it does tend tokeep us out of the verybiggestnames.

—ChristopherBrowne,Tweedy,BrowneCo.

Oursweetspot tends tobein companies with marketcaps from $1 billion to $5billion. Illiquidity insmaller-cap companies isfine for a portion of yourbook, but it's nice to have

the ability to change yourmind and more easily sellif things don't develop asyou hoped. The largestcompaniescancertainlybemispriced, but our abilitytocreateananalyticaledgegiventhenumberofpeoplelooking at them is morelimited.—BrianFeltzin,Sheffield

AssetManagement

The high-qualitycharacteristics we look forincompaniestoownattherightpricetendmoreoftento be in large-caps thansmall-caps.We agreewithall the arguments thatsmall-caps may benefitfrom persistent marketimperfections thatcan leadto thembeingmispriced—whichisonereasonwelikethem—but the fact is that

large-caps meeting ourcriteria getmispriced fromtime to time as well.Maybetheinefficiencyhasa different trigger, butwhatever the reason,we'regladitexists.—C.T.Fitzpatrick,Vulcan

ValuePartners

It ishardforustohaveanedge in analyzingMicrosoft's or Intel's

business,butwedobelieveit's possible throughunderstanding macrotrends and marketpsychology—and throughtheuseofaclearvaluationdiscipline—tobuyeventhemost widely followedcompanies when they'reout of favor and sell themwhen they're too highlyregarded. If Intel'shistoricalvaluationrangeis

between 12 and 25 timesearnings, with disciplineand patience there shouldbe opportunities to buy atthe low end of that rangeandtosellat thehighend,making goodmoney alongtheway.

—RalphShive,WasatchAdvisors

Wegravitatetowardlarger,diversified companies

where the inefficientpricing comes from anexcessive focus on short-term issues thatwe expectto mean-revert. If we'rewrong, in a big companyour downside risk islimited because there areother parts of the businessthat can hold up value orevenincreaseoverallvalueif we bought cheaplyenough. Inmy experience,

if we're wrong with asmaller company focusedon one product or onegeography, there's toomuch risk it's going tozero.

—DanielBubis,TetremCapital

I build an earnings modelfrom scratch for everymaterial position in thefund,whichisthebestway

to understand the keydriversof thebusinessanditsprofitability.I'mlookingforopportunitiesinwhichIhave a differentiated viewon forward earnings,preferably revenue-driven.By focusing on better-followed mid-cap andlarge-capstocks,Icanhavea much betterunderstanding of whatconstitutes consensus, and

specificallyhowandwheremyviewvaries from it. Insmaller companies thatattract little attention, it'sharder to know theexpectations embedded intheshareprice.—JedNussdorf,Soapstone

Capital

It's much easier to findlarge-cap stocks that areout-of-favor—they're on

the frontpageofTheWallStreet Journal and thefolksatCNBCarealloverthem. But in addition tolooking for what othersdon'tlike,wealsolookforwhat is relativelyneglected, which arealmost always smaller tomid-cap names. In thesecases our anticonsensusview is that the quality ofthe business and its

prospects are just beingmissedbythemarket.

—RobertKleinschmidt,TocquevilleAsset

Management

We want to maintain thediscipline that we willinvest in a company,regardless of size, if itmeets our criteria. Part ofthat is because we learnfromall thecompanieswe

own.Partofthatisbecauseit keeps us fresh andengaged and not stuck inthe rut of looking at thesame 100 companieseveryone else is. We alsotake the position that apenny more in return forour shareholders than wewould have had otherwiseisapennyworthhaving.Ifsmaller-cap companies cangive us that, we'll buy

them.—ClydeMcGregor,Harris

Associates

[The SEC's] RegulationFD, for better orworse, isused by many biggercompanies to restrictaccess to seniormanagement and limitcommunication to thecanned presentation. Welearn a lot from sitting

downwithmanagement atsmaller companies andreally talking about theirbusinesses, competitors,andopportunities.—EdwardStudzinski,Harris

Associates

The information-inefficiencytalecommonlytold about the small-capuniverse is over-hyped. Ina diversified institutional

portfolio, with 50-plusnames, you're deludingyourself if you think youcan have some uniqueinside scoop onmore thanahandfulofthenamesyouown. That's all the moretrue in recent years, withall the concentrated hedgefunds out there sellingthemselves as small-capexperts.—JamesKieffer,Artisan

Partners

INDUSTRYPREFERENCE

Central to any accomplishedinvestor's definition of his orher circleof competence is adescription of the industries—or more generally, thetypes of businesses—on

which he or she focuses.Hard-earned experiencewould appear to be themostimpactful teacher here—theemphasis is usually more onwhere they will not invest,rather than on where theywill.

***

Steppingoutsideyourareasof competence is often a

seductive siren song, butI've learned fromexperience not to listenanymore. Without theconfidence that comesfrom experience and theability to recognizepatterns, the risk is higherthat you'll overpay or selltoo soon in a panic. Ifyou'reavalue investor, it'spretty easy to explain toyourself or your investors

why a deep-value ideahasn't worked out yet. Butif you bought JDSUniphase at $100, whichwas down from $200 buton the way to $2, that'stoughertoexplain.—ShawnKravetz,Esplanade

Capital

The more specialized theknowledge necessary tounderstand a business, the

lesslikelywe'llinvestinit.Who's going to be thebetter biotech investor, thepersonwho ran drug trialsfor Merck for 25 years orus? We do little inpharmaceuticals,healthcare, and computertechnology.

—JamesVanasek,VNCapital

We've struggled tounderwritemoatsbasedon

intellectualcapital,sayinacompany like Qualcomm,whereitsearningspowerisenormous if all its patentshold up. That's anotherreason we're not active inthings like pharmaceuticalorbiotechcompanies.—JamesCrichton,Scout

Capital

In general, the best thingforusis tofindcompanies

that have really stumbled,butwhere you can look attheir past and understandwhytheyaregoingtoearnsomething much better inthe future. That's opposedto looking at a companylike Amazon.com, forexample,whichmightbeagreat business, but whereunderstandingexactlywhatthemodelisgoingtobeinthe future isn't easy. It's a

lot easier to look at theprospects for a rail-carmanufacturer, whosebusinesshasbeenthesamefordecades.

—StevenRomick,FirstPacificAdvisors

We don't typically bet onscientificinnovation,sowerarely find things we'llconsider in healthcare.Weavoid many areas in

technology because of thespeedoftheproductcyclesand the magnitude ofchangefromcycletocycle.—AdamWeiss,ScoutCapital

Successful technologieschangesomething,creatingan efficiency or demandthat wasn't there before.But the very fact that thechangehappensmeansthatsomebody else can come

along and change it again.If because of the threat oftechnological obsolescenceI'm uncertain about acompany's cash flowsseveralyearsout, I'llputabigdiscount on those cashflowsandconclude they'renot worth much. BecauseWall Street tends to put alarge value on the futurecash flows of technologycompanies, we rarely find

one that we consider veryattractive.

—EdWachenheim,GreenhavenAssociates

Back in the late 1990sweinvestedinafewtoomany“concept” stocks—earlier-stage companies withdeveloping technologieswhere the stories werecompelling and indicatedthat there would be

considerable future value.The problem is thatwithoutarealunderpinningof asset value or earnings,these types of companiescan run into big troublewhenthethesisdoesn'tpanout as quickly as expectedor new competitiondisruptsthestory.

—RandallAbramson,TrapezeAssetManagement

We're drawn to companieswith long productlifecycles, in which theproduct or service will bemoreor less the same fiveyears from now. If that'snot the case, we don'tbelieve we can withadequate confidence makereliable long-termearningsforecasts.—MurrayStahl,Horizon

AssetManagement

We'd like to believe anybusiness is analyzable, butwhen you have productcycles of only twelvemonths, as an investoryou're very reliant on thecompany hitting thatwindow exactly right. Ifthey don't and somebodyelsedoes,youcanbuylowall youwant, but you findoutprettyquickly thatyou

were buying a futureincome stream that was amirage.We haven't sworn offtechnology entirely, butwe'veessentiallyswornoffinvesting in short-product-cycle technology.We lookfor technology companieswhere the business cyclesareglacialincomparison.—LarryRobbins,Glenview

Capital

We're typically notattracted to mosttechnology businessesbecause of cut-throatcompetition, potentialtechnology obsolescence,short product cycles, andthe excessive use of stockoptions.Thereturnontimeis also a problem—youspend so many hoursanalyzing new products

and technology trends that50 percent of your timegets spent on 5 to 10percentofyourportfolio.At the same time,technology is an importantdriver of economic growthand grows at above-GDPrates, so we want to haveexposure to it. We like toattack difficult industriesthroughthesidedoor,sotospeak. With Arrow

Electronics, for example,we can own a leadingdistributor of technologyproducts—includingsemiconductors, softwareand electronic components—that supplies mostlysmall and medium-sizedcompanies. That allows itto benefit from the growthin high tech without thetypical risks associatedwithtechstocks.

—PatEnglish,FiduciaryManagement,Inc.

I first got interested intechnology stocks afterwatching things likeMicron Technology gofrom$20 to $40 to $20 to$40 to $20 to $40. Thecyclicalityinmanyofthesebusinesses can be moreregular than is oftenbelieved,soit'spossibleto

buy on the down leg of acycle because there willinevitably be an up leg.We've had considerablesuccess, in particular, inbuying technologycompanies that also havegreat balance sheets.Companies like this havethe flexibility to invest innew initiatives, buy newtechnology and invest inR&D. Even if they aren't

profitable today, you havethe potential for agoldmine if the businessturnsaround.

—JohnBuckingham,AlFrankAssetManagement

From the beginning wehave occasionally comeacross products ortechnologies that wethought were toocompelling to ignore by

sticking rigidly to ourplaybook. These ideas arehigher risk and so theywon'tmakeupabigpartoftheportfolio, butwemakeroom for them when thepotential is as high as wethinkitis.—CharlesMackall,Avenir

Corp.

Circle of competenceessentially comes down to

whetherweunderstand thebusiness.Thereareseveralsub-questions under that:Do we know the rightpeople in the industry?How well do weunderstand the productsand thecustomerdecision-making process?Are thereunanalyzable things thatcould have a big impact?No matter how well youunderstand the steel

industry, for example,there's tremendousvolatility and variability inthe business that may notbe susceptible toprediction,whichmakes itdifficult for us tounderwrite the businesswithadequateconfidence.—JamesCrichton,Scout

Capital

We tend to find more

special situations inindustries with highercyclicality, which mostoften aren't the mostglamorous sectors of theeconomy. How companiesboth prepare for andrespond to industrycapacity utilization ratesgoing from 100 percent to30 percent and earningsfalling off a cliff has adramatic impact on their

future prospects. If thedown cycle makes entrypoints attractive, that cancreate excellentopportunities.

—VincentSellecchia,DelafieldFund

We find that at timescompanies—or evenindustries—cantradeatbigdiscounts to their inherentgrowthratesbecauseofthe

perceptionthattheearningsarehighlycyclical.—JonJacobson,Highfields

Capital

We're far more interestedin cyclical companies thatare well capitalized, thatdon't lose money at thebottom of the cycle, andwhose peaks and troughsare both higher over time.We'dbelessapttobuyinto

something like a capital-intensive pulp and papermanufacturer,whichbleedsmoney at the trough and,when they do generatesome cash flow, needs tospendmuchofitonneworupgraded plant andequipment.—CharlesdeLardemelle,

InternationalValueAdvisers

Cyclical industries don't

scare us if we understandthe long-term supply anddemand dynamics of theindustry and believe thatthe company we'reinterestedinisontherightside of that.We think, forinstance,thatinsuranceisalousy business. There'sway too much capital, toolittle differentiation andway too manymanagements doing the

same dumb things. That'sall contributed to therebeing a generally softpricing market for six orseven years. That said,we're happy to owninsurance companies thatdon't think like everyoneelse and zig when theotherszag.—SteveMorrow,NewSouth

Capital

We don't have a problemwith cyclicality. WallStreet still looks forcertainty in areas that areuncertain. We feel goodabout lumpiness. We justtry tobecashcounters—ifyou can buy something at5× free cash with limitedchance of permanentimpairment,evenifitearnsonly half of what wethought,that'sokay.

—BruceBerkowitz,FairholmeCapital

The downside of anindustry cycle is aconsistent reason whythingsget cheap.We'llputa reasonable multiple onthe normalized earningspowerofthebusinessoverthree to four years—knowingitcantakefiveorsix—and, given the types

of thingswe lookat, oftencome up with intrinsicvaluesthatarethreetofivetimes where the stock istradingtoday.Whichisnotto say the wait can'tsometimesbepainful.—RobertRobotti,Robotti&

Co.

Cyclicals by their naturerepeatedly experienceboomandbustperiodsthat

create opportunities forinvestors like us who paycareful attention tosupply/demand economicsand believe in mean-reversion.If you look at the averageequity holding period overthe last15 to20years, it'sclear that therearea lotofpeople out there justrentingstocks.Theprimaryinefficiencywe'retryingto

exploit is that investorsdon't like it when thingsaren't going well and acompany is under-earningits potential or what'snormal,soourfocusonthelong side is to identifyoverreactions in the stockwhen that happens.Companies can get put inthe penalty box if theystumble. It doesn't happenall the time, but reliably

enough thatwe're rarelyatalossforideasbyfocusingon cyclical but temporaryissues in a company'sbusiness.—BrianFeltzin,Sheffield

AssetManagement

High-quality businessestendtobecharacterizedbythings like strong brandnames, customer loyalty,pricing control, some cost

advantage and growinglong-term markets. Low-quality businesses, whichdon't have much controlover their futures, exhibittheoppositecharacteristics.We generally considercyclical, commoditybusinesses to fit this morenegativeprofileand soarelessinvestedthere.

—BillNygren,HarrisAssociates

There can certainly be acyclical component [towhat we find interesting],but the more salientobservation is that there isvariability over time inhowthemarketlooksatthecompany or industry.Perceptions don't varymuch for things likeelectric utilities or even astable blue-chip business

like Coca-Cola. In thosecases it'sdifficult forus tofind the valuationdispersion and reflexiveselling at nonsensicalpricesthatwelookfor.—BrianBarish,Cambiar

Investors

We're unlikely to invest ina pure cyclical like a steelcompany, where thereturns are governed

primarilybymacroforces.—BoykinCurry,Eagle

Capital

Inareaslikebasicmaterialsand other commoditybusinesses, there usuallyjustisn'tenoughofamoat,whichmakesithardforusto get interested on afundamentalbasis.—AdamWeiss,ScoutCapital

I'm very leery of anybusiness that is so cyclicalthatitburnscashatornearthe bottom. I've concludedthere are enoughalternativesouttherethatIdon't need to accept thatkindofrisk.

—ChrisMittleman,MittlemanBrothers,LLC

One of the lessons I tookfromWarrenBuffett years

agowastodefinetheareasyou're comfortable withand stick to them. Igenerally stay focused onfood,beverageandtobaccocompanies. Brandedconsumer businesses arethose for which I have anatural affinity and that IthinkIunderstand.WhileIwouldhaveahardtimeonthe weekend observingwhatDRAMchip is in the

cellphone of the personwalkingnexttome,Ipayalot of attention to—andthink I learn a lot from—what people are wearing,or eating, or smoking ordrinking. Of course theseare also all businesses thatlend themselves to thetypes of global growthopportunitiesImostvalue.I'malwaystemptedtolookin other areas, but I come

backtoaskingwhethermyability to gatherinformation and developinsights about a businessare substantive enough tojustifyaposition Iwant toown for a very long time.Thathappensveryrarely.—ThomasRusso,Gardner

Russo&Gardner

There is somethinginevitable to me about

positional goods. Onceyou've provided for yourbasic needs, you start tomarch up the consumptioncurve and it is often themoretraditionalbrandsthatattract the consumer as hereaches a new position inlife.Themoreyouprosper,the more narrow theuniverse of items throughwhich you can expressyourprosperity.

—ThomasRusso,GardnerRusso&Gardner

We prefer companieswithout heavyreinvestment needs. Theaverage company has topour more than half itsearnings every year backinto the business tomaintainitself.Ifyoudon'thave todo that—likemostconsumer products

companies, for example—youhavemoretoinvest innew businesses, to giveback to shareholders, or tokeep on hand for a rainyday. That's a hugeadvantage that we don'tthink people are correctlyevaluating.

—StephenYacktman,YacktmanAssetManagement

Iliketoinvestinconsumer

brands in areas likechocolate, whiskey, beerand wine. These areproducts that have beenaround for thousands ofyears, thatpeoplelike,andIdon'tthinkthat'sgoingtochange. Changes intechnology or the trendtoward outsourcing don'tdiminish the fact thatpeopleliketohaveadrinkat the end of the day, or

thattheyenjoychocolate.—ThomasGayner,Markel

Corp.

I've alwayshad an affinityforcompaniesthatactuallymake things. We favorcompanieswithtransparentbusinesses that we canunderstand fairly quicklyand those that have largeandrecurringmaintenance,repair, and overhaul

revenues from an installedbase, such as elevatorcompanies or aerospace-partsfirms.

—AlexanderRoepers,AtlanticInvestment

Management

We're focused on foursectors that have exhibitedunvarying demandregardless of economicactivity and that have key

fundamental strengths thathelp explain why they'vebeen around for hundredsof years. The inherentdemand of people tosmoke, drink and gambleand of nations to armthemselvesisclearlystrongandlong-lasting.—CharlesNorton,TheVice

Fund

I'm biased more towards

industrial and capital-goods businesses, which Ifind more rational thanthosethataretiedprimarilyto consumer demand. I'mnot much of a consumermyself, so I don't have agreatfeelforwhatmakesalasting consumer business.Whydopeople likeCoachbags?How do you predictthe extent to which they'lllike themtomorrow?I just

don't know. WhenMotorola was doing sowellwith theRazrphones,I didn't recognize what afadthatwasandgothurtinthestockasaresult.

—RalphShive,WasatchAdvisors

I have often made themistake of investing inbusinesses thatneededandused more capital to

operatethanIthoughttheywould. That's one reason Itend to avoid heavyindustrialcompanies.Somevery smart people ownGeneral Motors now—Ihopetheymakemoneyandit's probably good for thecountry if GM survives,but I can't figure out howto make that work as aninvestment. We just don'town those types of

companies.—ThomasGayner,Markel

Corp.

One thing about being aninvestorfor20yearsisthatexperience leads you towriteoffbigchunksof themarket. I don't do retailbecause you have torecreate the demand everyday. I don't do financialservices because it's a

spread business with noreal free cash in it—youhave to grow equity togrow assets to make morespread. I don't domuch inindustrials because thecapital demands are highand, long term, the coststructure—particularlywith labor and energyprices—is challenging in aglobaleconomy.Idon'tdocommodities—we like

price-makersthatsetpricesbased on value added, asopposedtopricetakers.If you buy a high-qualitybusiness, youonlyhave tobe right once—buying atthe right price. The sale isfairly easy to execute. Incyclical or commodityareas,youhave tobe righttwice, on the buy and thesell.Ifyoumisstheexit,itmight be awhile before it

comesbackaround.—JeffreyUbben,ValueAct

Capital

It's easier to describewhatwe don't do: oil and gas,commodities, utilities andbiotech.Wefundamentallybelieve that energy andcommodities have beenvalue-destroyingbusinesses over time. Atthe same time, their value

tends to be driven by theprice of a commodity thatwe have no ability topredict.Withutilities, theydon't tend tobebusinessesthat can create excessvalue. Theymight be nicesurrogates for bonds, butnotmuchmore.Inbiotech,we just have no illusionsthat we know how toanalyze the business.Outsideofthesefewareas,

just about anything else isfairgame.—RickySandler,Eminence

Capital

As long as it's a good-quality business selling atan attractive price, I don'tcare much about what thecompany makes or sells.One thing we are veryconscious of is the degreeof leverage in a business.

That can be financialleverage,whichisreflectedonthebalancesheet.Itcanbe operational leverage,where you look at howmuch of the cost base isfixed or variable. It canalso be the degree ofleverage to a particularindustry or geography. Ingeneral, I'muncomfortablewith companies that arevulnerable to more than

one of those kinds ofleverage going againstthem at the same time. Acyclicalbusinessthathasalot of fixed costs, forexample,shouldnothavealotof financial leverageorbe too levered to onegeography or industry. Ifthings go the wrong way,management has its handstied in trying to get out oftrouble. This is a big

reason we rarely findopportunity in morecommodity-typebusinesses.

—DavidHerro,HarrisAssociates

We avoid industries inwhich informationarbitrage is extremelyimportanttostockprices.Idon't think we'd buy asingle-product

biotechnology firm, forexample. The same holdstrueinacrisissituationlikeBear Stearns [in 2008]. Ihadnoideawhetheritwasazeroorifitwasgoingtobe fine. In cases like that,ourtime-horizonadvantageis dwarfed by ourcompetitors' short-terminformationadvantage.

—BoykinCurry,EagleCapital

Webelieve in reversion tothemean,soitcanmakealot of sense to invest in adistressed sectorwhenyoufind good businesseswhose public shares tradeinexpensively relative totheir earnings in a morenormal environment. Butthat strategy [in 2008]helpedleadmanyexcellentinvestors to put capital to

work too early infinancials. Our basicfeeling is thatmarginsandreturnsoncapitalgeneratedby financial institutions inthe decade through 2006were unrealistically high.“Normal” profitability andvaluationmultiples are notgoingtobewhattheywereduring that time, givenmore regulatory oversight,less leverage (and thus

capital to lend), higherfunding costs, stricterunderwriting standards,less demand and lessesoteric and excessivelyprofitableproducts.

—StevenRomick,FirstPacificAdvisors

One way of dealing withinformation being moreavailableis tostopplayingthe game and seek out

securities or asset classeswhere there's lessinformationorcompetition.

—SethKlarman,TheBaupostGroup

Wetendtobelessinvestedin areas in which there'slessdifferentiationbetweenthe winners and the losersand in which results aremore macro-driven thancompany-specific. We

typically do not havesignificant investments inutilities or REITs, forexample.

—LeeAinslie,MaverickCapital

We don't like businessesthat are completely relianton human capital that canwalkoutthedoor.Wehaveno rule against it, but yougenerally won't find us

investing in things likeinvestment banks orconsultingfirms.—DonNoone,VNCapital

Because fiveor sixuniqueholdingsmakeup60to70percent of each of myportfolios, I excludecompanies withidiosyncratic risk profilesthat I considerunacceptable in such a

concentrated portfolio.ThatmeansIexcludehigh-techandbiotechcompanieswith technological-obsolescence risk, tobaccoor pharmaceuticalcompanies with bigproduct-liability risks,utilitiesandotherregulatedcompanies where thegovernmentcanchangetherules of the game, andcompanies that lack

sufficient transparency,like banks, brokerages andinsurancecompanies.

—AlexanderRoepers,AtlanticInvestment

Management

We have not done well infashion-related businesses,which I'd extend to retail,whereour record isalmostunblemished by success.We tend to be susceptible

to value traps in thesebusinesses. One examplewas our investment yearsago in Bombay Company,a home-furnishingsspecialty retailer.Wewereattracted by an enthusiasmfor the CEO, combinedwith the apparent financialanomaly of a companytrading at only 30 percentof its $700 million inrevenues. We would still

beawaiting the turnaroundhadwenot decided to sellout at a modest loss andmoveon.—DavidNierenberg,D3

FamilyFunds

We'veneverbeenthatfondof the hotel businessbecause the tenants moveout every night. Thatmakes the businesssusceptible to economic

swingsinawaythatofficebuildings with long-termleases to credit-worthytenantsaren't.Weprefertosee more predictablestreams of cash flow thanlodging companiestypicallyhave.

—MichaelWiner,ThirdAvenueManagement

Some areas lendthemselves better to our

types of analysis thanothers.It'sveryhardforusto figure out what brandsareworth,forexample.It'salso hard for us to figureout what future scientificdevelopments are worth.Wetendtostayawayfromthose kinds of things. Butat the right price, we'llconsideranything.—DavidEinhorn,Greenlight

Capital

Mostpeoplesaytheywanttostaywithintheircircleofcompetence, and that'ssmart.Butthere'snoreasontosay“Here'smycircleofcompetence and, guesswhat,it'snevergettinganybigger because I'm notgoing to learn anythingnew.” We're trying tounderstand new things ifwecan.

—BillMiller,LeggMasonFunds

There's a real premium inthis business oninnovation. That doesn'tmeanchasingthelatestfad,but it does meanrecognizing newopportunities and takingadvantage of them even ifthey don't fit exactly intoyourhistoricalplaybook.

—JeffreyTannenbaum,FirTreePartners

I have a problemwith theconcept of circle ofcompetence as defined bymanyvalue investors,whowon't invest in energy,won't invest incommodities, won't investoutside the U.S. Thisbusiness requires constantlearning, even sometimes

abandoning precepts aboutindustries and geographiesthat no longer apply. Ifyou'renotwillingorabletodo that, I think theenvironment ahead meansyou're in for a very toughtime.—JohnBurbank,Passport

Capital

WHEREINTHEWORLD?

When we first startedinterviewing highlyaccomplished investors forValue Investor Insight inearly 2005, a U.S.-centricfocuswasmorethenormthanthe exception. For anynumber of legitimate reasons—language barriers,accounting-principle

differences, limited researchcapacity—value-investingorthodoxy still argued forgeographic focus rather thanexpansiveness. While thisstance remains prevalent, inclear ascendance is theargument that as industriesand companies have becomeevermoreglobalinscope,somust the investors whofollow them. Regardless ofthe position taken, all

investors today must thinkcarefully about theirgeographic field of play andhowtheyexpecttocoverit.

***

It has become increasinglyclear to me that the bestopportunities in comingyears are going to beoutside the U.S. Thatwasn't the case when I

startedout,whenbuying astock in Canada seemedawfullyunusualtopeople.Over the past five yearswe've more than doubledour international exposure,tothepointwhere65to70percentofourportfolioona look-through basis isinvested outside the U.S.Companiesabletotapintogrowing affluence andpeople's innate desire to

improve what they eat,what they wear and howtheylivewillhavedecidedadvantages over thosefocused on matureeconomies like the U.S.and Europe, wheredeleveraging will take alongtimetoworkout.

—DavidWinters,WintergreenFund

Fromdayonewe'vehad a

significant portion of ourassets invested outside theU.S.—it's currently about30 percent of our grossexposure. This is probablytoo broad a generalization,but in our view non-U.S.markets tend to be lessefficient than the U.S.market. If you look at ourcoreopportunityset,whichwe define as the 3,000 orso stocks that trade more

than$10million aday,onaveragewetookadvantage[in 2005] of about 12percent of the availableopportunitiesintheU.S.,6percent in Europe and 3percentinAsia.Inanidealworld, I'd like to be moreselective in the U.S. andtake advantage of moreopportunities outside theU.S.

—LeeAinslie,Maverick

Capital

I'darguethatliterallyeveryinvestor today has to be aglobal investor tounderstandwhat'sgoingon—certainly inmarkets likeenergy and commodities,but also to take advantageofwherewe think thebestopportunities are going tobe.—JohnBurbank,Passport

Capital

Webelieve it'sprudent forlong-terminvestorstohavea significant and growingportion of their portfoliosallocated to equities inforeign countries that aregrowing faster than theU.S. andwhose currencieswill likely appreciateagainstours.—DavidNierenberg,D3

FamilyFunds

Ingeneral,youstillseelesslong-term commitment toowning equities byinvestors outside the U.S.When markets run intotrouble, you'll see morewholesale selling ofequities by big non-U.S.institutional holders. Theremay be some historicalprecedent to that, but we

hopeitcontinues.—WillBrowne,Tweedy,

BrowneCo.

Weprobablyheld35to40percent in non-U.S. stocksfive years ago and thatnumber today is closer to70percent.Mostof that isa result of company-by-companyassessment,but Iwilladmittocastinganeyetoward history and

wondering if today's U.S.-centric investor isn't likethe similarly positionedBritishinvestorintheearly1900swhowouldhaveleftalotofmoneyunearnedasaresultofhisnationlosingeconomic relevance due toprogress elsewhere whilehe or she stayed investedonlydomestically.—ThomasRusso,Gardner

Russo&Gardner

There's increasingly adistinction without adifference.NestléisSwiss,Diageo is British, Johnson& Johnson is Americanand Philip MorrisInternational isheadquartered down thestreetfromusbutnolongerhas any business in theU.S. We own all of themand in most of the ways

thatmattertoinvestors,theanalysis and valuation oftheir businesses is verysimilar.Businesses are dynamicentities,movingcapitalandassets to maximizeopportunity. Theyincreasingly operate on aworldwide basis, so wehave to as well. We'vefound that knowledge ofbusinesses and companies

is quite transferable andhave often applied ourexperience in one marketto another. For example,we'vehadsuccessoverthepast several years inbuying Coca-Cola bottlersat different times and indifferentmarkets.

—WillBrowne,Tweedy,BrowneCo.

Another reason it's

important to be moreinternational in youroutlook: If you're notpaying attention to whatcompetitors in emergingmarkets can do, you'relikely taking on risk withU.S.-company investmentsthatyoushouldn't.

—RobertWilliamson,WilliamsonMcAreeInvestmentPartners

For our type of investing,which involves buying bigstakes in companies andinvestingforthelongterm,weneedtransparencyandafirmly established rule oflaw.Ifwecan'tbelievethefinancial statements or wesee too much risk of therules being changed afterthe game starts, the wholeexercise is pointless. As aresult, we won't invest in

Russia. We've also neverownedamainlandChinesecompany, becausemost ofthem are controlled by thestate and there's too muchpotential conflict betweenshareholder and stateinterests.

—DavidHerro,HarrisAssociates

The foundation of ourprocess is the ability to

arrive at a reasonableestimate of intrinsic value,which is often underminedin emerging markets by avariety of reporting,governance, legal andregulatory obstacles. InSouth Korea, for example,consolidated financialstatements aren't alwaysavailable. In Russia, thegovernment hasn't kickedthe habit of controlling

companies that aresupposed to beowned andcontrolledbyshareholders.Even in countries wheregovernment is lessintrusive,regulationcanbeinconsistently and unfairlyapplied,addinguncertaintyto business models thatmakes forecasting verydifficult.Atalowenoughvaluation,of course, the incremental

uncertainty can be worthtaking on. But valuationshaveonlyrarelygottenlowenough in emergingmarkets relative to thedeveloped world for us tostep over the border. It'snot for lack of effort—we're always looking—butso far we've found plentyofopportunityelsewheretokeepusbusy.

—DanO'Keefe,Artisan

Partners

For better or worse, theAnglo-Saxon businessmodel puts the interests ofshareholders first. We arelesscomfortableinmarketswhere loyalties are moredivided.

—JeffreySchwarz,MetropolitanCapital

There are still language

barriers, particularly inJapan, but that's gottenbetter over the years asEnglishhasbecome firmlyentrenched as theinternational language ofbusiness. Culturally, insome parts of the worldwe're up against a kind ofsocial-democracy attitude,that says shareholders areequal constituents withemployees and customers

and suppliers and banks. Idon't ascribe to that at all,so in some cases we havesome convincing to do.Most often, if that attitudeis too prevalent we justwon'tbeveryactive.

—DavidHerro,HarrisAssociates

We like to operate underthe illusion that if we seesomething that is out-and-

out unacceptable beingdone, that there's a clearrulebook and well-definedavenue to complain aboutit. It's not clear that's yetthecaseinChina.

—WillBrowne,Tweedy,BrowneCo.

In general, there aren'tmany countries in whichwewouldn'tinvest.Butifacountry is too

economically or politicallytroubledor the ruleof lawdoesn't really prevail, wepass. The main country inwhich we won't investtoday is Russia. There'sstill too much risk forforeign (or even local)investors that you'll thinkyouownanassetand thenMr. Putin decides youdon't.

—Jean-MarieEveillard,First

EagleFunds

We do very little directinvesting in EasternEurope,where the level ofdisclosure and the qualityof corporate governance isstill poor. Many leadingcompanies are controlledby government-relatedentities or majorityshareholders who couldn'tcarelessabouttheinterests

of minority shareholders.We also aren't very activein theU.K.Londonhas itsown well-established andwell-capitalizedinvestmentcommunity, so we findvalue there is arbitragedout quicker than it is incontinentalEurope.

—RichardVogel,AlatusCapital

Forthetypesofcompanies

I generally invest in—sophisticated globalcompanies like Diageo,Nestlé,PernodRicard—theinformation is generallyaccessibleandcomplete,soI don't require a greatermargin of safety or lowermultiples because they'reinternational. Also, partlybecause the field hasn'tbeen as crowded, I've hadas good, if not better,

access to seniormanagement at non-U.S.companies.—ThomasRusso,Gardner

Russo&Gardner

We'renotafraidofpoliticalrisks, which we generallythink are exaggerated. Weinvested in Thailand afterthe coup. We're investingin Turkey in the face ofpolitical uncertainty. It's

not a big component ofwhat we do, but there arealways small pockets ofmispricedriskandpoliticaluncertaintycancreateverynicebargains.—OliverKratz,Deutsche

AssetManagement

Over the next 10 years it'sfar more likely that thehuge amount of capitalowned by the rest of the

world will grow byinvesting somewhere otherthan the U.S., whether it'sin infrastructure in Chinaor the Middle East, or todevelop consumer marketsinplaceslikeIndia.—JohnBurbank,Passport

Capital

Wehaven'tbeentraditionalemerging-marketsinvestors because we do

not chase growth orglamour, but we likenothing better than toinvestinemergingmarketson a contrarian basis.Strongeconomicgrowth isnever steady, so you canfind nice opportunities toinvest after booms havegonetemporarilybust.

—CharlesdeVaulx,InternationalValueAdvisers

Oneof thekeys toWarrenBuffett's early successwasinvesting inhigh returnoncapital consumerbusinesses that wererelatively immature whenhe bought them and thatgrew enormously alongwith the U.S., the largesteconomy in the world. Heowned companies likeGillette, Wells Fargo, andWashington Post Co. over

a period in whichconsumer products,financial, and mediacompanies grew frombeing a relatively smallpart of the S&P 500 to averylargepartof it.That'sa natural evolution in anylarge,developingeconomyand we expect thatdynamic to createconsiderable value inplaceslikeIndiaforalong

time.—JohnBurbank,Passport

Capital

We keep heading moretoward direct internationalinvesting, but worry thatwe'regoingtobethepatsy.WelookedatSouthKorea,but kept asking ourselveswhat edge we really hadthere. How do weunderstand the culture, the

management?The U.S. is going throughthe same decline faced byall past great civilizations.It's in thenatureof things.It takes a very long timeand happens in 10,000different ways. All smartcompanies and investorsneedtorespondtothat.Weactuallylookatourenergybets as more of a globalplay on the fact that 3

billion new capitalists inAsia are going to have asignificantimpactonfutureenergydemand.The good thing aboutinvesting is that you don'thavetodoeverythingtobesuccessful. There areplentyofdifferentways tomakemoney.

—BruceBerkowitz,FairholmeCapital

Because we put such astrong emphasis oncompanies based in closeproximity to us—two-thirds of our portfoliocompaniesareintheupperMidwest, with 50 percentvery nearby inMinneapolis/St. Paul—wecommit ourselves toknowing all the publiccompanies in that limiteduniverseverywell.

Our initial research isveryqualitative, focused ongetting to knowmanagement and lettingthem explain what theirmarkets are, how they'readdressing them, wherethey're investing and howthey make thoseinvestmentdecisions.Fromthat,wealsowant to learnfrom various otherconstituencies, from

suppliers to customers tocurrent and formeremployees. All of that isconsiderably easier whenyou'reclosetowherethesepeopleare.—WilliamFrels,Mairs&

Power,Inc.

My feeling is that it'sbeyond my skill set to tryto buy local companiesoutside the U.S. Some

people will make a lot ofmoney doing that, but notme. What I am doing isbuying companies likeGEandCitigroup andDiageo,who already havetremendous expertise andoperationsoutside theU.S.to take advantage ofinternational growth anddevelopmentopportunities.—ThomasGayner,Markel

Corp.

I once heard someone saythateverytimeyoudoublethe distance from whereyou are to where you areinvesting, you shoulddivide the quality of yourassessmentinhalf.

—FranciscoGarciaParames,BestinverAssetManagement

Ididhavethegoodfortunein the 1980s and into the

1990s to have our style ofvalue investing not bewidely practiced,particularly in continentalEurope.Value stockswerelargely neglected and itwas possible, if one waswilling to be patient, tooftenbuy themforasong.That's no longer true—many of the more secularinefficienciesaregone.But the fundamentals of

value investing—which tomy mind are based oncommonsense—stillwork,and work equally wellacrossborders.We lookatstocks exactly the sameway, whether in HongKong or Japan or Paris.People always ask, “Butdon't you want to investlike the locals,understanding the localidiosyncrasies?” and my

answer is simply no. Wenever buy stocks based onwhat we think otherinvestorsaregoingtodo.

—Jean-MarieEveillard,FirstEagleFunds

People tend to lumpinternational investing intothis general bucket ofopportunity,which tous iskind of silly.We expect aclosing of the relative

GDP-per-capita gapbetween the developedworld and many emergingmarkets, but as thathappens we believe you'restill going to have stocksbe cheap or expensivebased on cyclical ups anddowns and on valuationsthat overshoot and under-shoot. Unless you're smartabout picking your spots,you're not going to be

successfulnomatterwhereyouinvest.

—DavidSamra,ArtisanPartners

CHAPTER3

DeficientMarket

Hypothesis

Anall-too-commonerrorthat

novice investors make is toassume a consistentconnection between thesuccessofabusinessand thesuccess of an investment inthat business. There's noquestion that successfulcompanies can also beoutstanding investments, butthat'snotnecessarilythecase.Winning investments arisewhenthecurrentmarketpriceof a company's stock

underestimates what youbelieve its current value is—and you turn out to be right.The market today has to bemissing something, say thelevel and/or timing of futurecash flows or the value ofhidden assets. These are theinefficiencies that the moststrident Efficient MarketHypothesis proponents arguedon't exist, but which smartinvestors count on for their

success. Long-time DailyRacing Form PublisherSteven Crist captured thisveritywell indescribinghowto think about betting onhorses: “The issue is notwhichhorseintheraceisthemost likelywinner,”he says,“but which horse or horsesareofferingodds that exceedtheir actual chances ofvictory. There is no suchthing as ‘liking' a horse to

wina race,onlyanattractivediscrepancy between hischancesandhisprice.”Look at almost any

company'smarket value overa multiyear period if youwant assess the efficiency ofthemarket. Even the largest,most stable and most liquidcompanywill often exhibit asurprising variability inmarketpricefromhightolow—a variability that almost

certainly goes beyond theunderlying change in thecompany's actual value. Thisspells opportunity for astuteinvestors.In articulating any

investment strategy, then,managers should be able todescribe the typicalinefficiencies on which theyare looking to capitalize andthe types of situations inwhich they expect to find

them. For any given idea,theyshouldbeabletoexplainhow their view on acompany's prospects differsfrom what is built into thecurrent share price. Quitesimply, if an investor doesn'tknow why something mightbemispriced,thechanceofitactually being mispricedsignificantlydecreases.

THEHUMANELEMENT

The Baupost Group's SethKlarmanhasprovennotonlytobeoneofthebestinvestorsofhisgeneration,butalsooneof the most articulate inexplaining the underlyingvalue-investing principles onwhichhisstrategyisbased.Inoneofthemanyannuallettersthathe allowedus to excerpt

inValue Investor Insight, hecaptured nicely a commonimpetus for marketinefficiency, the humanelement involved in thesettingofprices:ImaginethateveryadultinAmerica became asecuritiesanalyst, full-timeformany,part-time for therest. Every citizen wouldscour the news for fast-breaking corporate

developments. Somewouldrun spreadsheets andcrunch numbers. Otherswould analyze competitivefactors for variousbusinesses, assessmanagerial competence,and strive to identify thenext new thing. Now, forsure, the financialmarketswould have becomeefficient, right? Actually,no.Thereasonthatcapital

markets are, have alwaysbeen, and will always beinefficientisnotbecauseofa shortage of timelyinformation, the lack ofanalytical tools, orinadequate capital. TheInternet will not make themarket efficient, eventhough it makes far moreinformation available,faster than ever before,right at everyone's

fingertips. Markets areinefficient because ofhuman nature—innate,deep-rooted, permanent.People don't consciouslychoose to invest withemotion—they simply can'thelpit.

All human beings aresusceptible to the emotionsand biases that can causestock prices to beinefficiently priced. The best

investorswouldappearbetterable to keep theirs in check,and to recognize when theemotionsandbiasesofothersare creating investmentopportunity.

***

At thecenterofallmarketpricingarehumanbeings.Ijoke that the FourHorsemen of the

investment apocalypse arefear, greed, hope, andignorance, only one ofwhich is not an emotion.Fear, greed and hope havewiped out more moneythan any market downturnever could. Because of allthefoiblesofhumannaturethat are well documentedby behavioral research—and now by neurologicalresearch—people are

always going to overshootand undershoot whenpricingsecurities.Areviewoffinancialmarketsall thewayback to theSouthSeaCompanynearly300yearsago proves this out. Aslong as human naturedoesn't fundamentallychange,wecancontinuetoarbitrage the pricinginefficienciesitcreates.—JamesO'Shaughnessy,

O'ShaughnessyAssetManagement

The mood swings of thesecuritiesmarketsresemblethe movement of apendulum. Although themidpoint of its arc bestdescribes the location ofthe pendulum “onaverage,”itactuallyspendsverylittleofitstimethere.Instead,itisalmostalways

swinging toward or awayfrom the extremes of thearc. In fact, it is themovement toward anextreme itself that suppliesthe energy for the swingback.Investment markets followa pendulum-like swingbetween euphoria anddepression, betweencelebrating positivedevelopments and

obsessing over negatives,and thus betweenoverpriced andunderpriced.There are a few things ofwhichwecanbe sure,andthisisone:Extrememarketbehavior will reverse.Those who believe thependulumwillmoveinonedirection forever—orreside at an extremeforever—eventually will

losehugesums.Thosewhounderstand the pendulum'sbehavior can benefitenormously.—HowardMarks,Oaktree

Capital

I'd argue the market isn'tterriblyefficientanyofthetime. Underpinning theefficient marketshypothesis is the notionthat markets tend toward

an equilibrium price andthat there's a normaldistribution around thatefficient price. It's a nicetheory, but I don't seeevidence for it in the realworld. Quite the opposite,valuations tend to orbitsome sort of appropriatevaluation, but spend nomoretimeinthemiddleofthe rangeas theydoat thevarious ends—it's not a

normaldistributionatall.We focus on takingadvantage of reflexiveselling that we don'tbelieve iswell considered.It may be due to somerecent bad news at acompany or from theperceivedimpactofamoremacro trend or event. Webecome increasinglyinterested in a stock asmisinformation and

disinterest on the part ofsellers serves to compressitsvaluation.

BrianBarish,CambiarInvestors

I had an inkling that 2009wouldbeagoodyearwhenInstitutional Investormagazine published anarticle in late 2008 titled“The Death of ValueInvesting.” In my

experience,“Deathof...“articles usually mark aturning point, irrespectiveof the subject. In thisinstance, I was struck notonly by the article'spotential as a contraryindicator, but also by theutter preposterousness ofits assertion. For valueinvesting to die, eitherhumanity would have todie too, or people would

have to become entirelyand consistently rational.The very reason price andvalue diverge inpredictable and exploitablewaysisbecausepeopleareemotional beings. That'swhy the distinguishingattribute among successfulinvestors is temperamentrather than brainpower,experience, or classroomtraining. They have the

ability to be rationalwhenothersarenot.

—BryanJacoboski,AbingdonCapital

I was originally trained asan economist and it tookmetwodifferentdegreesineconomicstoworkoutthatit really wasn't what itpurported to be. It claimstobeascienceofbehavior,but actually all of the

behavior was assumed. Ibecame disenchanted withthat and the longer Iworked in the markets themore I became convincedthat the paradigm ofrational economic beingswas deeply, deeply flawed—it just didn't match upwith the reality I wasobserving.—JamesMontier,Société

Générale

Human beings are subjectto wild swings in theirlevels of fear, risktolerance, and greed. Thatwon't change. I base mywhole approach on buyingwhenothersarefearfulandselling when others aregreedy. The reasonShakespeare is so relevantstill today is that his playswere all about human

nature, and human natureneverchanges.MarkSellers,SellersCapital

I've been around longenough to see irrationalityin all flavors, so less andless surprises me. I nolonger think I must bemissing something, andrealize the madness ofinvestor crowds can dosomenuttythings.

RickySandler,EminenceCapital

It'salwaysimportanttoaskwhether you have anycompetitive advantage inanalyzing a particularcompany. Can we knowthebusinessbetterbecauseno one else seems to bepaying attention? Is themarket's view beingdistorted by some

behavioral or structuralbiasthatwedon'thave?

—BrianBares,BaresCapital

A[n]argumentismadethatthere are just too manyquestion marks about thenear future; wouldn't it bebetter to wait until thingsclear up a bit? You knowthe prose: “Maintainbuying reserves untilcurrent uncertainties are

resolved,” etc. Beforereaching for that crutch,face up to two unpleasantfacts: The future is neverclear [and]youpayaveryhigh price for a cheeryconsensus. Uncertaintyactuallyisthefriendofthebuyeroflong-termvalues.

—WarrenBuffett(quotefromForbes)

Comfort in investing

comes at a high cost.Selling stocks in 2007would have feltuncomfortable, but inretrospect we all shouldhave done more of that.Buying or even holdingstocks in early 2009 wasequally uncomfortable, butinvestorsshouldhavedonethat as well. We getcomfort from theconsensus, but making the

sameinvestmentchoicesasa large number of otherintelligent people almostmathematically insuresyou'lldothewrongthingatthe wrong time becausesecurity prices reflect thatconsensus.—StaleyCates,Southeastern

AssetManagement

WallStreetsometimesgetsconfused between risk and

uncertainty, and you canprofit handsomely fromthat confusion. The low-risk, high-uncertainty[situation] gives us ourmostsoughtaftercoin-tossodds.Heads, Iwin; tails, Idon'tlosemuch!—MohnishPabrai,Pabrai

Funds

There are probably fivemain behavioral

impediments that keep ourindustry from spotting andavoiding bubbles. First isbasic overoptimism.Nobody gets marriedexpectingtogetdivorced,amindset that bedevilsmostof what we do. In ourindustrythattranslatesintothis sort of innate bullishbias.Second,peoplesufferfroman illusion of control, that

evenifthingsdogowrong,they'llbeable tosort themout. A lot of the modernrisk-managementtechniquescreatedatotallyfalseillusionofsafety.Theidea that by quantifyingrisk using a tool like VaR[Value at Risk] that youcan therefore control it isone of the slightly moreridiculous things to havecomealonginyears.

Third,there'saself-servingbias in our industry.Generally people makemoremoneywhenmarketsgo up than when they godown,so it'snotoften thatpeople stand in the way.You can imagine a riskmanager several years agoarguing against buying apot of collateralized debtobligations—he wouldhave been fired for

obstructing a sterlingopportunity.The next impedimentwouldbemyopia,anaturalshort-sightednessreminiscent of St.Augustine's plea, “Lordmake me chaste, but notyet.” This is probably themost cynical of the biasesbecause you often knowwhat you're doing iswrong, but rationalize that

you'll promise to be goodafter getting one moregoodbonusoutofit.Finally, there's changeblindness or inattentionalblindness.Wejustdon'tseewhatwe'renotlookingfor.We're governed by ourrecent experiences anddon't actually ponder thebigger picture very often.Just because somethinghasn'thappenedinthepast

12 months, or five years,doesn'tmeanitcan't.

JamesMontier,SociétéGénérale

Humans have a strongdesiretobepartofagroup.That desire makes ussusceptible to fads,fashions and ideacontagions.MichaelMauboussin,Legg

MasonFunds

People tend to suffergreater pain from losing agiven amount of moneythan they experiencepleasure from gaining thesame amount, so thetypical investor is a painavoider who shuns stockswhen there's any hint oftrouble. That tendencyresults in a consistentoverreaction to bad news

that we believe createsinvestmentopportunity.

DanielBubis,TetremCapital

Whenwefindourselvesintrouble, when we findourselves on the cusp offalling, our survivalinstinct—and our fear—can evoke lurching,reactive behaviorabsolutely contrary tosurvival.Theverymoment

when we need to takecalm,deliberate action,werun the risk of doing theexactoppositeandbringingabout the very outcomeswefear.—JimCollinsinHowthe

MightyFall

There's a great chapter [inDan Ariely's PredictablyIrrational] about the waysin which we tend to

misjudgepriceanduseitasan indicator of somethingorother.Thatlinksbacktomy whole thesis that themost common error we asinvestors make isoverpayingfor thehopeofgrowth. Dan did anexperimentinvolvingwine,in which he told people,“Here's a $10 bottle ofwine and here's a $90bottle of wine. Please rate

them and tell me whichtastes better.” Notsurprisingly, nearlyeveryone thought the $90wine tasted much betterthan the $10 wine. Theonlysnagwasthat the$90wine and the $10 winewereactuallythesame$10wine. When they weretasted blind, without thesignaling of the price,peoplecame toexactly the

right conclusion aboutwhichwas thebetterwine.That to me was atremendousexampleofthebias against value thatpeopletendtohave.—JamesMontier,Société

Générale

It is very hard to avoidrecency bias, when whatjust happened inordinatelyinforms your expectation

of what will happen next.Oneof thebest things I'veread on that is The IcarusSyndrome, by PeterBeinart. It's not aboutinvesting, but describesAmericanhubrisinforeignpolicy, in many casesresulting from doing whatseemed to work in theprevious 10 years even ifthe setting was materiallydifferent or conditions had

changed.One big problemis that all the people whosucceed in the recent pastbecome theones inchargegoing forward, and theythink they have it allfigured out based on whatthey did before. It's allquitenatural,butcanresultin some really baddecisions if you don'tconstantly challenge yourcorebeliefs.

—JedNussdorf,SoapstoneCapital

One of the unfortunatelessons of speculativebubblesisthattheyalwaysgo on longer than weexpect.It'swhathascaughtmeoutmorethananythingovertheyears—I'malwaystooearly. I usually see thebubbleand talkabouthowIwouldn'ttouchthisorthat

withabargepole,butthenwatch painfully as it goeson for two or three moreyears. For professionalinvestors,thatcanbeajobkiller.Youcan seehow ina world in which peopleare benchmark-measuredand totally obsessed withrelative performance,career concern can be adriving force in all this.Peopleareafraidofgetting

it“wrong”fortwoorthreeyears,sotheyjustgoalongandtheproblemfesters.—JamesMontier,Société

Générale

Humans have a tendencytoward overconfidence,which may be reinforcedby the stories that areprevalentatanygiventimeandbythefactthatwetendto act on a biased

information set to makedecisions. The list of factswe retain in ourconsciousness very likelyexcludes other facts weeither aren't observing orchoose to ignore. That's abig reason people becomeoverconfident,whichplaysa big role in bubblesforming.

—RobertShiller,YaleUniversity

In general, I believemarkets are basicallyefficient and that theacademics are right whenthey say markets are evenmore efficient as market-caps go up. Theinefficiencies that haven'tgoneaway,though,havetodo with crowd mentality,when specific news ormarket events cause the

crowd to rush in onedirection. If you have theability to thinkindependently and to bepatient, you can findopportunities when thathappens.

—JohnRogers,ArielInvestments

Investors overreact to thelatest news, which hasalwaysbeenthecase,butI

think it's especially truetoday with the Internet.Information spreads soquickly that decisions getmade without particularlydeep knowledge about thecompanies involved.People alsooveremphasizedramatic events, oftenwithoutchecking thefacts.It's the classic, “Are morepeople killed each year bysharks or by being

trampledbypigs?” typeofsituation—the dramaticevent can get more playthan it deserves. Thesetypes of overreactions arewhat we're trying to takeadvantageof.

—JohnDorfman,ThunderstormCapital

What themedia should becriticized for is thecheerleader aspect to its

coverage. Champagnecorks would pop witheverynew1,000points ontheDow,asifthatwasthenatural state of things andthatimaginingthatitcouldgo down—or even rootingforittogodown—wasun-American.It'sgottenbetterwhen you start to seepeople likeWarrenBuffettshowupmoreonchannelslikeCNBC, but I still find

financial news asentertainment, withsomeone like Jim Cramer,sortofsad.Coverageofthemarket is always aboutmaking money, when infact sometimes you shouldbe worried aboutpreserving your money.Since you don't getadvance warning aboutwhat kind of environmentiscomingnext,youshould

alwaysbeconcernedaboutpreserving your money.The person just watchingcable TV might neverknowthat.

—SethKlarman,TheBaupostGroup

There is still a large andloud industry out therewhichonadailybasistriesto advise anyone listeningexactly what they should

do today—often right now—to be a better investor.For all but the smallestpercentage of peopleinvolved in the market,that'sbadforyouandisnotthe way to build wealthovertime.—ChuckAkre,AkreCapital

Management

March 2009 was agenerationalbottom,inmy

opinion, and it scaredpeople to death. Themarket has doubled sincethen, but hedge fund netexposures are aboutwherethey were at the bottom,institutional assetsallocated to equities arebarely above where theywereatthebottom,andthepublic investor in equitymutual funds hasn't comeback.Thereisaskepticism

and even disdain forequities.They'll all be back. Itmaytakealongtime,butstockswill get overvalued againand people will be buyingon tips they hear at acocktail party withoutspendingaminutethinkingabout them. People arepeopleandwillgetgreedyagain.

In the meantime, thenegativity should be greatfor us. It gives us time toidentify attractivebusinessesandbuythematdiscounts.—SteveMorrow,NewSouth

Capital

Iwasalways so impressedby John Templeton'senthusiasm, the freshapproach he seemed

always to take and, ofcourse, how independent athinker he was. In 1939,right after Hitler marchedinto Poland, Templetonbought100sharesofeverystock on the Big Boardselling for less than $1.Within a fewyearshehadquadrupled his money. Healwayssaidthetimetobuywas at the point ofmaximum pessimism and

pain—something we've allhadexperiencewithlately.

—JohnDorfman,ThunderstormCapital

IT'SAMATTEROFTIME

Top value investors almostuniversally consider theirlonger-term investment

horizons to be a competitiveadvantage. With investmentdecisions increasingly drivenby short-term market,industry or companyconcerns, the reasoninggoes,individual share prices aremore likely to misrepresentthe future potential, whenindustry dynamics are morenormal,companymisfiresarecorrected or strongperformanceismoreapttobe

recognized.

***

Most investmentinstitutions define successas having a good result ineach and every discretetime period, so it's quitelogicalthatpeopleinthoseinstitutions look to buystocks that will do wellfromthecurrentmomentin

time until, say, the end ofthe year. As a result,favorableoccurrencessuchaspositiveearningsreportsor value-realization eventsthat are highly probable,but not likely to occurwithin the discrete timeperiod, are discounted at afairlyremarkablerate.If you traveled throughtime and brought back theWall Street Journal from

four years from now andcould specifically identifythe highest-returningsecurity between now andthen—into which youshould put all yourmoney—people wouldn't do it.The uncertainty of notknowing the pattern ofreturn, even given thecertainty of the outcome,would keep people frombuying it. Our opportunity

is to take advantage ofthose kinds ofinefficiencies.—MurrayStahl,Horizon

AssetManagement

Time arbitrage just meansexploiting the fact thatmost investors—institutional, individual,mutual funds, or hedgefunds—tend to have veryshort-term time horizons,

have rapid turnover,oraretryingtoexploitveryshort-term anomalies in themarket. So the marketlooksextremelyefficientinthe short run. In anenvironment with massiveshort-term data overloadandwithpeople concernedabout minute-to-minuteperformance, theinefficiencies are likely tobelookingoutbeyond,say,

12months.—BillMiller,LeggMason

Funds

Themostimportantchangein the business over thepast 40 years is probablyinvestors' time horizons.Today the majority ofinvestors—Ben Grahamwould call themspeculators—are focusedso closely on this week,

thismonthandthisquarter.Didthiscompanymeettheestimates or did that onemeet its guidance? Stocksare bought and sold onpenny deviations fromthose estimates, which ismind-boggling.Crazyas itis, we can't complain—itjust creates moreopportunities for investorswithlongertimehorizons.

—WilliamNasgovitz,

HeartlandAdvisors

It'sstilltruethatthebiggestplayers in the publicmarkets—particularlymutual funds and hedgefunds—are not good attaking short-term pain forlong-term gain. Themoney's very quick tomove if performance fallsoff over short periods oftime.Wedon'tworryabout

headline risk—once webelieve in an asset, we'rebuying more on any dipsbecause we're focused ontheendgame threeor fouryearsout.—JeffreyUbben,ValueAct

Capital

Music to my ears is whensomething is considereddead money and peoplesay,“It looksokay,but I'll

comeback to it laterwhenthis or that issue resolvesitself.” That to me shouts,“Lookhere.”

—JeffreySchwarz,MetropolitanCapital

One the last greatarbitragesleftistobelong-term-orientedwhenthereisa large class ofshareholders who have notolerance for short-term

setbacks.So it's interestingwhen stocks get beaten-upbecause a companymissesearnings or the marketreacts to a short-termbusiness development. It'scrazytomewhensomeonesays something is cheapbut doesn't buy it becausethey think it won't goanywhere for thenext6 to12 months. We have apretty high tolerance for

taking that pain if we seeglory longer term. Iactually thinkdoing that isoneofthefewwayslefttomakeanincrementalreturnversusthemarket.—MarioCibelli,Marathon

Partners

WhenIwasstartingout inthebusiness,Iwaspitchinga stock as a buy to anaccountinBoston.Itwasa

conglomeratetradingat4×earnings.Mypitchwasthatitwasreallycheapandwasgoing to go up a lot overthe next couple of years.When I finished, the chiefinvestment officer said,“That'sareallycompellingcase,butwecan'townthat.Youdidn't tellmewhy it'sgoing to outperform themarket in the next ninemonths.” I said I didn't

knowif itwasgoing todothat or not, but that therewasaveryhighprobabilitythat it would dowell overthenextthreetofiveyears.He said, “How long haveyou been in this business?There's a lot ofperformance pressure inthis business, andperforming three to fiveyears down the roaddoesn'tcutit.Youwon'tbe

in business then. Clientsexpect you perform rightnow.” So I said “Let meask you, how's yourperformance?” He said,“It's terrible, that's whywe're under a lot ofperformance pressure.” Isaid “If you bought stockslike this three years ago,yourperformancewouldbegood right now and you'dbe buying stocks like this

to help your performanceover the next three years.”That's our approach. Webuy today with an eye onperformance several yearsout. I can think of onlytwicewhenwhatwedidinthe year that we did ithelpedthatyear.—BillMiller,LeggMason

Funds

Investorscomeupwithall

kindsof reasons toownornot own stocks, and intimes of stress the reasonscan become nonsensicalbecause people get drivenbythiscascadeofnegativeinformation. We seeanalyst reportsall the timethat say they don't like astock short-term or theydon't see a catalyst in thenext six months, but thatit's attractive long-term.

Implicit in that is thenotion that, “I'm going toknowexactlytherighttimeto step in and I'll let youknowafewdaysbeforeit'sobvious to the rest of themarket.” Based on ourexperience and everythingwe've seen about people'sability to time the market,wedon'tunderstandhowtomakemoneyonthatbasis.

—WillBrowne,Tweedy,

BrowneCo.

With the frayed nerves ofinvestors after the 2008crisis and with thecontinued rise of hedgefunds, ETFs, andcomputerized trading, timeframeshavetruncated.Ourinvestmenthorizonisthreeyears, give or take, whichallowsustoinvestwithnoobviouscatalystother than

mean reversion and areturn to normalcy. Thatworks when nobody ispatientanymore.—SarahKetterer,Causeway

Capital

Theaverageholdingperiodon the New York StockExchange is nine monthsor less,which I don't evenconsider investing. Oversuchashortperiodoftime

you're just betting on theoverall direction of themarket or on the nextquarterlyearnings.—AaronEdelheit,Sabre

ValueManagement

Many investors don't startwith the question ofwhetherGeneralElectricorProcter & Gamble isundervalued, they start bytrying to match the

weighting in thebenchmark. In 2001 whenwe were short GE, peoplethought we were crazy:How could you short thegreatest company in theworldwiththebestCEOinthe world? I had noargumentwiththat,butwewerefocusedonlyonwhatit was worth and where itwas trading and concludedtherewasnochanceitwas

worth$55pershare,whichwe said publicly at thetime.The reason it traded therewas because I'd estimatethat 95 percent of thedollarsinvestedintheU.S.stock market were eitherindexed or closet indexed—people had to own it tokeep up with thebenchmark.Iftheythoughtit was overvalued, their

response would be tomaybebuyonlya3percentposition rather than the 4percent weighting in thebenchmark.That's the typeof irrational behavior thatcancreateinefficiency.—RicDillon,DiamondHill

Investments

I would assert the biggestreason quality companiessellatdiscountstointrinsic

value is time horizon.Without short-termvisibility, most investorsdon't have the convictionor courage to hold a stockthat's facing some sort ofchallenge, either internallyor externally generated. Itseems kind of ridiculous,butwhatmostpeopleinthemarketmissisthatintrinsicvalue is the sum of allfuture cash flows

discounted back to thepresent. It's not just thenext six months' earningsorthenextyear'searnings.Totrulyinvestforthelongterm, you have to be ableto withstandunderperformance in theshort term, and the fact ofthe matter is that mostpeoplecan't.

—DavidHerro,HarrisAssociates

Classicopportunitiesforusgetbacktotimehorizon.Acompany reports a badquarter, which disappointsWallStreetwithits90-dayfocus,butthatmightbeforexplainable temporaryreasons or even becausethe company is makingvery positive long-terminvestments in thebusiness. Many times that

investment increases thelikely value of thecompany five years fromnow, but disappointspeoplewhowant thestockuptomorrow.

—MasonHawkins,SoutheasternAsset

Management

The human brain isincapable ofconceptualizing something

vastlydifferentfromwhat'shappening today. But thebig-money ideas are thosewhere the changes are farbeyond what you canconceive today.Thecloseryou can get to conceivingthosetypesofchangesandthe higher the probabilitythey might happen, themorelikelyyouaretofindbigwinners.—LisaRapuano,Matador

CapitalManagement

While we may not alwaysbe able to estimate it withgreat confidence, everystockhasanintrinsicvaluethat is independent of itscurrent market price andtendstobefarlessvolatilethan that market price.That's because marketprices partly reflectinvestor emotions, while

intrinsic values reflectbusiness fundamentals.Giventhatoversufficientlylong periods of timemarketpricestendtorevertto intrinsic values, we'resimply looking to go longwhen the price is at adiscount to a value webelieve we can estimate,andtogoshortwhenit'satapremiumtothatvalue.What that typically means

on the long side is thatwe're assuming thingsremainmoreorlessnormalorgetbacktonormalwhenthe implicit assumptionreflected in the stockpriceis that things are going tofallofforneverrecover.

—ChrisWelch,DiamondHillInvestments

We have no problembuying things that take a

long time toplayout.Callmelazy,butIdon'twanttoworry about last week'ssame-store sales or nextweek'soilprice.

—JeffreySchwarz,MetropolitanCapital

We're trying to capitalizeontheincrementalmindsetof Wall Street. IBM beatsearnings by 10 cents in aquarter and everyone

cranksuptheirmodelsandscurries around and takestheir full-year estimate upby a total of 10 cents.We're trying to findcompanies where if WallStreet's EPS consensus is$1, $1.10 and $1.20 overthe next three years, we'relooking for somethingmore like $1, $1.30 and$1.80.Where we're seeingamaterialdifferenceinthe

trajectoryofthecompany'sgrowth because of anexpanding marketopportunity, operatingleverage or capital-redeploymentopportunitiesthat the Street is ignoring.Incaseslikethatyoudon'thave to be precisely right—approximately right canstill make you a lot ofmoney.—SteveMorrow,NewSouth

Capital

Ourthesisoftenisbasedonthe passage of time.Whatmakes a negative storynegative may just be thatthenextthreetosixmonths—the time space in whichWallStreet analysts live—don't looksogreat.Wetryto look at companies as aprivate investorwould. Tothat investor a company's

near-termbadnewsisonlyinstructiveif it informsthelong-term outlook. If itdoesn't, why should wecare?

—RobertKleinschmidt,TocquevilleAsset

Management

If you listen to earningsconference calls, most ofthe questions are aboutwhathappened thisquarter

orwhat next quarter lookslike. That focus wouldindicate that near-termissues are generallyextremelywellunderstood,so there isn't that muchvalueinourtryingtofigurethatout.But if you reallyunderstand how acompany's business modelworks, how its industry isstructured, the underlying

trends impacting theindustry, and wheremanagement is taking thecompany,there'sabitmoreopportunity to add value.Thatdoesn'tmeanweowneverystockforalongtime,butweanalyzeandvalueitwithamultiyearhorizon.—MorrisMark,MarkAsset

Management

Typical investor behavior

is to want to own thingscoincidental to success, sothere are plenty ofinvestors out there whowill bail at any sign ofdisappointment. Byextendingourtimehorizonout three to five years,we're trying to takeadvantage of bargains thatresult when negative newsandtwitchyinvestorsdrivestockpricesdown.

—SarahKetterer,CausewayCapital

Mostofthetimetheshort-termoutlookstinks for thecompanies we end upbuying, for company-specificorcyclicalreasons.Thebestopportunitiestendto be when the companynow facing a lousy short-term outlookwas not longbeforeconsideredadarling

of growth investors, andwhentheproblemsarenowperceived to be morepermanent. If you thinkthoseproblemsaren'treallypermanent, you can makevery attractive investmentsifyouturnouttoberight.

—Jean-MarieEveillard,FirstEagleFunds

We evaluate businessesover a full business cycle

and probably our biggestadvantage is an ability tobuy things when mostpeople can't because theshort-termoutlookislousyorveryhardtojudge.It'sagood deal easier to knowwhat's likely to happenthan to know preciselywhenit'sgoingtohappen.—WhitneyGeorge,Royce&

Associates

I have a ready answerwhen people ask me whyI'm such a long-terminvestor,whichisbecauseIfailedmiserablyasashort-term investor. I'm notagainst making money inthe short term, I just don'tknowhowtodoit.—ThomasGayner,Markel

Corp.

CHAPTER4

FertileGround

Great ideas are the lifebloodof successful investing. JoelGreenblatt, whose GothamCapital was one of the mostsuccessfulequityhedgefunds

ever and who remains activeas a teacher, author, andmanaged-index-fundproprietor, distilled theessenceofagreatideaforus:There'saclaritythatcomeswith great ideas: You canexplain why something's agreat business, how andwhy it's cheap, why it'scheap for temporaryreasons and how, on anormal basis, it should be

trading at a much higherlevel. You're never sittingthere on the 40th page ofyour spreadsheet, asWarren Buffett would say,agonizing over whetheryou should buy or not. Ifyou findyourself there, it'seithernotyetclearenoughin your head or it's not asstriking an idea as itshouldbe.Icandescribewhyweown

the stocks we do in a fewsentences. The hard work,ofcourse,comesinprovingthe assumptions that getyou to that point. But ifyou've done the workcorrectly, the actual ideaendsupbeingvery simple.The most money we'vemade has been on ideasthat, once you looked at itthewaywedid,wereprettyobvious.

The simplicity of the greatidea, however, belies amorecomplex challenge everyinvestor faces: How to focusattention on potential ideasthat are more likely to bemisunderstoodbythemarket,and therefore mispriced.Methods vary widely forhoming in on such ideas—andlimitingthetimedevotedto running down blind alleys—but the best investors

combine an avid curiositywith a keen ability to siftthrough the avalanche ofavailableinformationtofocuson the core elements of acompany's situation thatsignal potential opportunity.They know and can describewell the situations they'relooking for and thedisciplines they use to findthem.

INSEARCHOFUNCERTAINTYWhile value investors aretypically considered a risk-averse lot, that's more areflectionof theprice they'rewilling to pay for any giveninvestment than the types ofsituations they most oftenpursue, which are oftenfraught with uncertainty. Ascompanies constantly evolve

and change in response toindustry or company-specificchallenges and opportunities,the lack of clarity aroundthose changes—and the risksinherent in the potentialoutcomes—can cause sharepricestodivergewidelyfromunderlying business values.The ability to recognize andcapitalize upon that dynamicisakeyelementofwhatsetstopinvestorsapart.

***

There are two kinds ofeventsthatcreatevolatility,which creates opportunity.The first revolve aroundindividualcompanies,suchas earnings misses,unexpected news, M&Aactivity, restructurings andlegal issues—things thatcan make prices andvaluations change

relatively quickly. Ingeneral, prices changemuch faster thanfundamentalsofbusinesseschange,sowhatwewanttodo is understand whatmade thepricechangeandthenfigureoutwhetherthefacts have changed asmuch as the price. To theextent they haven't, thatcanbeanopportunity.The other major source of

volatility is when a macroevent or trend causesmarkets to move. Thesecan be industry-specific,butalsoreflectinterestratemoves, currency moves,politicalinstability,andtheoverall economic outlook.Themarket reflects at anymoment what investorsthink XYZ's business isworth, so ifmacroeconomic factors

forcepeopletobuyandsellitssecuritiesbutwebelievethose factors have nothingto do with the underlyingfundamentals of thecompany—or less to dowiththefundamentalsthanis being reflected in theshare price—that can alsobeanopportunity.—JonJacobson,Highfields

Capital

Our reference to“misunderstanding”amongour investment valuesrefers to our having avariant perception versusconsensus with respect tothe earnings power or thefree-cash-flow-generatingpotential of the business.Some misunderstandingscome from JoelGreenblattYouCanBeaStockMarketGenius-types of events—

such as spinoffs,emergence frombankruptcy, andrecapitalizations—wherethe movement of debt,equity,orassetsaroundona balance sheet leads toanalytical complexity orsome form of irrationalselling.Variant perceptions canalso arise from having adifferential view about the

ongoing business itself,such as new productlaunches, the impact of achange in management, oron how operating orfinancialleverageplaysoutovertime.Thekeyinalmostallthesecases is that something ischanging.Ifabusinesshasbeen around for 20 yearsand public for the last 15,it's hard to argue that

people are really missingsomething if there'snothing relatively biggoing on. That gets to theimportance of knowingwhy there is informationasymmetry.Ifyoucanzeroin on that, you're betterabletohandicaphowlikelyyou reallyare tobe seeingsomething other peoplearen't.—JamesCrichton,Scout

Capital

Change brings uncertainty,somany investors want towait out that uncertaintyuntil the situation is easierto analyze. We think thatuncertainty iswhat createsopportunities.—PeterLangerman,Mutual

SeriesFunds

You can usually only pay

an undemanding pricewhen there's fear oruncertaintyassociatedwitha name. That can resultfrom a variety of things:when companies arerestructuring, acquiring ordivesting; when aturnaround is necessary,either company-specific orin the industry; or whenthere'sbeenabigoperatingdisappointment of some

kind. The commondenominator is typicallyverylowexpectations.—JamesKieffer,Artisan

Partners

The hedge-fund industrygrewupbypreyingon theinefficiencies created bythe mutual-fund mentalityof only departing from abenchmark indexweighting with reluctance.

Events that transformcompanies can complicatethingswhenyou'refocusedon, say, having an 8percent weighting inindustrials. That's whythese types of companiescan often be mispriced.There's also change goingon and the market can beremarkablyslowinshiftingits focus from how thingshavebeentohowtheywill

be.—GaryClaar,JANA

Partners

Companies going throughoperating or financialrestructuring can go into abit of an informationvacuum,whichcanprovidea good entry point into aposition. There's oftenuncertainty about thespecific programs being

instituted, managementmaybe less apt toprovideguidance and, because thechange is ongoing, theresults are by definitionunclear.—JerrySenser,Institutional

CapitalLLC

We want to have a highconviction based on ourresearch that we canachievea50percentrateof

return on long investmentsover a two-year period.That potential return cancome from any number ofsources: turnarounds,changing product cycles,shifts in competitivedynamics, a revampof thecapital structure, or evencyclical recovery. The keyis whether we believe wehave an edge inunderstanding the

magnitudeortimingoftheimprovedperformance.—EllenAdams,CastleRock

Management

In our experience, it'srevenue and earningsmomentumthatcatapultsastock out of the swamp.We'relookingforelementsof positive change—freshmanagement blood, achanging market, a

changing regulatoryenvironment, a shift incompetition—whichsuggest a futurecharacterized by reliableand increasing earnings.Wehavetobepredictorsofgrowthtobeabletobuyatbargainprices.—CarloCannell,Cannell

Capital

You make a lot of money

in stocks when they getrevalued. We wantsituations in which theprobabilities are favorablefor margin recovery and areturn to normal revenuelevels coming out of adifficult period, whichwould result in multipleexpansion.—AlanFournier,Pennant

Capital

We named our firmThunderstorm Capitalbecauseathunderstormisafrightening but temporaryevent that usually passeswithout lasting damage. Inconstructingourportfolios,we try to invest in goodcompanies whose stocksare depressed byfrightening but temporarybad news. The trick, ofcourse, is to distinguish

thunderstorms fromCategory-5hurricanes.

—JohnDorfman,ThunderstormCapital

The market missing anopportunityoftenhasmoreto do with the psychologyaround companies that runinto trouble. “Everybodyknows” the business is introuble. “Everybodyknows” themanagement is

incompetent. If we take amore nuanced view, seesome positives among thenegatives and have someinsight into management'scapabilityofturningthingsaround, that's what makesitagoodidea.—JohnOsterweis,Osterweis

CapitalManagement

Wespecializeinthehighlycomplex while mostly

avoiding plain vanilla,which is typically morefullypriced.

—SethKlarman,TheBaupostGroup

Financialcomplexityisonereason companies getmispriced. People talkabout investing only ineasy-to-understandbusinesses, but we're notafraid of tackling

complicated financialanalysis. If we think wecanget ahandleonwhat'sgoing on, the fact thatothers tend to shy awayfrom these situations canprovide an opportunity forus.—CurtisMacnguyen,Ivory

Capital

We're not reluctant toinvest in pretty hairy

situations. That by nomeanssuggestscomplexityor controversy is alwaysbetter, but it can oftenscare enough people awaytocreateopportunity.

—TuckerGolden,SolasCapital

Companies in severefinancial stress tend to beoverlooked and under-loved,because theyhavea

riskor fundamentalprofilethat many equity investorsarenotcomfortablewith.—MitchellJulis,Canyon

Capital

What a lot of people don'trealize about distressedinvestingisthatyoucandothis type of investing in alow-riskway.Byanalyzingthecapitalstructureandtheunderlying asset values,

you can figure out withsomedegreeof confidenceat what point you're fullycovered.Ifyou'rebuyingat50 cents on the dollar andarecomfortable thatyou'recoveredat80centsor100cents on the dollar, thatisn't such a riskyproposition.—PeterLangerman,Mutual

SeriesFunds

A legitimate case can bemade that low-beta stocksare consistentlyundervaluedbythemarket.Portfoliomanagers tend tofavorhigh-betastocksasawaytobeatthemarket.Ifaportfolio beta is 2.0, theportfolioshoulddoublethemarket returns, right? Ofcourse it can go the otherwayaswell,butwiththeirbonuses dependent on

beating the market, manymanagers are willing totakethatrisk.—BernardHorn,Polaris

Capital

We don't like makingassumptions about highlyuncertain outcomes, suchashowanewproductwillwork or an industrytransition will play out. Ifyou look at most value

traps—say newspapers orvarious industrials overtime—they look extremelycheap if some significantproblemgoesawayorisn'tas bad as expected. I trynot to deal in those big“ifs.” Therefore many ofthecompaniesweownarequite boring, but theygenerate cash flows webelievewecanvalue.—EricCinnamond,Intrepid

Capital

Avoid entirely what youcan't totally get yourmindaround. It's just not worthit. There will be plenty ofother things to invest in—keepthecashforthem.—AmitWadhwaney,Third

AvenueManagement

SPECIALSITUATIONS

Frequentlythespecificeventsthat investors believe cancreateinvestmentopportunityarepromptedbythechangingnature of the company'sbusiness. Maybe its coreproduct line is maturing, itsindustry'sgrowthhasslowed,an ancillary business isbooming, or it is investing

heavily in new products orservices. The emphasis is onchangetowhichthecompanyis responding. When smartinvestors' assessment of theultimate impact thoseresponses will have is atvariance with conventionalmarketwisdom, ideas canbeborn.

***

We are often looking forbroken growth stories,when a once-greatcompany is no longerconsideredtobegreat.Themarket tends to overreactin these cases, as growthand momentum investorsmove on to the next newthing and the shareholderbase turns. Since I wasn'tinthestockbefore,I'mnotdisappointed if something

is no longer a high-flier.All I care about is thefuture potential relative towhatIhavetopayforit.—AlanSchram,WellCap

Partners

If you look at technology-driven growth industriesoverthepast twocenturies—steamengines, railroads,telephony, electric power,the Internet—people

become too excited aboutgrowthandoverinvestinit.When the bubbles burst,markets overcorrect on thedownside, even though thefundamental growthdrivers may still be aspresent as they werebefore. We love to findjewels buried amid therubble after that kind ofexplosionoccurs.—DavidNierenberg,D3

FamilyFunds

Most of the time we'repicking up the pieces aftera high-growth companyhitsthewallat80milesperhour, havingmade at leastone too many investmentsto try to sustain anunsustainable growth rate.Publicmarketscanactuallyconspire to screwcompanies up. When

you're growing fast, youget this bigP/E and prettysoon you have all thewrong investors withridiculous expectations.You try to meet thoseridiculousexpectationsanddo things contrary toshareholdervalue.—JeffreyUbben,ValueAct

Capital

If you think about the

lifecycle of a smallcompany, it usuallyinitially succeeds in arelatively small nichewhere it delivers uniquevalue and becomes amarket leader. Thebusinessinevitablystartstomature—producing strongcash flow with a lowergrowth rate—and thenatural response frommanagement is to take

someofthecashgeneratedand to invest it in newareas of potential growth.Hopefully these newgrowth initiatives arerelatedtothecorebusinessandhopefullythecompanycanhavesomecompetitiveadvantage. This pursuit ofincremental growth isexactly what managementshouldbedoing.One of two things will

happen. Either the newinitiativeswork,everyone'shappy,thestockhasahighmultipleandweneverfindit, or the new growthinitiativesarenotworking,the market becomesdisenchanted with thecompany because earningsand cash flow aredepressed and that drivesdown the stock price.Thosearethesituationswe

findattractive.—JeffreySmith,Starboard

Value

We typically look forunderperformingcompanies, against theirpeers and their ownhistory, and then try tounderstand why that'shappening. Sometimes theanswer is something wecan'tdoanythingabout. In

other cases, though, theunderperformance maycome from the companyhavingwastedmoneyoverthepastthreeorfouryearson acquisitions and themarket is concerned it'sgoing to do it again andisn'tassigningfullcredittoitsfuturecashflows.That'sprobablyanopportunityforus.

—RalphWhitworth,

RelationalInvestors

Inmanycaseswe'regettinginvolved when a rapidlygrowing company isslowingdownormaturing.There's a changing of theguard among theshareholder base and asthathappens,there'softenadisagreement over howquickly the growth isslowing and whether the

slowdown is permanent.When you're right that themarket is overreacting tothe challenges faced, theinvestment result can bequitepositive.—WallyWeitz,WeitzFunds

An areawe try tomine isbustedIPOs.Buyingat theIPO often means you'rebuying from smart sellers,but we'd much rather buy

from dumb sellers—whichis more likely to happenafter an IPO companydisappoints in some wayandthepeoplewhoboughtintheinitialofferingbail.

—StevenRomick,FirstPacificAdvisors

We don't have anydiscernible edgedeterminingwhetherIBM'searnings are going to beat

the Street by a nickel, orwhether the multipleshouldbe16,18,or20.Wedon'tknowwherethepriceof oil is going or whethersmall-cap stocks are goingto outperform large caps.These things are reallyunknowable andunpredictable. But thereare a wide variety ofsituations in which thereare dislocations—like

mergers, spinoffs, short-termbadnews,legalissues—where we think weunderstand why theremightbeahugedisconnectbetween supply anddemand for a givensecurity. Then if we cananalyzewhatthetruevalueof thebusiness isand lookacross all the differentsecurities on a company'sbalance sheet, we may be

able to find somethingthat'smispriced.It's analogous to going toLas Vegas on Super Bowlweekendandbettingonthegame. By definition, theline on the Super Bowl isthe most efficient on theboard. Every piece ofinformation is completelydisseminatedandthelineisset by all the buyers andsellers coming together, of

which there are thousands.The best bet on the boardinLasVegasismuchmorelikely to be on a gamebetween twocollege teamsfor which most peoplecouldn't name the coach,anyof theplayers,oreventheteamnicknames.Butifyou know one of the bestplayers on a team is hurt,orthatoneteamgotinat4o'clock in the morning

because there was asnowstorm—andtherestofthe market doesn't knowthat—you have an edgemakingthatbet.—JonJacobson,Highfields

Capital

One key situation we findof interest is when webelieve unrepresentativeaccounting obscures thetrue value of the business.

With DirecTV, forexample, subscriberacquisition costs areexpensed immediatelyratherthancapitalizedovertime, which hides the truefree cash flow. WithChesapeake Energy, thebest deals they've donehave been percentageinterests they've sold inmany key fields, but theyhaven'tbookedanyofthem

so that doesn't show up inreturnsonequity,itdoesn'tshowupinearnings,anditdoesn'tevenreallyshowupin book value asreceivables. Badaccounting is often acommon denominator inmany of our biggestpositions.A second commonsituation is when themarketseemstobemaking

massively negativequalitative judgments thatwe believe, on deepanalysis, are misplaced.With Chesapeake,everybody appears to hatenatural gas forever and isangry at AubreyMcClendon [the co-founderandchairman,whowas forced to liquidatenearly all his companyshares in 2008 to meet

margin calls], so theincredible assets they havesort of get lost in thediscussion.The last common threadwould bewhen companieshaveanabsolutejewelofabusiness that gets lost inthe shuffle of a biggerconglomerate. Our successin Disney so far, and webelieve in the future, isabout ESPN, which

nobody asks about onconference calls becausethey want to hear aboutmovies or the animationbusiness. With OlympusCorporation in Japan, it'sabout their medical-devicebusiness,nottheircameras.RuddickisabouttheHarrisTeeter grocery business,not textiles. WorthingtonIndustries is about gascontainers, not the steel

business.—StaleyCates,Southeastern

AssetManagement

We'vealwaysputemphasison finding hidden valueandhiddenassets.We likelooking at multi-segmentbusinesses where it's a bitmore complicated toanalyze all the parts andthere's not an obviousanswer to the question of

whattheentirecompanyisworth. In this context, wepay a lot of attention toprivate-market values andtrying to understand howunderperforming segmentsshouldbevalued.—PeterLangerman,Mutual

SeriesFunds

Acommonopportunityforus is when two businesses—which would trade on

different valuationparameters if separate—operate under the sameroof,resultinginthewholeappearingmispriced.—TimothyMullen,VNBTrust

We like to invest incompanies in which wethink people are payingattention to the wrongthing, so if 80 percent ofinvestor attention is

focused on something thatyou think is less than 20percent of the story, it's agoodopportunity to take alookatthebusiness.

—BillNygren,HarrisAssociates

One key source ofopportunity is whencompanies are buildingnew assets that willgenerate incremental

revenues,prof-itsandcashflows. Many times theseare what we call “inside-out” growth stories,wherea large legacy business issomehow perceived aschallenged, but a newerone is thriving and takingonmoreprominence.—MatthewBerler,Osterweis

CapitalManagement

We often see value in

holding companies, wherethere are several disparatebusinesses and a singleearnings multiple doesn'tcapture the true value. Orin companies that own asignificant asset that maynot currently be earninganything but is quitevaluable.—JonJacobson,Highfields

Capital

We find opportunity inlooking at the differentvalues ascribed to acompany's different assetclasses.Ifthedebtmarketswouldprovide100percentfinancing of a company'stotal market value, thatusuallymeanstheequityisundervalued. WhetherFacebook is worth 15×sales or 10× sales is notsomething we'll take a

positionon.Butifthedebtmarket is telling us that acompany's equity appearsto be undervalued, that'ssomething we're interestedin.”

—StevenTananbaum,GoldenTreeAsset

Management

At PIMCO there aremorethan 70 different creditanalysts covering just

about every credit on theplanet and producingresearchthatveryoftenhasa valuable read across tothe equity. That includesbeing on top of specificfinancing events that maybe debt-negative, equity-positive, or vice versa.Allofthatisaveryrichsourceof ideas and fundamentalinsightintocompanies.—CharlesLahr,PIMCO

We find that geographymakes a difference. Thefurther a company is fromNew York, Boston,Chicago, L.A., and SanFrancisco, the lessattention—and often lessrespect—they get. In the1990s,westartedfindingalot of companies in theupperMidwestthatweren'twell followed but had

smart, entrepreneurialmanagers who werebuilding great businesses.Minnesota is still probablyour favorite state for stockideas.—ScottHood,FirstWilshire

Securities

Special situationsunfortunately aren't asplentiful as we'd like, butinclude things like

companies going throughlarge reorganizations orcompanies that are beingspunoff.Aswell-knownasspinoffs are for beingpotentiallymispriced,thereappear to be enoughstructural reasons forinefficiency—having to dowith limited information,forced selling, andmanagement incentives—that they often still work.

Over the past 30 years theaverage spun-off companyhas outperformed themarket by 10 percent peryear.—TimothyBeyer,Sterling

CapitalManagement

We take a close look anytimeacompanyistryingtocreate value through sometype of spin-off or majorrestructuring, which can

resultinmispricingsfortheparent as well as thespinoff company. Thedocumentation filed withthe SEC when companiessplit up is quite complexand the pro-formafinancials can be veryfuzzy, dealing with trickyquestionssuchashowdebtandoverheadareallocated,how assets are depreciatedand how costs will evolve

in the separate companies.Most people don't do thework of going throughwhat can be hundreds ofpagesof financials,butwefind it can often uncoverinterestingideas.

—EdwardMcAree,WilliamsonMcAreeInvestmentPartners

Often spin-offopportunities are bond-like

in nature, generating a lotof cash, with a great baseof assets and excellentincentives in place for therightthingstobedonewiththecashgenerated.Butthenumbers generally don'tlook so great at thebeginning, because it's inmanagement's interest tounderpromise andoverdeliver. Coupled withthe fact that the

shareholderbase isusuallyin flux at the beginning—manyholdersoftheparent-company stock don't wantto or, because of theircharters, can't own thespinoff—inefficienciesarise.—MitchellJulis,Canyon

Capital

Many times companiesfindthemselvesinwhatthe

market considerspredicaments because theyhave been farsighted andare spending on futureopportunities. The goodthing about that type ofspending from ashareholder's standpoint isthatifthecompanyisright,you benefit, and if it turnsout to be wrong, it stopsspending the money andyoualsobenefit.

—MurrayStahl,HorizonAssetManagement

Most companies expandduring good times andwind up over-leveragedandwithtoomuchcapacitywhen the business goessouth. We like to see theopposite, companies todayinvesting on the cheap inadditional capacity forwhenthingsturnup.

—JamesVanasek,VNCapital

Obviously, just because acompany makes a new,long-term investmentdoesn't mean it's the rightone. As an investor,though, the existence ofcontroversial initiativeslikethatcreatesapotentialbuying opportunity. It's uptoyoutodecidewhethertopursueitornot.

—ThomasRusso,GardnerRusso&Gardner

At thepeakof the Internetbubble, I went to aninvestor presentation by[check manufacturer]DeluxeCorp.inwhichtheydescribed how the Internetwas going to flatter, nottarnish,thecheckbusiness.Then the CEO launchedintoabigdiscussionabout

how he was going toconvert his core franchisetoanewplatformhecalledInternetgift sales, and thattheyweregoingtolose$50millionayearonit.Iwentaway and didn't buy thestock, disgusted with thatidea. What I learned fromthis, however, was thatreally dumb ideas like thisoneactuallyhaveahabitofmeeting an early death. In

fact, it turned out to besuch a dumb idea that itdied quite quickly, leavingthe business to flourishunder its core dynamics,unburdened by ill-consideredstrategicmoves.Thatwasabiglesson.—ThomasRusso,Gardner

Russo&Gardner

OPERATINGTURNAROUNDSThe bad news that typicallyprecipitates the need for anoperating turnaround, aswellas the ongoing uncertaintythat revolves aroundmanagement's turnaroundeffort, canwreak the kind ofhavoc on stock prices thatvalue investors are keen tocapitalize upon. That a

company is in turnaroundmode, of course, doesn'tmean the turnaround will besuccessful. That makes theabilitytodistinguisheventualwinners from losers in theturnaround game an essential—if decidedly nontrivial—skill in any contrarianinvestor'stoolkit.

***

We're looking for theprospectof anacceleratingrate of positive change.Thatmeanswe'renaturallydrawn to managementchanges, turnarounds, or,more generally, tosituationsinwhichchangesin the macroeconomic,competitive or regulatorylandscape require acompanytoremakewhatitdoes or how it does it.

Sometimes it's even morestraightforward, where wesee unrecognized assetsthat can generatesignificantvalue,orwhenacompany blew somethinglike an acquisition or aproduct rollout and webelieve thefixwillhappenmorequicklyandwithlesspain than the marketexpects.—MarikoGordon,Daruma

CapitalManagement

We search for companiesin which change can alterthe future for the better.Thatcanmeanachangeinmanagement.Itcanmeanachange in management'sattitudetowardrunningthebusiness, say byrecognizing that 120percent of the earningscome from 80 percent of

the assets, so they shoulddo something about thatother 20 percent at somepoint. It can mean a newbusiness opportunity thathas yet to take off. It canmean a change in thedynamics of a company'scash flow and how it's tobeused.Ifweperformouranalysiscorrectly, the value addedwe bring is an earlier and

betterunderstandingof thecompanies in our portfoliothan other investors mighthave.Ifthecompaniesthenbegin to improve, theirearnings should increaseand they're likely toearnahigher price/earningsmultiple.

—DennisDelafield,DelafieldFund

We're looking for

businesses that are goingthrough some kind oftransition—inmanagement, in thebusiness mix, in theindustry. Often a previousmanagement teamoverextended andoverleveragedthecompanyand somebody new hasbeen brought in tostraighten it all out, bycuttingcosts,sellingassets

or paying down debt. Agoodbusinessthathappenstohaveabadbalancesheetis much easier to fix thantheopposite.—JamesRooney,Avenir

Corp

Just because a company iscapable of throwing offlots of cash doesn't meanthey're doing so at anygiven moment or that

they're using the cashcorrectly. We're valueinvestors first, so we'relookingfordepressedstockprices.Oftenwhatcausesadepressed stock price is amisallocation of free cashflow, through ill-timed orill-conceived acquisitions,pouring money into badbusinesses, or any numberofwrong capital-allocationdecisions.Butthosetendto

befixableproblems,whichis a lot easier to do whenthe core business isintrinsicallyhealthy.—AndrewJones,NorthStar

Partners

Missing a product cycle,for example, is generallyfixable. So are problemsthatresultfromacompanyout-growing itsinfrastructure—it's a high-

class problem to have, butcan result in some realearnings trouble. Botchedacquisitionscanalsocreateinteresting opportunities ifwebelievethedelayedcostsavings or strategicbenefits will eventuallyshow up and increaseearnings.—KevinO'Boyle,Presidio

Fund

Our experience showsthere's a positivecorrelation betweenimprovements in acompany's return oninvested capital and itsstock performance. Thatmakes sense, given that acompany's earnings todayare the result of projectspending it made in thepast. We obsess overascribing value to today's

capital projects, aswell ason deconstructingbusinesses into theircomponentpartssowecanbetter value the existingassetbase.More than anything, we'relooking for inflections inbusinesseswheresomesortof structural change willdrive returns on investedcapital to be materiallyhigher. In all of our

conversations withcompanies, theircompetitors, and theirsuppliers, we're trying toidentify structural changesthat we can get ahead ofand believe will result inbetterreturnsoncapital.I'dsayatleasthalfthetimeit has to do with newleadership changing howthings are done. Forexample, we love when

management or a boardchanges compensationsystems to move from agrow-grow-grow,earnings-per-share-driven culture toone focused on returns oninvestedcapital.—JoeWolf,RSInvestments

Three-year to five-yearturnarounds almost alwaysrequire a deep infusion ofoutsidemanagementtalent,

a change in culture, anoverhaul of the coststructure and some fairlydramatic shifts inoperational execution. Wewant to identify thesepotentialturnaroundsearly,but it's often only after ayearor soof careful studythat we're ready to act.Dependingonthesituation,we want to see tangibleevidence—say,an increase

ingrossmargins,declininginventorylevelsorreducedoperating expenses—thattheturnaroundisworking.Ifwebelievethesharescandouble or triple if we'reright—whichisn'tastretchif earnings and valuationsare starting fromparticularly depressedlevels—we have noproblem leaving the firstbumpinthestockpriceon

the table.We're helped bythe fact that once themarket has given up on acompany, it can be quiteslowtoembraceitagain.—LloydKhaner,Khaner

Capital

Management changes canhelpa lotwith timing. Ifaboard of directors isseriousaboutrestructuring,they'll often hire someone

from a best-in-classcompany to make ithappen. Those peoplearen't cheap, which showsthe board is serious, andthe fact that the person iswilling to come indicatesthey think they can addvalue.Anexecutivefromafirst-class company takingoveralaggardcanmeananopportunity is ripe for thepicking.

—PhilipTasho,TAMROCapital

While managementchanges aren't alwaysnecessary, we often viewmanagement changespositively in turnaroundsituations. You're muchmore likely to get a frank,thoroughappraisalofwhathas gone wrong and why,so you'll probably

understand the situationbetter.My confidence alsoincreases when a strongnew manager has beenattracted to a situation andis highly motivated toperform.—KevinO'Boyle,Presidio

Fund

Mybestideas,byfar,havebeen in situations where anew CEO takes over an

undermanagedfranchise.Ifwe only focused on onething,thatwouldbeit.Themarket just does not pickup on the ramifications ofchangequicklyenough.The big question afteridentifying a CEO youhave confidence in isgetting the timing right.Youcan'twaitfortheCEOto come out with hisrestructuring plan in front

of 250 analysts. The bestthing is when you alreadyknow the person and thebusiness and can act veryquicklyafter thenewCEOisnamed.—KennethFeinberg,Davis

Advisors

Whatwillgetmeexcitediswhen one of our analystscomesintomewithastorylike this: “Preston, I've

been following this stockfor two years but haven'tfound a good reason towrite it up. It used to bekindofahigh-flier,butthestock chart now looks likedeath warmed over. Theshares were at $40, had abig drop and have beentrading between $15 and$18formonthsandnobodycares. The company islikely to have some big

writeoffs thisyear tocleanup the balance sheet.And,by the way, two monthsago the board fired theCEO and the new guy issomeone I know from aprevious company wherehedidagreatjob.He'snoteven talking to the Streetforsixmonthsashegetsahandleonthings.”—PrestonAthey,T.Rowe

Price

Stockpricesgoupfor twoprimary reasons. The firstis investors' willingness topayahighermultipleforacompany'searningsorcashflows. That's whattraditional value managerslook for—undervaluedsecuritiesthatwillbemorerichly rewarded in thefuture.We'retryingtofindthataswell,butwe'realso

looking for evidence offundamental turnaroundsand the additional stock-price upside that comesfrom higher earningsexpectations.

—RonaldMushock,SystematicFinancial

Management

The primary reason toinvest in a turnaround iswhen you're able to invest

in great management atvalue prices. The bestpeople are attracted to achallenge, but the fact thatit's a challenge keepsvaluations in lineearlyon.Wall Street tends not tobelieve something isturning until it's fairlyobvious, which can giveyou time to do real workand build your positionbefore the market starts

payingattention.Even in poor marketenvironments, turnaroundscandowellbecausethey'reusually coming off suchlow bases.As a result,wefindthatourresultsarelesscorrelated to the overallstockmarket, especially indownmarkets.—LloydKhaner,Khaner

Capital

As a general point, wearen't seeking classicturnarounds. If we lookback at mistakes we'vemade, particularly insmaller-cap companies, it'sbeen when we neededsomefundamentalproblemto be fixed for theinvestment to work out.We'vedevelopedahealthyrespectforhowharditistoturnabusinessaround.

—TimothyHartch,BrownBrothersHarriman

Gettingturnaroundsrightisvery tough. It takes atremendous amount ofresearch effort, theturnarounds almost alwaystake longer than youexpect,andit'sjusteasytoget it wrong. That doesn'tscare us away, but we'reverycognizantoftherisks.

We're unlikely to act untilweseetangiblesignsoftheturnaround happening orsome clear positivesentimentfromtheindustryormanagement.—ScottHood,FirstWilshire

Securities

ThefirstbasicthingI lookfor is that the business iscurrently profitable, whichmeans generating good

returns on capital withoutthe excessive use ofleverage. Iwas tempted inmy youth by turnaroundstories or betting on newproduct or service offers,where you could hit theball out of the park ifthingsgotfixedorthenewproduct took off. But I'vehad enough failurespursuing those types ofideas that I've for themost

part lost the stomach forthem.From a performancestandpoint, I'm morefocusedonwhatsomethingisthanwhatitcanbe.—ThomasGayner,Markel

Corp.

We don't do turnarounds.What attracts us to thewhole concept of valueinvesting is the idea ofhaving amargin of safety,

in terms of value overprice. That margin ofsafetyonlyexists ifvaluesare stable and it onlyimproves if valueincreases. Withturnarounds,you'remakinga bet—maybe a veryintelligent one, but still abet—that somethingbroken can be fixed. Evenin the best case, you maybe looking at years when

valuedeclinesorstagnates.Our experience is thatwe'rebetteroffinvestingina good business that isconstantly compoundingvalue from the beginningof our ownership, withoutwhat to us is theunacceptable risk that theturnaround doesn't work.We just don't think weneed to take that kind ofrisktoearnstrongreturns.

—C.T.Fitzpatrick,VulcanValuePartners

Not to be flip, but all wecount on in a number ofour investments is just forthings to return to normal.There's a lot less risk inwanting that to happenthanlookingforsomehugetransformation in acompany'sbusiness.

—ChristopherGrisanti,

GrisantiBrown&Partners

CHAPTER5

GeneratingIdeas

Theactivequestforideasisauniversalcomponentofeveryinvestor's toolkit, but the

methods chosen to do so areoften all over the lot. Someinvestors use computerscreens extensively, forexample, while others don'tuse them at all. Somefrequently pursue top-downideas sparked by an industrytrendorsecularchange,whileothers pursue only ideas thatbubble up individually.Regardless of the methodsemployed,however,theidea-

generation process typicallyreflects the same abidingcuriosity and dogged pursuitof information seen in theresearch and analysis effortsthatfollow.

BEHINDTHESCREEN

The ever-increasingsophisticationoffinancialand

market databases and thetechnology available to usethemmakeiteasierandeasierfor investors to screen on allmanner of attributes in thesearch for prospectiveinvestments. The extent towhich top investors takeadvantage of that capability,however,isfarfromuniform,ranging from not at all to anear-total automation of theinitial idea-generation

process.Similarlydiversearethe metrics on which theyscreen, not surprising giventhe diversity of companycharacteristics onwhich theyfocus.

***

I do a lot of screening,which can be a valuablecheck on emotion, if youlike. Iwouldn't necessarily

suggestblindfaithinthem,but there is a degree ofhonestly about numbersthatcanbequiteusefulfordisciplining yourself whenlooking at potentialopportunities.—JamesMontier,Société

Générale

Weoftenstartwithscreensonallaspectsofvaluation.There are characteristics

thathavebeenprovenoverlong periods to beassociated with above-averageratesofreturn:lowP/Es, discounts to bookvalue, low debt/equityratios, stocks with recentsignificant price declines,companieswithpatternsofinsider buying and—something we're paying alot more attention to—stocks with high dividend

yields.—WillBrowne,Tweedy,

BrowneCo.

Ourheritagehasbeenverymuch to focus ontraditionalvaluemetricsoflow P/E, price/book, andprice/salesratios.Aninitialscreen for us might belooking for stocks tradingatlessthan2×bookvalue,less than 1x sales and less

than15×forwardearnings.That's still at the core ofwhat we do, but we'veevolvedtoalsoscreenonavariety of other metrics.We have a JoelGreenblattscreen, for example,looking at stocks with acombination of highearnings yields and highreturnsoncapital.Wealsolookatavarietyofbalancesheet measures, including

basic things like net cashversus market value. Theart part of the processcomes in deciding whichcompanies thatscreenwelldeserve more fundamentalanalysis.Thekeyshereareusually an initialassessment of the qualityof the business and itsgrowth potential.Wewantto buy cheap—particularlyrelative towhere the stock

has historically traded andwhere companies in itsindustry should trade—butusually only when there'srealpotentialforgrowth.

—JohnBuckingham,AlFrankAssetManagement

We start by screening forclassicvalue.Thiscouldbea low price-to-net-assetsratio, a low premium or adiscount to book value, a

P/E ratio less than thereturn-on-equity ratio or,depending on the industry,a modest premium or adiscount of the marketvaluetorevenues.Wealsohave various screens thattry topredictabuild-upofcash. Companies thatcontinually generate cashabove and beyond theircapital expenditurerequirements are hopefully

going to do good thingswith that cash andshareholders shouldbenefit.—CarloCannell,Cannell

Capital

We screen for financialmetrics that may showsymptoms of the types ofsituationswe lookfor.Sayrevenueshavebeenflatforthe past three years, but

operating expenses haveincreased in each of thoseyears. We also typicallylookforcompaniesthatareunderperforming on anynumber of profitability orproductivity measures,against peers and againsttheirownhistory.Becausethey're under-earning,manyofthecompaniesthatinterest us look expensivebased on current numbers,

but are actuallyundervalued relative to thepro-formaearningsthatcanbe generated if our plan isimplemented.

—PeterFeld,StarboardValue

Wehaveacomputermodelthat ranks our valueuniverse of the 1,000largest domesticcompanies. It ranks all

1,000 companies fromcheapest to mostexpensive, on the basis ofcurrent price to thenormalized earnings weextrapolate from historyfive years into the future.Fromthiscomputerscreen,wedo an initial reviewonthe cheapest quintile ofthese stocks, lookingmoreclosely at the companyfinancials and the industry

dynamics.After this initialresearch, we reject about75 percent of thesecompanies. The other 25percent we do detailedanalysis on, includingvisiting the company andmeetingmanagement.

—RichardPzena,PzenaInvestmentManagement

Some of our most usefulscreens look to identify

businesses that are eithershort on capital or haveexcesscapital.—JamesCrichton,Scout

Capital

Our basic screeningprocess weights threefactors equally: return ontangiblecapital–whichwedefine as operating cashearnings over workingcapital plus net property,

plant and equipment – themultiple of EBIT toenterprise value, and freecash flow yield. We rankthe universewe've definedoneach factor individuallyfrom most attractive toleast,andthencombinetherankings and focus on thetop10%.—StephenGoddard,The

LondonCompany

We look at all the usualvaluation screens toidentify stocks that arecheap relative to bookvalue, earnings and cashflow. I'malso interested incompanies whose marginsare significantly higher orlower than they've beenhistorically.—JonJacobson,Highfields

Capital

Sincewe'retryingfirstandforemost to limit ourdownside, our valuationscreening is centered onwhere a stock is tradingrelative to its own history.We look at variousmeasures,butwebasicallygo back as far as we canand calculate for eachcalendar year the highmultipleofcash flow, say,and the low multiple of

cash flow at which thestock traded. (The cashflownumberweuse is forthat entire calendar year.)From that, we determinethe median high multipleover the entire history andthemedianlow.We'll then look at theupside to thathighand thedownside to that low fromtoday'smultipleoncurrent-year estimated cash flow

and calculatewhatwe calla favorability ratio. Wewant to do further workonly on companies wherethe favorability ratio is atleast 3:1, meaning theupside to the median-highvaluation level is at least3xthedownsidetothelow.In other words, for themultiple part of the returnequation,wewanttheoddsinourfavor.

—BrianKrawez,ScharfInvestments

Having an edge as aninvestorisabitlikehavinganedge as a radiologist oramechanic or a pilot.Theedge comes from beingable see patterns andreliably diagnosing whatthey will mean. I'd like tothink that the combinationof inputs we use to

correlate and predict issomewhatuniquetous.In identifying potentialshort sales, for example,seeing decreasinginventory turns for acompanyauditedbyanon-Big Six accounting firm isan interesting correlation.Or we might draw someconclusions over anincreaseinthegapbetweencash flow from operations

and net income combinedwith increasing analystcoverageofacompany.—CarloCannell,Cannell

Capital

The long-term rate ofreturn on equities in thiscountry is in theneighborhood of 10percent, which correlatesclosely to theactual returnon owners' capital for all

thosebusinessesovertime.MypremisethenisthatthereturnI'llearnonastock—absent distributions andassuming a constantvaluation—willapproximatethecompany'sROE over a number ofyears. So we choose toswim in the pool ofcompanies where thereturns have been muchbetter than average and

wherewe believe over thenext five to ten years thatopportunity will remainlargelyintact.Andbecauseyou're saying, “Akre, youfool, you know we don'thave constant valuations,”we also work hard to paylow valuations at theoutset.—ChuckAkre,AkreCapital

Management

One of our best screenslooks for companies thatare earning higher andhigher returns on investedcapital,butaretradingatareasonable price based onfree cash flow. Thesecompanies are becomingincrementally betterbusinesses, but the markethasnotcaughtupwith thefact that they'reincrementallybetter.

—ZekeAshton,CentaurCapital

Mostofourinitialresearchis on finding the truestandouts in any givenbusiness. That's largely anumbers-driven exercise,focusing on returns onequity, margins, andgrowth in key sales andprofitabilitymetrics—allincomparison with the

competition. We'veidentified more than 400companies—primarily inthe U.S., but notexclusively—thatwecouldimagine owning and thatwe try to keep fairly closetrackof.—FrancoisRochon,Giverny

Capital

Weconsiderourselvesfirstand foremost value

investors,butwedon'tstartby looking for cheapstocks.We spendour timefollowing outstandingbusinesses that we wouldwant to own should theyever become cheap.They're rarely inexpensivewhen we start trying tounderstand them, but wefollowthemcloselysothaton the rare occasion theybecomediscounted,wecan

act right away. Coming atit this way also meanswe'renotwastingour timechasing statistically cheapcompanies that we willhavenointerestinowning.Time is precious in thisbusiness.—C.T.Fitzpatrick,Vulcan

ValuePartners

Withthemarketasvolatileas it has been, we've been

more diligent aboutmaintaining watch lists tocatch companies whosestockstradeoffsharplyforreasons that may be moreoverall-market related.We're not looking forshort-termtradesbut,aswelearned in late 2008 andearly 2009, stocks of eventhehigh-qualitycompanieswe want to own can getremarkably cheap quite

fast. We want to bepreparedforthat.—DavidNierenberg,D3

FamilyFunds

One important changewe'vemadeistodevelopawell-maintained list ofcompanieswewouldwantto own at the right price.Because of the suddennessof the [2008] crisis, thereweresomanysecuritieson

sale that we were a bitparalyzed in trying toanalyze them all. We'vemade the investment tostay current about on-deckideas so we can act morequicklywhenopportunitiespresentthemselves.—JasonWolf,ThirdAvenue

Management

Our best ideas tend tocomefromwhatIcall“old

research, new events.”That's typically the goodcompany you've studiedcarefullyandwouldlovetoownat the rightprice, thatgets marked down after ittrips or its industry goesoutoffavor.—RickySandler,Eminence

Capital

Tappingintoourownpriorwork has probably

produced the largestnumber of ideas. The riskis that you let the priorexperience—whether youbought into something ornot—bias your view. Wetry to stay cognizant ofthat,but just find itcanbeveryhelpfultoleveragethehead start we have fromwork we've already done.We've tried to automatesome of the process by

settingupstock-pricealertson companies we'vealready analyzed, but itisn't an exact science astarget prices can becomeobsoletefairlyquickly.

—TuckerGolden,SolasCapital

I've concluded that if youfindyourselfgoingbacktothewellwiththesameideaa third time, you're not

generating enough ideasandarelikelytogetkilled.You're not as vigilant asyoushouldbebecauseyouthink you know it already.When I find myself doingthat, I tell myself I'm justnotworkinghardenough.—JeffreyUbben,ValueAct

Capital

One narrow screen I liketargets insider buying—

when a lot of insiders arebuying, I don't care whatthe valuation is, that'salways an interestingsignal.

—ZekeAshton,CentaurCapital

We often look at cases inwhich a company withsignificant insiderownership is aggressivelybuyingbackshares,butthe

insidersdon'tparticipateinthe buy-back. Thatindicatesthatsomeonewhomay knowmore about thebusiness wants to ownmoreataparticularprice.—RobertRobotti,Robotti&

Co.

We don't take all insiderbuying and selling at facevalue. Some people andsome trades you pay a lot

more attention to thanothers. When a founderCEOwhohas100%ofhisnet worth in a stock buysanother $10 million worthon the open market, that'sinteresting. When adirector buys nearly $100million of a company'sstock, that's interesting.When top management isexercising options thatdon't expire in 15 years,

that makes us leery,especially when they'republicly talkingabouthowgreat everything is at thecompany.—StephenGoddard,The

LondonCompany

[W]e basically spend ourtime trying to uncover theassorted investmentmisfitsin themarket's underbrushthat are largely neglected

by the investmentcommunity.Oneofthekeymetrics we assign to ourcompanies is an analystratio, which is simply thenumber of analysts whofollow a company. Thelower thebetter—asof theend of last year, about 65percentofthecompaniesinour portfolio had virtuallynoanalystcoverage.—CarloCannell,Cannell

Capital

Wewanttoknowthelevelof attention paid to thecompany by Wall Street,much preferring those thatareunder-followedand forwhich there are lowexpectations. The blessingof low expectations is thatbeing right about thingsturning out better meansthe stock will probably do

quite well, while beingwrong usually means notmuch happens because thelow expectations are builtintotheshareprice.

—JamesShircliff,RiverRoadAssetManagement

We look for companiesthat don't have heavyinstitutionalownershipandfor which the sell-side isgenerallynegative,butthat

we think are addressingtheir failings throughmanagement and strategychanges. Often we're justtryingtodotheworkearlybefore sell-side analystsjump on the story and thecompany finds its rightshareholder base andvaluationlevel.

—GaryClaar,JANAPartners

Wedo exactly one screen,which is to segment ourpotential opportunities bymarketcap.Startingwitharank-ordervaluationscreenis more likely to lead youinto less-than-optimalbusinesses,whichwe can'tafford tobe inwithsuchaconcentratedportfolio.

—BrianBares,BaresCapital

Onethingwedon'tdo isa

lot of computer screeningfor ideas. I've alwaysconsidered screens to betoo backward-looking.Many of our bestinvestments would havescreened very poorly—with negative cash flow,horrible returns on equity,decliningsalesandsuspectmanagement. We're tryingto look beyond all that tothechangesinmanagement

or changes in the businessthat can correct theproblems.Thekeyforusisto be able to make acredible case for thecompany looking verydifferent in two to threeyears from how it lookstoday.—JohnOsterweis,Osterweis

CapitalManagement

We don't do traditional

screens and are actuallylooking for situations inwhich the publiclyavailableinformationthatacomputer can analyze isgiving false signals. Forexample, we bought autoinsurerProgressivein1999whentheirearningslookedbad because they werespending heavily on adirect-to-consumerstrategylike Geico's. A computer

would see that as anegative earnings trendresulting in a too-highmultiple, but it doesn'tknow how to judgewhether certain spendingmight generate big returnsinthefuture.

—BoykinCurry,EagleCapital

FOLLOWTHELEAD

The pursuit of good ideas isoften a more top-down anditerativeprocess than impliedbytheheavyuseofcomputerscreens.A trend, a theme, orevena throw-away line inanobscure industry journalinspiresa lineof inquiry thatis always filled with blindalleys, but from time to time

uncoversamispricedgem.

***

It's very important todefine where you're goingto look for opportunities.Timeisapreciousresourceand if you make it yourtask not to miss anything,you set yourself up forfailure.Therearetoomanyopportunitiesoutthereand,

bydefinition,youwillmissmany of them. That's whywe narrowwherewewantto look first by the themeswe consider mostcompelling. We're notnecessarily seeing thingsothers don't see, but wewill likely have a verydifferent view on themagnitude of the trend orthe speed at which ithappens.

—OliverKratz,DeutscheAssetManagement

Our ideas typically havemore todowith the trendsinaparticularindustrythanwhether XYZ stock looksvery cheap. We want toinvest in good businesseswith industry or company-specific tailwinds behindthem,andwhichhappentobecheap.That'sadifferent

mindset from findingsomething that'scheapandconstructing a story aboutwhy the negative issuesshouldgoaway.—BrianBarish,Cambiar

Investors

We take the traditionalvalue investor's processand just flip it around alittle bit. If you're lookingfor something that's cheap,

you'llprobablydoavarietyof screens—on price-to-sales, price-to-earnings,price-to-book, whatever—to identify stocks thatappear to be inexpensive.Once you have that list,thenyoustarttoresearchifthere are good reasons thestocksdeservetobecheap,or if maybe there's aninvestment opportunitybecause they're cheap

withoutagoodreason.Wethink that's the way mostvalueinvestorsapproachit.We never do screens likethat. We start byidentifying situations inwhich there is a reasonwhy something might bemisunderstood, where it'slikely investors will nothave correctly figured outwhat's going on. Then wedo the more traditional

work to confirm whether,infact,there'sanattractiveinvestment tomake.That'sasopposedtostartingwithsomething that's justcheapand then trying to figureoutwhy.Wethinkourwayismoreefficient.—DavidEinhorn,Greenlight

Capital

I'd say most of the ideasthat havemademoney for

theportfoliohavebeentheresult of some form ofreasoningbyanalogy.Oneexampleofthatisapplyingwell-understood andsuccessfulU.S. investmentideas to markets outsidetheU.S.—GuySpier,Aquamarine

Fund

As we extend our timehorizons, we try to think

about things not justunique to one security orsituation but applicableacross a bigger industrytrend. Thematic umbrellashelp us organize ourthoughts about biggeropportunities. We then gosystematically onecompany at a time, onesecurityata time, to try toidentifywherewecanfindthebestinvestments.

—LarryRobbins,GlenviewCapital

For me it's all qualitativeand contextual. Once youbegin to research anindustry, you have tosurveytheentirelandscapeto understand it, from thecompetitors within theindustry to the competitivethreats from outside theindustry. Ideas naturally

flowoutofthatprocess.—ThomasRusso,Gardner

Russo&Gardner

Many opportunities Ipursue have a thematic,top-down element, wherean industry's structure orcertain situationaldynamics are a tailwind tothe company's business. Itmay be the industry hasconsolidated or supply is

otherwise tightening,resulting in pricing powerfor thekeyplayers. Itmaybe a company with astructural cost advantagethat will allow it to takemarketshareandacceleraterevenuegrowthoveralongperiodoftime.Thepointisthat I focus on thefundamentals of thebusiness first, not on howcheap the stock is or how

much it's off its 52-weekhigh. That helpsme avoidvalue traps and/orbusinesses with structuralchallenges.—JedNussdorf,Soapstone

Capital

We believe our job is tolookouttwoorthreeyears,to identify who's winningand who's losing in eachindustry, and to recognize

the discrepancies betweenourviewsand themarket'sviews. Given the depth ofindustry experience andresources our sector headshave, it would be unusualforsomeonetocalluswithan idea that we don'talready have someknowledge of.As a result,the vast majority of ourideas come from thinkingthrough the ramifications

of industry developmentsor the recognition ofchangeswithinamarketasopposed to the one-off,“Here's an idea, let's chaseitdown”approach.

—LeeAinslie,MaverickCapital

We like it whenexpectations are very lowand we have a contrarianview on a broader issue

impacting the company.Low expectations helplimitthedownsideandcanresult in prices that leaveyoupayingnothingfor theupside if good thingshappen.

—JeffreySchwarz,MetropolitanCapital

The majority of ourinvestments are originallydriven from the top down.

We'll identify an industrythat has underperformedfor the past 5 or 10 yearsthatwebelieveisdueforacyclical regression up tothe mean. From that, wesystematically review thewhole universe ofmicrocaps in that industry,sortingthemonthebasisoffinancial measures andsubjective assessments ofmanagementtoidentifythe

companieswe'llboreinto.—DavidNierenberg,D3

FamilyFunds

One thing Peter Lynch [ofFidelity Magellan fame]did really well was tofigure out how else tomake money on a goodidea. Look right down theindustry structure andfigure out the other waysthat this particular

information can generatean edge. In our portfoliotoday,we identifya themeand then we try to figureout where all theopportunitiesare.—JeffreyUbben,ValueAct

Capital

You never know whereyour research will takeyou. Say you're interestedin copper. You may start

with the miningcompanies, then move tothe refiners, then theintermediate processors,then the metal-bendermanufacturers and on upthe line. If one area of thebusiness looks particularlylousy, you may want tolook at the companies thatbuy from those people.You may look at thecompetitors or the

alternatives to copper.Thirty-five companiesdown the road, you'relikelytobeinacompletelydifferent business andindustry and you'll comeacrosssomethingthatlooksinteresting.

—JamesVanasek,VNCapital

It's hard to have uniqueinsights in this business,but they often just come

from working onsomethingthatleadsyoutosomething else. I workwith two analysts andeveryonceinawhilewe'llsay, “Let's brainstormabout new ideas,” but Ican't say we've ever comeupwithanideathatway.

—EdWachenheim,GreenhavenAssociates

It's kind of a bizarre

conversation to have, butwe actively discuss whatisn't being talked about.Maybe an industry is at alow point in its cycle,where our favoritecompanywouldbeonethatis still making money andlooking to expand whilecompetitors are losingmoneyandretrenching.Ifacommodity is trading at amulti-year low, we'll look

at the producers of thecommodity who may besuffering. If a commodityisatanall-timehigh,we'lllookat companies thatusethe commodity as a rawmaterial and are gettinghurt as a result. This allbecomes a starting pointandthenwewanderaroundfromthere.

—JamesVanasek,VNCapital

Nottobeoverlysimplistic,buta lotof it comesdownto following the news andreading. You never knowwhat might jump off thepage and say, “Look atthis.”Asanexample,yearsagoIwasreadinganarticleinTheEconomist inwhichsomeonewastalkingaboutemerging consumerism inAsiaandtherewasasingleline saying something

about how this company,that company and LotteConfectionery might bebeneficiaries. I had neverheard of LotteConfectionery, but as Ilooked into it I found outnotonlythatitwasalarge,global candy and sweetscompany based in SouthKorea, but also that itwascash-flow positive and itsstockwastradingataround

net cash per share. Youobviously end up hitting alot of dead ends, but I'vefound plenty of things noone seems to be payingattentiontointhisway.

—ChrisMittleman,MittlemanBrothers,LLC

I think there are very fewtrulyoriginalideas,soalotof our [short] ideas comefrom what I call

observational commonsense. We talk a lot topeople we respect in thebusiness. We readeverything, looking forpatterns we've seen in thepastthatledtogoodideas.It doesn't have to benegative news—often youread a bullish article orreportandyoucanjusttellthewriterismissingit,thatthere's something wrong

andit'sworthalook.We'realso avid observers ofhuman behavior, lookingforcaseswherepeoplecancollectively lose theirmindsforlongerperiodsoftime than you couldimaginepossible.—JamesChanos,Kynikos

Associates

Many of our other ideasjust come fromhavingour

eyes wide open. You readpublications like yours.Youtalktocontactsyou'vedeveloped in variousindustries. It's often justabout paying attention towhat's going on in theworld.—RickySandler,Eminence

Capital

We don't have a rigidprocess, but there are

always linkages. My firstinvestment 20 years agowas Fireman's Fund.Studying Jack Byrne'sresuscitation of GEICObefore going to Fireman'sFund led me to BerkshireHathaway and this guyWarren Buffett. Thenduringthebankingcrisisintheearly1990sI lookedatmany banks, but choseWells Fargo because

WarrenBuffettownedit.—BruceBerkowitz,FairholmeCapital

We have a disciplinedidea-generation process,but it has to be open toserendipity—often it's thefootnote in the tradejournal where you seesomething interesting thateventually becomes anidea.

—ShawnKravetz,EsplanadeCapital

RELIABLESOURCES

Each investor brings his orher own experience base,strategy, and acumen to theinformation-filtering processin looking for new ideas.

Therefore it's not surprisingthattheinformation-gatheringprocess in pursuing ideas,while often clever andcreative,neednotnecessarilybe that proprietary,sophisticated, or evenoriginal.

***

For the last 40 years I'vebeen reading things like

Variety and AutomotiveNews and Farm Journalthat give you an idea ofwhat'sgoingonaroundtheworld. A story that hasalways stuck in my mindsince I first heard about itin high school is that inWorld War II, an Alliedintelligence analyst wasreading the social papersand wondered why allthese German generals

were going to a particularlocation in the middle ofnowhere. He figured outthatitwasthelocationofafactorymakingGermanV-1bombsandsendingthemto England. The hard partis connecting all the dots,but you have to assembleplentyofdotstoconnectinthefirstplace.—MarioGabelli,GAMCO

Investors

I like to have informationpushedatme,soI'vesetupkeyword alerts onsomething like 3,000companies, which resultsin20to25pressreleasesadayannouncingthingslikemanagement changes,reorganizations or newdividends. Ideas come outofthatallthetime.Another thing I've done in

my personal account is tobuy one share of probably250 micro-cap companies,which is kind of my owncustomized researchservice. The daily maildelivery is kind of aChristmas grab bag—younever know when anannual or quarterly thatarrives is going to catchyoureye.One last thing I'd mention

as an idea generator istracking new-lows lists. Ialways say margins ofsafety are created out ofbroken dreams, and there'safreshlistof thosebrokendreams published daily forustohuntthrough.

—PaulSonkin,HummingbirdValueFund

We screen a lot on themetrics you'd expect for

companies with acombination of lowvaluationandhighbusinessquality,butwealsoliketosearch article databasesusing keywords thatindicate problems or bigchanges at a company—things like “profitwarning,” or “spin-off,” or“restructuring.”

—DavidSamra,ArtisanPartners

We've over time built anumber of systems andreports that enable us totrack globally themovement of debt, equityand assets around onbalance sheets. We followinadisciplinedwaythingslike spinoffs, rightsofferings, new equityissuanceandbuybacks.—JamesCrichton,Scout

Capital

You can usually only payan undemanding pricewhen there's fear oruncertaintyassociatedwitha name. If I was strandedonadesert islandandwasgiven only one way tocome up with investmentideas, I'd want to see thedaily list of biggestpercentage decliners.

There's no better indicatoroffearanduncertainty.—JamesKieffer,Artisan

Partners

We look at the new-lowslist for long ideas and thenew-highs list for shortideas. I look at the 13Ffilings of 20 to 25 otherinvestors I respect to seewhat they're buying andselling.Bloombergalsoon

a monthly basis has thehighest-ranked and lowest-ranked stocks by sell-sideanalysts. I look at thelowest-ranked for buyingopportunities and thehighest-ranked for sellingopportunities.—JonJacobson,Highfields

Capital

We use a lot of grapevineideas, asking people what

they have finished buyingthat might be interesting.Why wouldn't you look atwhat other great investorshavefound?

—BruceBerkowitz,FairholmeCapital

It's always interesting ifthose who have filed withthe SEC as 5 percentowners are names werespect. Historically, if

we'veseeMartyWhitman'sname,we like it. Ifweseethe T. Rowe Price Small-Cap Value Fund, we'rehappy.—DavidNierenberg,D3

FamilyFunds

We follow 13D and 13Ffilings of other people werespect. We readpublications like yours. I'dmuch rather steal a good

idea than generate a badonemyself.—SteveMorrow,NewSouth

Capital

Wegeta lotof ideas fromstudying what the peoplewe respect are doing. Wesit on panels, go toconferences, and regularlypickup thephoneand talkto our friends in thebusiness.As you getmore

experience, the networkyou've built becomes aresource that is difficult toreplicate.

—JohnRogers,ArielInvestments

We learn a lot from otherinvestors. I go to ideadinners and regularly talktoa lotofpeople I respectin the business. I'm notafraid of ideas owned by

other people, but youobviously need to do yourown work and make suretheyfitwhatyoudo.There is no shortage ofpeople trying to put ideasin front of us. We won'tinvest without doing ourown research, but the giveand take with otherthoughtful analysts cansparkideas.—JamesRooney,Avenir

Corp.

Probablyhalfourideasaregenerated internally in thenormal course of business,from speaking withportfolio companies, theircompetitors, customers,and suppliers, or from thereading we do to researchanygivencompanyanditsindustry. Another 25percent or so of our ideas

come from more nichebrokerage and researchfirms with whom we'vehadagoodexperience.Wegetthebalanceofourideasfrom other buy-sideinvestors we know andrespect.Otherinvestorsareparticularly helpful forgettingaquick takeon thebull and bear case for anypotentialidea.That'snotatallareplacementfordoing

ourownwork,but ithelpsfocus our attention as wetry to determine ifsomething is worth adeeperdive.

—RobertKirkpatrick,CardinalCapital

I don't talk much to otherfund managers, but I dohave a network ofinvestigative reporters I'vegotten to know who call

me from time to time todiscuss longor short ideasthey'vecomeacross,whichcanbehelpful.

—FrancoisParenteau,DefianceCapital

We find that Wall Streetresearchdoesafairlygoodjob of describing theeconomicsofanyindustry,but a bad job on reachingconclusions about

companies. Most analystsjustrepeatwhatacompanytells them. They're oftenmorefocusedonprotectingtheir relationships withmanagement than onprotecting the averageinvestor from a potentialloss.—RobertOlstein,Olstein

CapitalManagement

PARTTwo

BuildingtheCase

CHAPTER6

CuttingThroughthe

Noise

Professional investors are an

exceedingly competitive lot,unsurprising given that theirchosenfieldisonewherethescoredelineatingwinnersandlosers can be tallied at everymarket close. But as results-drivenasinvestorstendtobe,thebestmoneymanagersputequal emphasis on theprocess they follow forconducting research andmaking portfolio decisions.They have a clear

understanding of the mostimportantquestionstheywantanswered and how best toanswer them. As we'vestressed many times already,the areas of focus andmethods of discovery canvary widely. Some investorsputgreatemphasisonhavingmacroviewsthatinformtheirdecisions,whileothersfirmlyreject that approach. Someconsider time spent with

management critical to theirresearchprocess,whileothersconsider it a waste of time.Some see industryspecializationamonganalystsasabenefit,othersseeitasadetriment. But nearly allsuccessful fundamentalinvestors see their researchand decision-making processas a primary source ofcompetitive advantage andshould be able to explain in

detailwhythat'sso.Equity strategist James

Montier, now at Bostoninvestment firm GMO,describes the importance ofprocessthisway:As much as I'd like to beable to control theoutcomes,Ican't.Theonlything Icando ismaximizetheprobabilityofgettingagoodoutcomebyfollowingwhat I've defined as the

right process. A goodprocessdoesn'tnegatebadoutcomes or badjudgments, it just tries tomitigatethem.It's like a pilot's preflightchecklist. Pilots do thesame thing thousands andthousandsof times in theirlives, but they still gothrough the physicalchecklist to eliminatewhatcould be a catastrophic

error if they try tocircumventit.Investorsarewell served by havingsimilar types of checklistsandstickingwiththem.The Baupost Group's Seth

Klarman makes a similarpoint in a slightly differentway:Money managers mustkeepfirmlyinmindthattheonly things they reallycancontrol are their

investment philosophy,investmentprocess,andthenatureof their client base.Controllingyourprocessisabsolutely crucial to long-term investment success inany market environment.James Montier recentlypointed out that whenathletes were asked whatwent through their mindsjust before competing inthe Beijing Olympics, the

consistent response was afocus on process, notoutcome. The same oughttobetrueforinvestors.Just as the best and most

rigorously followed processwill at times yield badoutcomes, the most arbitraryand slipshod process canperiodically produce a goodoutcomeaswell.Butifyou'relooking for away to bet, themanager with the superior

process is far more likely towinoutovertime.

SECOND-LEVEL

THINKINGIn describing a key goal oftheir research and analysis,top investors focus on thenecessity of having—and

being able to justify—whathedge-fund pioneer MichaelSteinhardt termed a variantperception about any givenstock they're looking to buy.What have you uncoveredandwhatdoyoubelieve thatis at variance with what themarket believes and isreflected in the share price?Without that, they say, howcan you possibly expect tobeatthemarket?

***

First-level thinking issimplistic and superficial,and just about everyonecan do it (a bad sign foranything involving anattempt at superiority).Allthefirst-levelthinkerneedsis an opinion about thefuture, as in “The outlookfor the company isfavorable, meaning the

stockwillgoup.”The second-level thinkertakes many things intoaccount:What is therangeof likely future outcomes?Which outcome do I thinkwill occur? What's theprobabilityI'mright?Whatdoes the consensus think?How does my expectationdiffer from the consensus?Howdoesthecurrentpricefor the asset comport with

the consensus view of thefuture and with mine? Isthe consensus psychologyincorporated in the pricetoo bullish or bearish?What will happen to theasset's price if theconsensus turns out to beright,andwhatifI'mright?Thedifferenceinworkloadbetween first-level andsecond-level thinking isclearly massive, and the

number of people capableof the latter is tinycomparedtothenumberofpeople capable of theformer.—HowardMarks,Oaktree

Capital

There's an old saying inpokerthatifyou'renotsurewho the patsy is, youprobably are. You cannothave an opinion about an

investment unless youunderstand the consensusand can articulate why it'swrong.Ifyoucan'tdothat,you're most likely thepatsy.If you think whateverybody else thinks, it'salready priced in. Thinkabout betting on the SuperBowl, why is Pittsburghbeing a four-point favoritethewrong line ifyouwant

tobetonSeattle?Youmaynothave toknow if you'rebetting for fun on Sunday,butyousurebetterknowifyou're making decisionswith $8 billion of yourclients'money.—JonJacobson,Highfields

Capital

Ifyoufindastockthatyouthink is undervalued butyou're unable to identify

how your insights into thecompany differ from thosethemarketisusingtopricethe stock, it's probably notreallyundervalued.—SteveMorrow,NewSouth

Capital

This may sound obvious,but we work very hard tounderstand thefundamentalsofabusinessand to identify the key

driversbehindacompany'spotentialsuccessorfailure.We end up focusing onmany of the factors you'dexpect—competitivepositioning, returns oncapital, organic growth,etc.—but always with aneyetowardsidentifyingthebiggest differencesbetween our view and theviewofthemarket.

—LeeAinslie,Maverick

Capital

Why something ismispriced is too oftenignoredbyvalueinvestors.Thegeneralthinkingisthatit doesn't really matter—ifyou're right thatsomethingis mispriced, it willeventually take care ofitself. We think it mattersbecause you canconceivably avoid a lot of

pain waiting for truth toprevail if youhave agoodread on why it currentlydoesn't.—CurtisMacnguyen,Ivory

Capital

MACROVERSUSMICRO

Prior to the 2008 financialcrisis,itwasrareforinvestorswe interviewed to put muchcredence in applyinginformed macroeconomicviews to buying stocks.Conventional value-investingwisdom had been that tryingto forecast GDP growth orinterest rates or the level ofthe overall market wasexcessively difficult andtherefore unhelpful in

assessingtheattractivenessofany given stock. The 2008crisis, in which individualstocks' relative merits wereoverwhelmed by horriblemacro news that took allshare prices down more orless together, modified thatconventionalviewsomewhat.That's not at all to sayeveryone switched toa focuson macroeconomic expertise,but its relevance to the

research and analyticalprocess is now subject tomuchlivelierdebate.

***

One conclusion I madefrom our 2008 and early2009 experience beingmore unpleasant than Iwould have liked is that Ineeded to betterincorporatemyworldview

into individual securityselection, with the goal oftrying to minimize futureunpleasantness. We'refocused on betterconnecting the dotsbetween the overalleconomicenvironmentandtheopportunitiesorpitfallsfacing individualbusinesses. In 2008 wewere looking at trees anddidn'tseetheforest.

—ChuckAkre,AkreCapitalManagement

Mostofthetime[investingwith less regard formacroeconomic forecasts]istherightapproach,butinmy experience there havebeen times when one or ahandful ofmajor factors—such as large waves ofliquidity going in andgoing out—overwhelm

traditionalmetricsofvalueto set market prices. Insuch times, ignoring thosefactors has proven to bedangerous.

—MohamedEl-Erian,PIMCO

We, like a lot of people,have been trained to bebottom-up stock pickersand not worry about themarket. The fact is,

however, that most of therisks we see today in ourindividual ideas are macroinnature,soasstewardsofcapital we ignore thoserisksatourperil.Informing yourself onmacro issues is not reallyanydifferentthantheworkyou do to inform yourselfabout a company or anindustry. You read. Youtalk to people. You learn

from the companies youown.You subscribe to thebest services. It clearlytakestimeandenergytodoitright,buttodootherwisetoday strikes us as a bigmistake.—BrianFeltzin,Sheffield

AssetManagement

OneelementtoourprocessI have added in recentyearsiswhatIcall“PEST”

Control. I grew up in thebusiness with the basicassumption that I didn'tneed toworrymuch aboutmacro issues as long as Ihad enough margin ofsafety from a cheap stockprice. That's no longer asafe assumption, so weforce ourselves to morefully assess the risks ofPolitical,Economic,SocialandTechnologicalchanges

thatcouldderailourthesis.—JeffreyBronchick,Cove

StreetCapital

In a market with all thesepotentially negative andserious macro factors, ourgrossandnetexposuresarelikely to remain low. Youdon't want to be a sittingduck waiting for yourfundamental catalysts toplay out while all these

macro factorsmight swingyour stocks wildly and, insome cases, overwhelmany fundamental catalystsyou'recountingon.—CurtisMacnguyen,Ivory

Capital

Iusedtocompletelyignorethemacroenvironment,butnowIpayattentionandtryto have a basic view thatinforms how we look at

everything. We're takingour cues on that from thecompanies and industrieswe research every day.That's more relevant to usthanthetranscriptfromthelatest Federal ReservemeetingorsomeBureauofLaborStatisticsreport.—RickySandler,Eminence

Capital

Ifyou'reahedgefundwith

the audacity to chargebetween 1 percent and 2percent as a managementfee and take 20 percent ofthe profits, your clientshave the right to expectsomething more. Oneaspect of what I consider“more” is that when themarket's overvalued, myclientsexpectme to figureit out and be hedged andout of harm's way. When

the market's undervalued,they want me to beleveraged to the upside.We're not a slave to ourmarket view, but the truthofthematteristhatarisingtidedoesliftallboatsandafallingtidelowersthem.—LeonCooperman,Omega

Advisors

Virtually all studies showthatabout60percentofthe

return and volatility of theaverage common stock isdetermined by themovementintheaggregatestock market. So whilewe're bottom-up stockpickers, we think it'simportanttohaveaviewofthe economy and theoverall market to help usdeterminewhich industriesandsectorstoemphasize.—StevenEinhorn,Omega

Advisors

[Making reasoned macrocalls]startswithhavingthebest and longest-time-series data you can find.You may have to takesome risks in terms of thequalityofdatasources,butit amazes me how peopleare often more willing toact based on little or nodatathantousedatathatis

achallengetoassemble.—RobertShiller,Yale

University

I do fall in the camp ofinvestorswho nowbelievethat blissfully ignoringmacroeconomic trends is amistake. Paying attentionto macro issues is stillprobably a waste of effort95percentof the time,butthatother5percentcanbe

very important.Oneofmyefforts in this regard is tobetter understand what'sgoing on in creditmarketsand to figure out whatthose markets might besignaling that the equitymarketsaren't.

—ZekeAshton,CentaurCapital

We're bottom-up stockpickers,sothemainreason

we concern ourselveswiththe macro environment isto pressure-test thecompanies we invest in.Using a nautical analogy,we're looking at theweather forecast to makesureourboatwillbestrongenough,nottopickthedaytogosailing.Even our macro viewsstem largely from bottom-up work. We were

interestedinFannieMaein2007 but first wanted tounderstand their credit riskbetter. We spoke with theratings agencies and askedthemwhatwouldhappenifhouse prices fell. “Youmean a six-sigma event?”they asked. “No,” I said,“just if prices fell 5 or 10percent.” They said,“That'ssix-sigma!”Well,ifhousepricesgoingback to

where they had been just12 months earlier wasconsidered six-sigma bythe ratings agencies, Ithoughtwewereintrouble.

—BoykinCurry,EagleCapital

We're not macro people,butyoucannotbeinvestingother people's moneywithout thinking about thestateoftheworld,muchof

whichisunsettling.Think about the U.S.government's debt leveland what happens ifinterest rates increase.Think about housingvalues, the unemploymentrate and the price ofgasoline and what thatmeans for consumerpurchasing power. What'sgoing to happen in theMiddleEast?What'sgoing

tohappeninJapan?What'sgoing to happen with theU.S. dollar? There are anunusual number of seriousthingstoworryabout.When that's the case thatall makes its way into theportfolio by our assessingthe impact all of thesethings could have on eachcompanyweownandfullyunderstanding thedownside.Wealsothinkin

timeslikethesewhentherearesomanyimponderablesout there, it's important tohave a significant cashcushion in case somethinggoeswrong.

—DennisDelafield,DelafieldFund

We've always beendedicated, bottom-upinvestors,fullybelievinginthat old line from Peter

Lynchthatifyouspend15minutesayearstudyingtheeconomy, you've wasted10.WhileI'mnotpreparedtorenouncethatposition,Ido believe we need to doourbottom-upworkwithagreater appreciation forwhat's going on in theworld.

—JimRoumell,RoumellAssetManagement

It'simportantnottogettoocaught up in themacroeconomicorpoliticalcurrents and just focus onthe fundamentals ofindividual businesses.Bigger issues obviouslymatter,buttheyshouldjustbe a part of the manyinputs you look at inassessingthequalityofthebusiness, its prospects andwhatyouthinkit'sworth.It

doesn't matter how wellyou handicap the nextpresidential election if youcan't discern a goodbusinessfromabadone.

—DavidHerro,HarrisAssociates

More people are saying,“Everything's macro,you'vegottothinkintermsofriskon,riskoff.”Ithinkthat'sreallyanuttything.I

just don't believe you canbeeffectiveintryingtogetthosedecisionsrightintheshortterm.—HowardMarks,Oaktree

Capital

Iwouldarguethatifmacrofactors are too big adeterminant in yourappraisal of a company'sintrinsic value, you shouldjust sit that out. Given all

the issues in Europe, forexample, we don't have tobet onEuropean consumercompanies whose fortunesareclosely tied tohow thedebt crisis there plays out.In theU.S., we don't havetobetonhealthcare stockswhose futures depend onmacro healthcarelegislation or the financialstrength of governmententitiesthatpayalotofthe

bills.Weshould justmoveon to where the micro isdrivingvalue.—StaleyCates,Southeastern

AssetManagement

In general, we build theportfolio one stock at atime and don't really gooffensive or go defensivebased on what we thinkmighthappeninthemacroenvironment. We'll always

havethingsintheportfoliothat will do better whentimes are tough or whentimes are good, but theytend to balance each otherout. When you focus asmuch as we do onoperating turnarounds,those kinds of stocks—ifyou're right—should dorelatively well regardlessof how healthy theeconomyis.

—MarikoGordon,DarumaCapitalManagement

Whileitisalwaystemptingto try to time the marketandwait for the bottom tobe reached (as if it wouldbe obvious when itarrived), such a strategyhas proven over the yearsto be deeply flawed.Historically, little volumetransacts at the bottom or

on the way back up andcompetition from otherbuyers will be muchgreater when the marketssettle down and theeconomybeginstorecover.Moreover, the pricerecovery from a bottomcan be very swift.Therefore, an investorshould putmoney toworkamidst the throesofabearmarket, appreciating that

thingswilllikelygetworsebeforetheygetbetter.

—SethKlarman,TheBaupostGroup

IgaveaspeechrecentlyinwhichIborrowed[OaktreeCapitalChairman]HowardMarks' concept of the “Iknow” vs. the “I don'tknow” investor. The “Iknow” investor thinksknowledge of the future

direction of economies,interest rates and marketsis essential for investmentsuccess and is confidentnot only that he can havesuch knowledge, but thathe'll have it first as well.These are people who arequite popular at dinnerparties.The “I don't know”investor doesn't believethat you need to know the

futureoreventhatyoucan,so spends most of his orher time on how big themargin of safety is and inassessing what risks canresult in the permanentimpairmentofcapital.Thistendstobeacontrarianlotand they aren't hugelypopularatdinnerparties.

—JamesMontier,GMO

Wemostlyhavenothingto

say about the marketoverall. Given that wemaintain a disciplinedrange of net exposure,whetherweget themarketright or wrong doesn'tmakethatmuchdifference.Ifournetexposureisat40percent rather than 60percent and the marketmakes a 10 percentmove,that's a 200-basis-pointimpact.That'snotnothing,

butithasfarlessimpactonhowwedo than individualstockselection.—AdamWeiss,ScoutCapital

In the end, I fall back onthe fact thatourprocess ismeant to identifyundervalued companies onan absolute basis, usingconservative assumptions.If I can find them, I'll buythem.IfIcan't,I'llholdthe

cash until I can. Thatprocessismeanttoworkinany macro environmentand so far it's held upprettywell.—EricCinnamond,Intrepid

Capital

I've always told people Ihave no idea what themarket's going to do orwhenreturnswillappearinthe portfolio. I don't think

either of those ispredictable. The best wecandotodayistofocusoncompanies with balancesheets to weather a credit-constrainedworld,businessmodels thatwillbearoundfor years to come andvaluations that are cheapenough to make the waitfor recovery worthwhile.That'swhatwecancontrol—the rest of it takes care

ofitself.—AndrewJones,NorthStar

Partners

The first lesson [post-financial crisis] was thatbottoms-up fundamentalcompany analysis stillmattersquiteabitandthatignoring the experience ofGraham,Buffettandour35years to become macro-driven “generals fighting

the last war” would haveprobably left us on thesidelines at exactly thewrong time. Parkingourselves in cash in early2009towaitforclearsignsthemiserywasoverwouldhavecausedus tomiss thebest purchase point forequitiesinmylifetime.—StaleyCates,Southeastern

AssetManagement

There's no question thatgetting the macro pictureright ishugelyvaluable—IjustwishIwerecapableofdoingit.Whenitcomestomacro events, you caneither predict or react. I'veproven timeandagain thatmy crystal ball is horrible,so my focus has to be onreacting to extremes inindividual securities byselling at high valuations

and buying at lowvaluations.

—BruceBerkowitz,FairholmeCapital

Manyofourpeersseemtohave concluded thatbottom–up investing isn'tgood enough anymore, anopinion we don't sharebecause the assumption isthat it's easy to have anonconsensus macro view

that adds value. So manyof themacro overlays youhear today talk aboutEurope having troublerestructuring its debt andtheU.S. economygrowingslower than it hashistorically. Could you beany more consensus thanthat?With the five- to seven-yeartimehorizonwethinkabout,you'reusuallybetter

off thinking that thingsaregoingtobesortofnormal,as opposed to having astrong conviction aboutwhat the economy's goingto look like that overridesall of your bottom-upwork.Our view today thatthings normalize over fiveto sevenyearsmightbeasanticonsensus as most ofthe macro overlays outthere.

BillNygren,HarrisAssociates

ItalktoinvestorswhohavejustbeeninNewYorkandwho want to know mymacro view andwhether IthinkJapanisgoingtobeavortex thatpulls thewholeglobaleconomydownwithit. Their eyes glaze overwhenIstarttalkinginsteadabout C.R. Bard's Foley

catheters or the newBankFusion software atMisys. But that's whatmatterstous.Ourgoalistofind earnings streams thatare defensible in goodtimesandbadandthatalsodemonstrate seculargrowth. It's frankly anadvantagetonotgetoverlydistracted bymacroeconomic concerns,which canmake it hard to

pull the trigger on a greatbusiness when theopportunitypresentsitself.—JeffreyUbben,ValueAct

Capital

BUSINESSFIRST

It's rare in speaking withaccomplished investors that

they say their initial effort inassessing an investment'sviability is how cheap thestock is. That's obviouslyimportant in the end, butgiven that any credibleassessment of a company'svalue relies in large part onjudging the prospects for itsbusiness, most investorsfocus first on understandingthe dynamics of thecompany's competitive

environment, the seculartrendsaffectingtheindustriesinwhichitcompetes,andtheimpactalloftheabovehasonthe sustainability andprofitability of its businessmodel. As GAMCOInvestors'MarioGabelli putsit, simply, “Only after youunderstand the business canyouunderstandthestock.”

***

The biggest lesson learnedfrom my father was thatinvesting was all aboutbusinesses and people.He'd talk aboutMcDonald's versus BurgerKingortheriseofNikeorhow Steve Jobs startedApple, all in a way thatwas very interesting for akid. There was nothingabout P/E ratios ormarketcaps—thingshefiguredwe

could learn later. Hewanted us to understandtheessenceofbusinessandwhat made a businesssuccessful.—ChristopherDavis,Davis

Advisors

One of the best lessons Ilearned early on was tolook at companies ascompanies first—tounderstandwhat theywant

to achieve and thelikelihoodtheycanachieveit. People too often focuson stocks first and thinkthey can generate an edgein how they're looking atvaluation.Intheend,staticvaluation is relativelyefficient and it's whatcompanies do that drivestheirfutures.—OliverKratz,Deutsche

AssetManagement

Before I even look at afinancialstatement,Itrytofind out as much as I canabout the history of thecompany, to understandhow it has arrived at itscurrent predicament. (Ifwe're looking at it, it'susually a predicament.)The Internet is very goodfor this type of research.I'm trying to findevidence

ofsimilarissuesinthepastandwhathappened,tohelpjudge whether currentproblems are controllableand rectifiable. If acompany loses dominantmarketshareinabusiness,for example, in myexperience it almost neverrecovers that share. If itretains dominant share butlets its costs get out ofcontrol, the probability of

that problem being solvedis very high. I want toknow whatever I can tohelp me make thosedistinctions.—MurrayStahl,Horizon

AssetManagement

We focus on companieswith long competitive-advantage periods, whichputs a premium on ourtruly understanding the

business dynamics overtime. As a result, featuresof businesses we'retempted by typicallyinclude stable marketshares, stable margins,pricing power and longdata series, so we canevaluate how the businesshas performed throughgoodtimesandbad.—JamesCrichton,Scout

Capital

Our research is veryfocused on the context inwhich a company isoperating and onunderstanding why thevaluation is so low. Ifyou'rebuyingahouse,youdon't ask your real estatebrokertoblindfoldyouandtake you to the cheapesthouseintownandjustlookat it from the inside. You

havetostickyourheadoutof the window and walkaroundtheneighborhoodtoreally understand what it'sworth.Sowhenwelookatbanks,we want to know theleverage ratios forconsumers in theirprimarymarkets.Whenwe look atcement companies, wewant to know whereconstruction activity is

historicallyrelativetoGDPintherelevantmarketsandwhatimportpricesare.Justbuying cheap stockswithout paying enoughattention to thosecontextual issues can getvalue investors intotrouble.

—DanO'Keefe,ArtisanPartners

We focus on industry

structure. We likeconcentrated industrieswith two or three primaryplayers.Asvalueinvestors,wearetypicallybuyingtheunderperformer. There areissues to fix, but thecustomers are rooting foryou and the leadingcompetitor, with highmargins and a high stockprice,isprobablynotgoingtogoforthejugular.

—JeffreyUbben,ValueActCapital

The three primary driversfor a stock are the macrofactors that influence thebroader market, thedynamicsoftheindustryinwhich the companyparticipates, and thespecific prospects for thecompany itself. We don'tthink we're particularly

adept at predicting thebroader market, but we'requite comfortable firstanalyzing an industry orsub-industrytrendandthendiving deeper intocompany-specificissues.

This “middle-down”approach, as we call it,keeps us from putting somuch importance on acheap valuation, a great

company-specific story, ora particularly appealingmanagementthatwemissabroader industry trend thatmakes all that irrelevant.As Warren Buffett hassaid, when managementwith a great reputationtakesonanindustrywithabad one, it's the industrythatusuallycomesoutwithitsreputationintact.We often find multiple

ideas supported bycommon viewpoints. Ingeneral,wethinkit'seasierto hit the side of the barnthanonesinglespotonthebarn.—MichaelKarsch,Karsch

Capital

We spend a lot of timetrying to figure out howcompetitors would attackthe business of the

company we're interestedin. The harder that is, themoreinterestedweare.Wetry to avoid marketsperceived to be soattractivethatcapitalcouldstartpouringinatanytime.—MarioCibelli,Marathon

Partners

There are usually only afewthingsyouhave togetright about a company for

it to be a successfulinvestment. What are thekeydriversof thebusinessand how are theychanging? What is thecompany doing to positionitself for that future, andwhat is it doing to operatemore efficiently andeffectively? How are theyredeploying capital? Ourview is that if you canget85percentofthewaythere

by answering the bigquestions,don'twasteyourtimeon the last15percentbecausethemarginalutilityisn'tworthit.—SteveMorrow,NewSouth

Capital

Thekeyquestionswewantto answer focus onassessing the basicattributes that to us makean interesting stock: Does

the company generatestructural free cash flows?Is there some element ofdefensiveness in thebusiness model that willhold off competitors fromcoming in and disruptingthe economics? Is theresomeelementofsecularorcompany-specific growthpotential? How capable ismanagement? What is thecatalysttovaluecreation?

—MatthewBerler,OsterweisCapitalManagement

[My daughter] was six orseven,sorather thantrytoexplain moneymanagement and the stockmarket, I said I'd tell herhowIspentmytime.ItoldherthathalfthetimeIreadthings likenewspapersandmagazines and half thetime I spent speakingwith

my colleagues. She said,“That's not work!” Butthat'swhatIdo.It'sverycommontodrowninthedetailsorbeattractedto complexity, but what'smost important tome is toknow what three, four, orfive major characteristicsof the business reallymatter. We have a greatteam of analysts who findthe ideas and do the

investigative work and Isee my job primarily asasking the right questionsand focusing the analysisin order to make adecision.

—Jean-MarieEveillard,FirstEagleFunds

WHAT

QUALITYMEANS

While not all value investorsemphasize the quality of thebusinesses in which theyinvest, many follow WarrenBuffett's lead in theirpreference for a greatbusinessatafairpriceoverafair business at a great price.Thosewhoemphasizequalityalsohaveaveryrefinedsense

of what they believe qualitymeans when it comes tocompanies and theirbusinesses.

***

Our ideal investments areinfranchisebusinesses,theterm we use to signify aright, a license, or aprivilege that confers aneconomic advantage that

willpermitthecompanytoearn above-average returnson capital over longperiods of time. Thatgenerallymanifestsitselfinsome form of competitivebarriertoentry,frombrandstrength, intellectualproperty, the regulatoryenvironment, or scale. Italso typically means thebusiness is somewhatshielded from

unpredictablemacroeconomicforcesand,even better, that it shouldgrow in good times andbad.Companieswith thesecharacteristicsarewinners,and they tend to staywinners.—PeterKeefe,AvenirCorp.

We start from the premisethat we want to invest ingreat businesses that share

common characteristics.They provide essentialproducts and services,meaning they are more“have-to-have” than “nice-to-have.” They have verysatisfied and loyalcustomers. They haveleadership positions andsustainable competitiveadvantages in attractiveindustries and markets.Financially, theyearnhigh

returns on capital—certainly above their costof capital—and generatehigh after-tax free cashflow that can be used toinvest, make acquisitions,pay down debt, buy backstockorpaydividends.—TimothyHartch,Brown

BrothersHarriman

We like simple,predictable, free-cash-flow

generative, resilient andsustainablebusinesseswithstrong profit-growthopportunities and/orscarcityvalue.The typeofbusiness Warren Buffettwould say has a moataroundit.We'vedonealmostnothingin energy or other cyclicalbusinesses. We avoidhealthcare because of allthe regulatory uncertainty.

We've done nothing activein financial services,except on the short sidewith MBIA. When you'reputting8%,12%or15%ofyour money in something,it's not a day trade. Youhave to focus first andforemost on high-qualitybusinesses that can't blowup and should grow invalueovertime.—WilliamAckman,Pershing

SquareCapitalManagement

Whatmakesahigh-qualitybusiness?At a basic level,the product or servicebeing sold is critical tocustomers but is only asmall part of their coststructure,andthecustomerrelationship tends to besticky and recurring.Generally, we end up inintellectual-property-based

businesses that can priceoff of a value-add ratherthan some sort of costbasis.—JeffreyUbben,ValueAct

Capital

We're looking forbusinesseswithlowcapitalintensity, the ability togeneratehighlevelsoffreecashflow,andaprivilegedbusiness model that

enables the company toproduceexcesscapital.Wewant the financial andbusiness models to betransparent. In terms ofcompetitive dynamics, wewant to understand thevalue of the company'sproduct or service tocustomers and the strengthof its competitive moat.From an industryperspective, we ideally

want to see long-termsustainable growth andseculartailwinds.—JamesCrichton,Scout

Capital

My favorite ideas tend tobecompaniesthatgeneratefree cash flow, not cheapcyclicals or stocks tradingat big discounts to book.One big advantage ofinvesting in companies

generatingfreecashflowisthat you can be morepatient because theintrinsic value tends togrow while you own it—they're adding cash to thebalancesheet,payingdowndebt, buying back theirstock.Thestockpricemaynotperformforatime,butthe intrinsic-value growthwilleventuallybereflectedin themarketprice.You're

gettingpaidtowait.—AndrewJones,NorthStar

Partners

High-return businesseshave something specialwhich allows them to earnabove average rates onemployed capital. Thatmay be intellectualproperty, scale economies,a regulatory advantage,high customer switching

costs, or some sort ofnetworkeffect.Wewanttosee evidence the businessmodel produces unusualreturns, to understandwhyand to believe that's likelytocontinue.Partofthatisafunctionof theopportunityyet to be realized—we'realwaysasking, “Howwideand how long is therunway?”—ChuckAkre,AkreCapital

Management

Anareaonwhichwespenda lot of effort is to definehow big the runway ofopportunity is in thebusiness.We'renotlookingfor short-term or arbitrageopportunities, but caseswhere we can see areasonable probability of ahuge upside, which we'renotpayingfor.

—RobertJaffe,ForceCapitalManagement

The most important thingthat I figured out early onwas the benefit wheninvestinginturnaroundsoffocusingoncompaniesthatoperate in growingmarkets. If a company hasmarket growth as atailwind, it's quite a biteasier for management to

execute an operationalturnaround.—KevinO'Boyle,Presidio

Fund

It takes a lot to kill astrong, establishedfranchise even if acompany loses its way.Think IBM. ThinkMcDonald's. The rightmanagement can make allthe difference in whether

the business comes back.The strength of thefranchiseandthequalityofmanagement are what Ispendmostofmytimeon.—LloydKhaner,Khaner

Capital

We're not usually lookingfor the scruffy cyclical orturnaround story, but forbusinesses with highmarket shares in their

principalproductorservicelines, with long productcycles but short customer-repurchasecycles,andwithrelatively low capitalrequirementsthatallowthecompany to generate highcash returns on tangibleassets while growing.We've always consideredbusinesses requiringenormous amounts ofcapital for fixed assets,

especially when they'reeconomically sensitive, tobeatabigdisadvantage.

—DonaldYacktman,YacktmanAssetManagement

One important aspect ofbusiness quality is howsuccessful it will be in aless-buoyant economicperiod.Cantheycutcosts?Can they take marketshare? Will their balance

sheetanasset?Theanswerto those questions canmake a huge difference inthe viability of anyinvestment.

—DavidSamra,ArtisanPartners

Sinceweoftensuggestthatcompanies refocuson theircorebusiness, themajorityof our research time isspent on determining the

healthandsustainabilityofthat business. We need tofully stress test ourassumptions on the corebusiness—that's wheresomething could gowrongif it were going to gowrong.

—PeterFeld,StarboardValue

In companies earningabnormal returns, there's

somethinguniquegoingonandwewanttounderstandwhatitis,whyitexistsandwhether it's sustainable.We're trying to findbusinesses that have greatmoats, which translatesinto great returns oncapital. Moats are fairlyrare but come from avariety of things, such asintellectual property, scaleeconomies, a regulatory

advantage, high customerswitching costs, or somesortofnetworkeffect.Truemoats give you moreconfidence in projectingfutureperformance.—ChuckAkre,AkreCapital

Management

To us, the definition of agoodbusinessisifyoucanspecifically identifyreasons why it should be

able to earn a return inexcess of its [cost of]capital. It could beanything: a competitivecost position, a franchisebrand, an installed base ofbusiness, uniquetechnology—some reasonto believe that even if thecurrent management failsto restore earnings,somebodyelsewouldwantto try. Say, an acquirer of

the assets. Or the boardreplacing managementwithothermanagement.Oreventhesamemanagementtrying another plan,because it's worth tryingand you can specificallyunderstand why it's worthtrying.

—RichardPzena,PzenaInvestmentManagement

CRUNCHINGTHENUMBERSWhile it's less common thanyou might think forsuccessful investors to holdaccounting-related degreesand credentials, that is not atall to say they're uninformedwhenitcomestothenutsandbolts of income statements,balancesheets,andcashflowstatements. In fact, most top

managers stress theimportanceoflookingbeyondthe stated accountingnumbers to draw insight thatmight give them an edge inanalyzing a company and itsstock.

***

The goal with all ouraccounting adjustments isto arrive at numbers that

best reflect true economicreality. We'll increaseearnings if depreciationcharges are overstated, forexample,whichisoftenthecaseincountrieswherethetax code tends to governreporting decisions. We'lldecrease earnings ifdepreciation charges areunderstated, as oftenhappens in countries likethe United States where

earnings per share and/orshare prices matter greatlyto thecompensationof thetopexecutives.We lookateverything—pensionliabilities, environmentalliabilities, restructuringcharges, etc.—and makeadjustmentstoarriveatthe“true” results. Sometimesthose adjustments canmake something muchmore attractive than the

marketseemstorecognize.—CharlesdeLardemelle,

InternationalValueAdvisers

We spend a lot of timeaccounting for theinefficiencies of generallyaccepted accountingprinciples, which are mostprominent in longer-termassets.Thatcouldbelandheldonthe books at cost, which

over time is worthsomething very differentthan cost. Any asset thatcan be depreciated ispotentially valued atsomething materiallydifferent than currentmarket value. When acompany buys equipmentorbuildsabuilding, itsetsdepreciation schedulesbased on useful lives andother accounting

conventions, but thoseschedules know nothingaboutthefuturesupplyanddemandforthatequipment,or the occupancy levelsand cap rates for thatbuilding.Over timeas thatasset is depreciated, therecanbemajordiscrepanciesbetween book value andtruemarketvalue.

—AriLevy,LakeviewInvestmentGroup

We primarily focus onunderstanding the uniteconomicsof thebusiness.In a retailer, for example,wehavetounderstandhowone store works: what arethe capital requirementsandmaintenancespending,how does the lease work,how does the cash flowbuild? This is the waymanagersinthefieldthink,

and we find this approachhelps us best understandthedriversofthebusiness.When we chose to pick afight with the market—aswe call it when we buysomething—it's usuallybecauseoftheworkwedoat this level.WallStreet isvery top down, say, inlooking at how muchrevenue at what overallmargin equals how much

EBITDA. We work fromthe bottom up, which wehope helps us understandbetter thanthemarkethowreturns on capital can beimproved.Another advantage ofknowing the uniteconomics is thatwe thinkit allows us to identifyproblems early. When wesee a deterioration in unit-level returns on capital,

thatcangiveusachancetorespond before it's fullyreportedintheP&L.—JoeWolf,RSInvestments

Our most important focusis on understanding abusiness'returnoninvestedcapital and, perhaps moreimportantly, its return onincremental investedcapital [ROIC],which I'velearned to appreciatemore

andmore over the past 25years. We scrub thefinancials to get a reliablepicture of the company'shistorical full-cycle ROICand want to see itsignificantly ahead of itsweighted average cost ofcapital, which means thecompany is creatingshareholdervalue. If abadacquisition has beenwritten off, for example,

we'll evaluate whethersomeorallofthatwrite-offshould be added back tothe capital base inassessing the return oncapital. We're not justlooking backwards, butalso want to see thatprospective returns—basedon our estimates ofearnings and theinvestments necessary togenerate those earnings—

aregoingtobeattractive.—PatEnglish,Fiduciary

Management,Inc.

We analyze receivablesand inventories todetermine changes in eachrelativetochangesinsales.Inventoriesandreceivablesincreasing faster than salescanbeearlywarningsignsof future slowdowns.Inventories building in the

right places, like rawmaterials and work-in-process, can be signs offuturestrength.—RobertOlstein,Olstein

CapitalManagement

One exercise we gothrough on all our mostinterestingideasiswhatwecall balance-sheetoptimization. It's our termfor debt recap. What can

management do, fullyunder its control, with thecapital structure to createvalue?UseMicrosoftasanexample. Ithas$60billionofcashonhand,verylittledebt and throws offsomething like $30 billionin free cash flowper year.The equity has beentrading at 8x to 10xearnings and the companycan issue debt at less than

3.5%, so there's a hugedifferencebetweenthecostof debt and the cost ofequity. As an exercise,what would happen if itwent to a net $60 billiondebt position? Given thefreecashflow,that'sstillamodest capital structure.They take the $120 billionin cash proceeds and buyback a significant amountof their equity. With a

loweredcostofcapitalandshares outstanding cut inhalf,ifwerunthatthroughour cash-flow model –assuming no growth – wecomeupwithasharevaluein the low- to mid-$40s,versusaround$28today.We look at this as ourdownside protection andalsoasawaytodistinguishouranalysis.It'sdifficulttoout-predict the Street

consistently onMicrosoft'sgrowth over the next fiveyears, but very fewanalysts focus on valuecreationthroughthecapitalstructure, so it canprovideus with a differentperspective on how tovaluethestock.—StephenGoddard,The

LondonCompany

Thedetailmatters. It's one

thing to say incrementalmarginsareXpercent,butwe need to show all thedetail used on things likepricing and fixed andvariable costs to justifywhy that conclusion isaccurate.—JamesCrichton,Scout

Capital

One reason we can findopportunities is that the

market is pretty good atforecasting top-linegrowth, but then it gets abit fuzzier as you go fromsales growth to whatearningsgrowthisgoingtobe, and thenmost researchgets really fuzzy when itcomes to things like howmuch capital will beneeded to support growth,wherethecapitalwillcomefromandhowmuchexcess

cashwillbegenerated—allof which feeds intoultimatebusinessvalue.

—BillNygren,HarrisAssociates

I think the number onevariable in the investingequation that Wall Streetoverlooks is marginleverage. Most investorsfocus on leverage fromsales growth, which is

relativelyeasytofigureoutand everybody looks atthat. But in the greatorganic growth stories,such as Starbucks, HomeDepot,Wal-Mart, andBedBath&Beyond,alotoftheshare price upside hascome from thesecompanies increasingoperating and net marginsas they grow. If you getthis typeofcompanyearly

enough in the story,whichiswhatItrytodo,youwillget a tremendous amountof appreciation from bothsales and margin growth.That'sthemostoverlookedsourceof bigmoneygainsIcanthinkof.—ArneAlsin,AlsinCapital

Management

Apredilectionofminethathas caused problems at

times is to favor stories orcompanies that arecomplicated or esoteric.Theclassicexampleformewas Novell, the softwarecompany, which providedprobably the most painfulinvesting experiencewe'vehadduringmytenurehere.It's a long story, but webought the stock manyyears ago because it wasverycheaponanenterprise

value basis and it had aproduct, called NetworkDirectory, that I thoughtwas a real game-changer.The problem was thatNovell had so discrediteditselfinthemarketthroughprevious missteps that thetarget customers weren'twilling to buy anythingfrom them. I was soenamored with NetworkDirectory's product

specificationsthatImissedtheforestfromthetreesonwhethertheycouldactuallysellit.—BrianBarish,Cambiar

Investors

I should point out that wecangotoofarinourzealtocrunch numbers. We oncemissed a big run-up inBlack&Decker because Idocked them for some

unfunded pensionliabilities that took themsomething like 2 percentout of our buy range. Weloved the company andloved the products andthoughttheyweredoingallthe right things to turnaround their business. Sowe missed a double bypaying so much attentiontodetailthatwemissedthebigpicture.

—RobertOlstein,OlsteinCapitalManagement

WHATCOULDGOWRONG?

As they analyze industries,businessmodelsandfinancialstatements,valueinvestors,inparticular, place considerableemphasis on what can go

wrong and the potentialimpacts those negative turnsof event could have. Theyfrequently repeat phrases,such as, “It's important tolook down first beforelooking up,” or “We'refocused first on return ofcapital rather than return oncapital.” They take seriouslytheanalysisoftheirmistakes,with the obvious goal of notrepeating them. This

obsession with the downsidereflects a mindset capturednicely by Gotham Capital'sJoelGreenblatt,whosays,“Ifyoudon'tlosemoney,mostoftheremainingalternativesaregoodones!”

***

If you look at sportshistory, the championshave usually been the best

defensive teams, not thosewith the most excitingoffenses. I went to schoolat Michigan State whenWoody Hayes was thefootball coach at OhioState.Woody's philosophywas that a “three-yards-and-a-cloud-of-dust”offensewasallyouneededifyouplayedgreatdefense.Welosttohimeveryyear.I've always believed that

above-average, long-termperformance in the stockmarket ishighlycorrelatedwith avoiding seriouserrors,soIalwaysfocusonwhat can gowrong first. Iwanttoknowthedownsiderisk potential beforelooking at the upside.While it isn't in real life,paranoiacanbeavirtue intheinvestmentbusiness.—RobertOlstein,Olstein

CapitalManagement

We are big fans of fear,andininvestingitisclearlybetter to be scared thansorry.

—SethKlarman,TheBaupostGroup

You're a product of yourexperience,so thefact thatI came of age as aninvestor in the 1970s has

basically made me scaredof everything. I've foundthat abject fear and soundanalysis can be a veryhealthycombinationforaninvestor.—SusanByrne,Westwood

Management

Thevery first thingwedowhenwestart toanalyzeacompany is to askourselveshowfarthestock

pricewouldfallifwewerewrong. It's not someback-of-the-envelopecalculation, but a fullassessment looking atliquidationassetvaluesandstressing the businessmodel andvaluation levelsunder any number of badscenarios. If the downsideis more than 30 percentfrom today's price, it'sunlikely we'll invest,

regardless of the upsidepotential. If we can'testablish a concretedownside number—whichprobably means it isn't farfrom 100 percent—weabsolutely won't buy thestock.Going through this firstsetsthetonewewanttosetinourresearch.Ratherthanstart out looking toconvinceourselveswhywe

should buy something, westart out trying to provewhy we shouldn't buy it.Wetrytokeepthatlevelofskepticism alivethroughouttheprocess.—RagenStienke,Westwood

Management

Webelieveinthepowerofcompounding and thesimple math is that youcan't compound very well

if you suffer too much onthe downside. I don'tunderstand why peoplewho can go on at lengthabout why this or thatcompany will grow andprosper often spend littletimeonwhatcangowrongand the impact it couldhaveontheshareprice.It'snot as if defining thedownside is more difficult– it's probably easier than

estimatingtheupside.—TomPerkins,PerkinsInvestmentManagement

Top of mind for us inidentifying potentialinvestments is a notionborrowed from WarrenBuffett that we call thefive-yearrule.Ifweholdastockandthemarketclosesfor five years, will wesleep well at night with it

in the portfolio? We findanswering that question isa great line of defenseagainst big mistakes. Ifyou'dfindyourselfneedingregularmarket feedback tobe comfortable with yourestimateofvalue,maybeitdoesn't really have themarginof safetyyou thinkitdoes.—MitchellKovitz,Kovitz

InvestmentGroup

We always ask beforebuying whether we'd becomfortable putting thestock ina lockbox for fiveyearsandnottouchingit.Ifwe'renot,weshouldn'tbuyit. That's not an argumentforputtingyourheadinthesand, but we think youneed that level ofconfidence in the businessto thinkmostclearlywhen

thingsgotemporarilyawryand clients are questioningyou.—PatEnglish,Fiduciary

Management,Inc.

Youcan't takea long-termview without confidencethat the company'sfinancial condition willallowittomeetout-of-left-field macro or microchallenges. There's an old

saying that the balancesheet doesn't matter untilit's all that matters, so wewant to be ahead of that.That's particularlyimportant in smallercompanies, which aregenerally built on morefragile foundations thanbig,diversifiedones.Wemeasureleveragefairlybroadly by looking at theratio of assets to

stockholders' equity. Thisallowsus to see risk itemsthat might not otherwiseshow up if we wereprimarily focused on long-termdebt,likehigher-than-usual levelsof receivables,or bulging inventories, orincreasing short-term banklines of credit that mayhaveawayof turning intomore permanent debt. Ourgeneral rule of thumb, for

non-financials, is to lookfor a 2:1 ratio of assets tostockholders'equity,whichwe consider a reasonablemarginofsafety.—WhitneyGeorge,Royce&

Associates

If you've looked at tens ofthousands of balancesheets,asIhave,youknowwhat to look for in eachsituation. Generally,

though,welookatdebt-to-equity ratios, liquidity,depreciation rates,accounting practices,pension and healthcareliabilities, and hiddenassets and liabilities. Theoverriding question is ifsomething goes wrong,what'sourprotection?

—EdWachenheim,GreenhavenAssociates

One[ofmymorecommonmistakes] would beignoring the potentialimpactofleverage.Iknowthe effect goes both ways,but say you do a sum-of-the-partsanalysisandthinktheassetsofacompanyareworth $100. If thecompany has $70 of debt,overstating the asset valueby only $10 makes theequity value go from $30

to $20. In the grandschemeofthings,being10percent off isn't that big amistake, but when there'sheavyleverage,itis.

—Jean-MarieEveillard,FirstEagleFunds

To some extent, balancesheet risk is a characterissue for us. The CEOwhosecompanyhasagreatbalancesheetprobablyisn't

going to make the big,dumb acquisition that willkill the company. He'sprobably not the guythrowing $2 millionbirthday parties for histhird wife at companyexpense. Other investorslike the leverage thathaving debt gives you onthe upside, but wegenerally try to lookdownbefore we look up—

leverage doesn't look sogreatfromthatperspective.

—JamesClarke,ClarkeBennittLLC

Value investors' advantageusuallycomesfromhavinga time horizon longer thanmost investors,overwhichthe issues that might bemaking something cheapeither cycle away or arefixed. In companies with

strong financial positions,itcantakelongerthanyouthink for things to workout, but you always get tocome back and playanother day. If you startwith a bad balance sheet,the clock is ticking loudlyright out of the chute andyou may never get thechancetoprovehowsmartyour long-term analysisreallyis.

—JayKaplan,Royce&Associates

One thing we are veryconscious of is the degreeof leverage in a business.That can be financialleverage,whichisreflectedonthebalancesheet.Itcanbe operational leverage,where you look at howmuch of the cost base isfixed or variable. It can

also be the degree ofleverage to a particularindustry or geography. Ingeneral, I'muncomfortablewith companies that arevulnerable to more thanone of those kinds ofleverage going againstthem at the same time. Acyclicalbusinessthathasalot of fixed costs, forexample,shouldnothavealotof financial leverageor

be too levered to onegeography or industry. Ifthings go the wrong way,management has its handstied in trying to get out oftrouble. This is a bigreason we rarely findopportunity in morecommodity-typebusinesses.

—DavidHerro,HarrisAssociates

What we try to do witheach potential investmentismarktomarkettheassetsand liabilities that havebeen reported on thebalance sheet usinggenerally acceptedaccounting principles. Theunderlying goal is todetermine what thecompanywouldbeworthiftheassetsweresoldandtheliabilities were paid off,

providing us with a directassessment of downsideprotection.—MatthewSwaim,Advisory

Research,Inc.

The most direct influenceon my strategy was mytimeworking forAdvisoryResearch, where the firstemphasis is on markingassets and liabilities tomarketanddeterminingthe

true net asset valuesupporting any potentialinvestment.Butbehindthatisagreatdealofempiricalresearch from people likeGraham and Dodd, RogerIbbotson, and Fama andFrench showing the long-term outperformance ofvaluestrategies focusedonsmaller-capcompaniesthattrade cheaply versus bookvalue. The idea that as a

startingpointasaninvestoryoulooktopaynomore—andideallyalotless—thanwhat you could realize ifyou sold all the assets andpaid back all the liabilitieshasalwaysbeenapowerfulconcepttome.

—AriLevy,LakeviewInvestmentGroup

We're probably morefocused than the typical

equity investor on stayingpower. Spreadsheets makeeverything look linear andcontrolled, but the realworld oscillates,overshoots, collapses, andrebounds.Acompanywithoperational and financialflexibility—what we meanby staying power—is abletoexerciseoptionsthatarequite valuable at differentpointsinthecycle.Without

the firm handle on thatflexibility that creditanalysis provides, we'dargue you can't fullyunderstand the wealth-creation process as anequityinvestor.—MitchellJulis,Canyon

Capital

MBAs learn all aboutoptimizing capitalstructures, but I've been

quite content stickingwithcompanies thathaveextra-safe balance sheets. I'lltrade return on equity forsafetyanyday.

—JimRoumell,RoumellAssetManagement

One general defenseagainstvaluetrapsis tobyand large avoid product-cycle businesses. You canhave faith that Nokia gets

its act together insmartphones, or thatMotorola returns toprominence inhandsets,orthat the latest device fromNintendo is a big hit, butwe think that'svery tricky.For a company caught intheheadwindofabusinesscycle, we can makeassumptions aboutrecovery that we considerto be well founded. We

believe we're much lessable to make similarassumptions about futureproductcycles.We're also leery ofindustries with excesscapacityindependentofthebusinesscycle.We'rebeingvery careful today in theautomobile industry, forexample,wherethere'sstillalotofexcesscapacityandstepped-up competition is

coming from China andelsewhereinAsia.—SarahKetterer,Causeway

Capital

Idotendtostayawayfromcompanies overlydependent on raisingcapital and the goodopinion of the securitiesmarkets.MarkTwainusedtosayhewasagoodwriterbecause he could

“remember everything,whether it happened ornot.”I'mleeryofsituationswheremanagementhastoomuch temptation to reportgreat earnings, whetherthey really happened ornot.—ThomasGayner,Markel

Corp.

Over the years we havealso become very leery,

based on experience, ofcompanies that need toraise capital in order tosurviveandprosper.It'snota good thing to bevulnerabletothewhimsofthe capital markets, whichcan close rapidly andsurprisingly.—JeffreyTannenbaum,Fir

TreePartners

I've learned from

experience to avoidacquisition-driven storiesduring the actualacquisition-growthphase—big problems always comeofthat.—JeffreyUbben,ValueAct

Capital

The biggest mistakes weever made involved a fewinvestments in highlyacquisitive companies that

hadbalancesheetleverage.Thebiglessonisthatwhenyou mix financial risk, inthe form of leverage, withoperatingrisk,fromhavingto integrate acquisitions,you compound the overallrisk dramatically. If wecome across a leveredacquisitivecompanytoday,we're most likely to shortit,hedgeitorpassonit.—JeffreyTannenbaum,Fir

TreePartners

We've made mistakes inrecent years investing insecularly challengedbusinesses, includingnewspapers, yellow-pagespublishers, printingcompanies,andbookstores.The pace of change hasaccelerated in many ofthese types of businessesand it'sprovenchallenging

forustostayaheadofthat.We've essentiallyconcludedthatthesimplestway to avoid mistakes insecularly challengedindustries is to just notinvestinthem.—EugeneFox,Cardinal

Capital

We're very unlikely tomakethebet thataseculardecline in an industry or

that a company just won'tbe as bad as the marketexpects. You can maketempting valuationargumentsatcertainpointsforbusinesseswith secularheadwinds, but modelingthetrajectoryofthedeclineisverydifficult.Inthelate1990s if you were firststarting to model thedecline in consumer photofilm forKodak, you likely

assumedaslowsingle-digitannual percentage declineover time. That's whathappened for a few years,butthenitstarteddecliningby 20–30–40 percent peryear, which had a largeimpact on profitability.We've also found in thesetypesofcompaniesthattherisk of misallocation ofcapital is high.Management may have a

lot of free cash flow attheir disposal, they'reanxiouslylookingforwaystogrow,andtheyoftenendup paying too much foracquisitionswhentheyfindthem.—CanonColeman,Invesco

A bubble is a logicalimpossibility,when peopleare investing on a premisethatnotonlywon'thappen,

it can't happen. The techbubble in 2000 wasn'tbecause stock prices werehigh, it was because stockprices incorporated thebeliefthatmanycompaniesin the same industry wereall going to have 20percent market shares andhigh margins. That can'thappen, so you betterrecognizeitwhenthat'stheexpectation.

—MurrayStahl,HorizonAssetManagement

I can't tell you how manytimes I heard [during theInternet bubble] “You justdon't get it.” I'd say thingslike, “Let's compareKennametaltoCisco.IbuyKennametalandeveryyearit makes 25 percent moremoney. Yes, I know themarket is telling you it

doesn't want to put a highmultiple on it, but I stillhavethatmoneyattheendof the year. And I'll havemore money at the end ofthe next year. Whywouldn't Iwant toget thatreturn?” And then I'd say,“Let's compare that toCisco. Cisco's market capis $500 billion. Say you'rehappy with a 15 percentreturn, so Cisco needs to

make$75billionforyoutobe happy. They're making$1 billion. Not in yourwildestdreamcantheygetto $75 billion—the size oftheindustrydoesn'tsupportit,nothingsupportsit.”Butpeople would still say,“Youjustdon'tgetit,”andI'd finally say, “You'reright,Ijustdon'tgetit.”

—RichardPzena,PzenaInvestmentManagement

One element we've addedto the tail end of ouranalyticalprocessinrecentyears is to considerscenarios that could sendthe stock down 30 percentormoreandwewouldnotwanttoaddsubstantiallytoour position. Commonexamples would be thingslike the loss of a giantcustomer, or market

incursionsfromapowerfulcompetitor. Given theoutsizedpositionswe take,we want in a disciplinedway to contemplate thosescenariosupfrontandpassontheinvestmentifthey'reevensomewhatlikely.—KianGhazi,Hawkshaw

Capital

One lesson reinforced bythefinancialcrisisisthatif

you own common stocks,they will periodically godown 50 percent. We'veheard Warren Buffett andCharlieMunger talk aboutthat and I've remindedmyclients of it from time totime,but I'dhave to say itwasn't particularly top-of-mindbeforethetroublehit.Whenmakingbetsonwhatwill happen, it's veryimportant to consider all

thatcanhappen.—ChuckAkre,AkreCapital

Management

It's hard to get away fromtruisms and clichés, butthingsthatappeartoogoodto be true—investments orotherwise—usuallyare.—ThomasGayner,Markel

Corp.

FROMTHETOPWhile they won't alwaysadmit it, most investors holdaspecialplace in theirheartsfor successful and honestcorporate managers. That'sprimarily driven by thesignificant role strongmanagement can play inincreasing share value—thesurest way into an investor'sheart—but it also reflects

respect for the difficult jobtop managers have. As TheFairholme Fund's BruceBerkowitz says of the bestCEOs: “These are peoplewho are great operators andmanagers, with excellentpeople skills—not qualitiesvalue investors are generallyknownfor.”Investors similarly hold a

special enmity for corrupt orinept management, who

waste shareholders money,line their own pockets at theexpenseofthecompany'strueowners or otherwise breachthe trust put in them.“Investors face a variety ofrisks, whichwe canmore orless address in how weconduct our analysis andmake our investmentchoices,”saysThomasRussoofGardnerRusso&Gardner.“But the risk that can really

set you back—and that ismore difficult to control—isif you have a managementthat takes these great cashflows and wastes them orexpropriates them more fortheirownbenefitthanforthebenefitofthecompany.That,I think, is the biggest riskpublicequityownersface.”Researchingpeoplemaybe

oneofthemoredifficulttasksinvestorsface,requiringmore

subjective judgment thanneeded when parsing abalance sheet, for instance.While some top investorsdownplay the importancethey put on assessingmanagement capability, agreater number spendconsiderable time and use avariety of methods to learnabout top managers' trackrecords, their skills, theirthought processes, and their

motivations.

HowImportantIsManagement?

WarrenBuffett has famouslynoted when talking aboutmanagement that, “I try tobuy stock in businesses thataresowonderfulthatanidiotcanrunthem.Becausesooneror later, onewill.” This saysmore about Buffett's

emphasis on business qualityand sustainability than hisdisinterest in top managers'talent. In fact, his ownmanagement style in runningBerkshire Hathaway putsprimary emphasis onidentifying first-classmanagers to run hisbusinesses andgettingout oftheir way in letting them doit.Thisemphasisonknowingasmuchaspossibleabouttop

managers' skills, aspirations,and motivations in runningtheir companies is widelyshared among the bestinvestors.

***

Making judgments aboutmanagement is importanttousandsomethingIthinkvalue managers tend tounderweight. You can

analyze somethingstatistically, but if youexpect to own it for 10years, management isgoingtomakethousandsofdecisions you can't predictandmay never even knowabout, which collectivelymake earnings compoundat a ratemore or less thantheywouldhaveotherwise.Those things can add upover time to thedifference

between a great performerandanalso-ran.

—BoykinCurry,EagleCapital

Julian Robertson [of TigerManagement] wasmaniacalontheimportanceofmanagement:“Haveyoudone your work onmanagement?” Yes, sir.“Wheredid theCFOgo tocollege?” Umm, umm. “I

thought you did yourwork?” He wanted you toknoweverything therewasto know about the peoplerunningthecompaniesyouinvestedin.

—LeeAinslie,MaverickCapital

We've looked carefully atwhy we so often sellinvestments too early.People tend to give you a

pass on that, saying youinvested in the safest partof the profit cycle. But Ihave to say, people havemade a lot of moneybuying stocks from me.Overan investmentcareer,that's not a good thing.What I discovered is thatthe investments that havedone much better than Iexpected—after I sold—are consistently those in

superior businesses and/orwith superiormanagements. That's whywe now spend so muchtime analyzingmanagement'sprioractionsandtheirresultsincreatingshareholdervalue.—KenShubinStein,Spencer

Capital

I'matastageinmycareerwhere I'd say human

behavior is the mostimportant determinant of abusiness's long-termsuccess. I don't care howsmart an analyst you are,you can't really knowwhat's going on inside abusiness. We want toinvest not only in highlycapablemanagers,butalsothose with clear trackrecords of integrity andactinginshareholders'best

interest.—ChuckAkre,AkreCapital

Management

Ourentireinvestmentteamhas had training ininterview techniques andlie detection. I don't thinkyou can spend too mucheffort trying to understandthe quality ofmanagement—attheendoftheday,it'sthe most important

investment criterion. I'velearnedovertimethatgreatmanagement teams deliverpositive surprises and badones deliver negativesurprises.What's important?Integrity, intelligence,competitive drive and aproven desire to createvalue for all shareholders.We just find the odds ofsuccess to be too low in

situations where we havetofighttogetmanagementto work on our behalf.We'dmuch ratherwork aspartners.

—LeeAinslie,MaverickCapital

The importancewe put onmanagement reallydepends on the type ofinvestment we're making.If a company is

underearning against itsindustryorhistoricallevelsand the challenge is to getthings back to normal,myperspective is that ifcurrent management isn'tup to the challenge, a newone will be. But in asituation where thebusiness is growing andmanagement's ability toreinvestcapitaliscriticaltothe thesis, knowing and

believinginmanagementisveryimportant.—AlanFournier,Pennant

Capital

We sometimes buycompanies with badmanagement, if that fact ismorethanaccountedforinthe price. At a cheapenough price on a decentbusiness,I'mwillingtorideout any problems until

somebody, if not currentmanagement, figures outhowtoturnthingsaround.—RobertOlstein,Olstein

CapitalManagement

HandicappingtheJockeys

Asanyonewhohaseverbeenin a hiring position knows,even the most rigorous and

reasoned selection processcan result in situations inwhich only days after a newemployee's arrival yourecognize that the hirewas amistake. Such mistakes inassessing a CEO can beparticularly costly for aninvestor. So it's no surprisethat top money managershaveclearanddetailedviewson what they want to knowabout management and

exactly how they will goaboutfindingitout.

***

We onlywant to invest inmanagement teams withequal measures of talentand integrity, because onewithout the other isworthless. The talent partlargely speaks for itselfthrough an objective look

at performance, especiallyovertime.Integrityisabithardertojudge,butit'soneof those things that youknowwhenyousee.Thinkabout how you decidedwhom you were going tomarry. You spent lots oftimetogether.Youmetherfamily. You met herfriends. You learned whatshe cared about and herbasic value structure. We

dothesametypesofthingsto get to knowmanagement of thecompaniesweinvestin.It'simperfect, but to our wayofthinkingnothingismoreimportant.—ThomasGayner,Markel

Corp.

We haven't tried toevaluate, before they havea record, who will be the

superstar managers.Instead, we find peoplewho have batted .350 for10 to 50 years. We justassume we won't screw itupbyhiringthem.Wetakepeoplewho play the gamevery well and allow themtoplay.

—WarrenBuffett,2005BerkshireHathawayAnnual

Meeting

One key benefit ofexperience is that we'veheard it all frommanagement teams overthe years and havedeveloped a pretty refinedsense of what's importantand what to look for. Wewant to hear frommanagement why thecompany has historicallybeensuccessfulandhowinthe current competitive

environment they expect itto remain so. We want tounderstandhow theymakedecisions, both to see ifthere's a clear disciplineand to assess whetherthey'refocusedonbuildinglong-term shareholdervalue. We want to heartheir goals and judgewhether they're realistic.When the new CEO of asteady grower all of the

sudden wants to doublerevenues in two years,watchout.—WhitneyGeorge,Royce&

Associates

Whatarewelookingforinleadership? Intellectualhonesty is probably first. Iwant the person who isgoing to address theelephant in the room. Itdrivesme crazywhen you

meetwithmanagementandthere are real issues andthey act like they aren'tthere.Also important is acontrarian bent, aconfidence to go againstthe prevailing trend. Yougenerallydon'twantpeoplewhoaresayingthisiswhatwe should do because thisis what others are doing.You want people who are

spending when others arenot,andtakingchitsoffthetablewhen everybody elseisputtingthemon.—JeffreyUbben,ValueAct

Capital

We tell management thatthe idea is not for them toget investors to buy theirstock, but to give themreasons never to sell it.When they get that, we're

interested.—JamesRooney,Avenir

Corp.

It's certainly not an exactscience,butwewant tobeconvinced the peoplerunning the company areknowledgeable, capable,trustworthy and energetic.Iftimesaretoughwewantthemtobeupfrontaboutit,and if times are good we

want them to always belooking around the nextcorner for trouble. Webelieve getting to knowmanagement over timebuildsarapportthatallowsus to pick up subtle cluesabout the company'sprospects that others arelikelytomiss.—ScottHood,FirstWilshire

Securities

In addition to the capacitytoinvestbehindgrowth,it'sequally vital in ourcompanies that corporateleadership has the will todo so even when suchinvestmentsburdencurrentreported profits. Jean-Marie Eveillard used totalk about the importancefor investors to have the“capacitytosuffer,”andI'darguethatsamecapacityto

accept short-term pain forlong-termgainiscriticalinmanagement. The marketoften doesn't like anyburdenon reportedprofits,so adequate levels ofinvestment often invitescorn and ridicule thatleadershavetobeableandwillingtoendure.—ThomasRusso,Gardner

Russo&Gardner

Access to management isvery important to us. Ourstarting point is usuallydisappointment anddecimated stock prices, sowe need to understandfully what the problemsare, how they arose,whether managementrecognizes them, whatthey're doing to fix them,and how consistently thefixesarebeingapplied.All

of that requires regularinteraction withmanagement. We don't atall consider it a one-wayconversation—we haveideas forwhat they shouldbe doing and think a realback-and-forth dialoguebetter brings out their trueintentions.—AndrewJones,NorthStar

Partners

IfI'veconcludedthere'sanissue that can be solved, Ithen want to knowmanagement'splantosolveit. If there's a lot oforchestration involved,meaning they can'taccomplish much in thenext year or two despitetheir willingness, that's allthe better. That meansmanagement can and willdo things toameliorate the

situation, but the marketwon't care because theresults are still two, three,orfouryearsout.—MurrayStahl,Horizon

AssetManagement

We're putting increasedimportance on our seniorportfolio managers beingfully engaged in theongoing dialog withmanagement. That's not

something to delegate andthen read a report on. Ihave to be visiting peopleface to face, attendingconferences, and sitting inon the conference calls.Successful investing,especially during times ofstress, requires conviction,whichishardtotrulyhaveunless you're really outthereyourself.

—JohnRogers,Ariel

Investments

Our models don't justregurgitate what thecompany says. When wevisit a company, we havelittle interest in what theythink they're going to earnnext quarter or next year.We're more focused onunderstanding theirbusiness,howtheyoperate,howtheyviewtheworld.I

think the companiesappreciatethat.—MarioCibelli,Marathon

Partners

Spending time withmanagement isn'timportant in the earlystages of the researchprocess. We'd ratheranalyze the company, itsopportunities and issues,and how it has allocated

capital in thepast,withoutfirst being fed the partyline. When we do meetwith management, itshould be an educateddiscussion between twoknowledgeableparties.

—CharlesdeVaulx,InternationalValueAdvisers

We obviously prefer toinvest with goodmanagement than not, but

our assessment there isn'tcentral to our process.Wefully develop ourinvestment thesis beforewemeetwithmanagementand then look to confirmwhether their ideas forcreating value are alignedwith ours. If they aren't,we'reunlikelytobuyinthehope that they or theirreplacements eventuallycome around. Our

experience is that you canwait a very long time forthattohappen.—RagenStienke,Westwood

Management

I thinkI'vebeenin thetopfive percent of my agecohort almost allmy adultlife in understanding thepower of incentives, andyet I've alwaysunderestimatedthatpower.

—CharlieMunger,PoorCharlie'sAlmanack

The first thing I do [inresearching a company] islook at the proxy for theannual meeting. I want tosee what management hasdone before, howreasonable compensationarrangementsare,who'sonthe board of directors andwhat their backgrounds

are. Red flags includethingslikesomebody'sson-in-lawbeingonthepayroll,other related-partytransactions, compensationsystems that aren'tadequately performance-related and board seatsoccupiedbythecompany'slawyerandCPA.What's good ismanagement with apedigree of

accomplishment in well-run companies where theymay have learnedsomething. When basesalaries are reasonable andthe preponderance ofexecutive compensation islong-term andperformance-driven.—DavidNierenberg,D3

FamilyFunds

Character today is best

judged in the proxystatement—what do theypay themselves and how?Is their financial self-interest truly aligned withmine as a shareholder? Ihaveabsolutelynoproblemwith the people runninghuge, complicated, globalbusinessesmaking a lot ofmoney. The big problemwehavenowis thatyou'reseeing a lot of superstar

compensation for onlyminor-leagueperformance.—ThomasGayner,Markel

Corp.

I don't think you canoverstate how careful wehave to be about theincentives of people whomake decisions that affectus or who give us advice.When you see conflicts ofinterest, it's a very good

indicator that something isgoing to go very wrong,very soon.Oneof thebestremedies here istransparency—but it onlyhelps if people actuallycare about the conflicts ofinterest that might beexposed.

—DanAriely,DukeUniversity

The ideal turnaroundCEO

is in the first-time CEO,betweentheagesof48and52. They have 25 to 30years of experience, buthave never had a numberone spot. They're seekingout a challenge, haveeverything toprove,and—while they've surely donevery well—probablyhaven't yet had the hugepayday, which they badlywant.

The CEOs I invest inattract the best talent andhave that magiccombination of creativityand business acumen.That's who you want toalign yourself with in thisbusiness—or in anybusiness,forthatmatter.—LloydKhaner,Khaner

Capital

We're looking for

managers who havedemonstrated they arekillers at businessexecution, andwhohaveahistoryofalwaysacting inthe best interests of allshareholders. I'm notinterested, for example, inCEOs who appearpersonally greedy. Ifrequently ask CEOs howthey measure success.They often speak about

meeting the needs of theirvarious constituencies,including shareholders,employees, customers, andthecommunity.Manyhavesaid they measure theirsuccess by the rise in theshareprice.Theclosertheyget tosaying theymeasuresuccess by growth in thecompany's real economicvalue per share, the moreinterestedIam.

—ChuckAkre,AkreCapitalManagement

The historical record onhowmanagement allocatescapital—acquisitions,divestitures, buying andselling of shares, etc.—isultimately most importantto shareholder value, butwealsopayattentiontothelevel of management anddirector share ownership

andwhetherthey'rebuyingor selling. We mean realshare ownership, not justoptions. It's rare to seeexcellent capital allocationwithout significant shareownership.—ClydeMcGregor,Harris

Associates

If I was stuck on a desertisland and had to make adecision on management

talent,I'dchoseasummaryof past returns on capitalover a cell phone to callpeople.—JeffreyBronchick,Reed,

Conner&Birdwell

Because we're looking forcompanies generatingsubstantial free cash flow,we put a significantpremiumonmanagerswhoare first-rate capital

allocators and who haveourinterestsatheart.Ifwefind a great business, theonly way it becomes agreat investment is ifmanagement directs themarginaldollaroffreecashflow to its highest-returnpurpose. That's howintrinsic value getscompounded over longperiodsoftime.—JamesRooney,Avenir

Corp.

Themost important aspectof analyzing managementis how well they'veinvested cash in the past,notwhat they say they aregoing to do. Because wetypically own companiesgenerating a lot of freecash flow,we're in troubleif management doesn'tallocatethatcashwisely.

—DonaldYacktman,YacktmanAssetManagement

Ifthestocksweownareasbeaten down as we thinkthey are, we better seemanagementand theboardacting on the samepremise.—StaleyCates,Southeastern

AssetManagement

We think management's

reinvestment acumen issomething Wall Streetdoesn't adequately value.Most analysts are capableof developing linearearningsmodels,multiples,and price targets, butthey're very likely to missthe extent to which smartcapital allocation cancompound value over a 5-or10-yearperiod.—PeterKeefe,AvenirCorp.

There are five ways forcompany management tospend money: dividends,payingdowndebt, internalinvestment, acquisitions,and share repurchases.When we see excess cashonabalancesheetwedon'tgo in with a knee-jerkresponse like, “You betterbuy back your stock,”because that's limiting and

canbestupidifdoneatthewrong time or for thewrong reasons. We focusonwhethertheyhavecleardisciplines and processesfor determining which ofthose five things theychoose at any given time,andwhetheritmakessensein the context of thegrowth/return tradeoff. It'samazing how oftencompanies say, “We likea

balance of each,”which ismeaningless. Others say,“We buy back enoughsharestooffsetthedilutionofourstock-optiongrants.”Thisbetraysafundamentalmisunderstanding offinancial management.How the shares wereissued is irrelevant—youfirst have to know if therepurchase is attractive inthe context of all potential

uses of the capital. Wehave what we consider abest-practice model formaking these decisions,whichwemake a point tocommunicate early andoften.

—RalphWhitworth,RelationalInvestors

The preference by manyinvestors for dividends isunderstandable, given that

it'savalue-agnosticwaytoreturn capital and itdummy-proofs theallocationofcapital.Ifyoulook at corporate share-repurchaseactivityoverthepast 10 years, it was veryhighin2006and2007,andverylowin2008and2009.That'stheoppositeofwhatit should have been. So Igettheargument,“Givemethemoney and I'll allocate

it myself,” but smartcorporate capital allocatorscanandshouldcreatevaluebyusingthemoneytobuyback shares at a discount.Ifyouowned50percentofa business with a partnerand he offered to sell youhis stock at half what youthoughtitwasworth,you'ddo that in a second. Sinceyou have the bestinformation on your own

company, there's value tocreate in buying backsharesinsuchsituations.—BradSinger,ValueAct

Capital

The most importantdiscussion we have withmanagement is when weask how they allocatecapital. You can usuallypick out the empirebuilderswith that question

alone—theytendtohaveahard time zeroing in on aconcrete answer. The bestmanagers can usually sayclearlyandwithconfidencewhere they see the highestreturn-on-invested-capitalopportunities and whattheyexpectthosereturnstobe.They also are typicallysmart about buying backtheir shares—not just onsome systematic basis, but

opportunistically whenthey believe the shares arecheap.

—RobertWilliamson,WilliamsonMcAreeInvestmentPartners

Probably the mostimportant part of ourdiscipline is keeping inconstant touch withmanagement. My assistantgivesmeanupdatedlistof

every company I haven'tspokenwith in five weeksandIjustdialthemup:“HiJohn, this is Candy Weir,I'm curious whether theretail traffic we spokeabout last month haspicked up.” Or, “We'vebeen working on yournumbers and believe youcan do a 20 percent grossmargin this year.What doyou think about that?”Or,

moreimportantrecently,“Isee you have a debt issuecoming due in May 2010,whatareyourplanstodealwith that?” We takecopious notes andtranscribe ourconversations, so that thefour analysts I havecranking out earningsmodels keep a runningrecord of what we'velearned and incorporate it

into the models, with myinput.IalwaystellpeopleI'mnotlooking for insideinformation,justforinsightinto how they run theirbusiness.IfI'minvestingatleast$10 to$20million intheir company, I'm notreally doingmy job if I'mjust reading press releases.There are always ways toask questions of

management that provideyouwithsome insight intowhether the assumptionsyou'remakingaretherightones.We either eventuallyget enough information tobecomfortableorwedon't.—CandaceWeir,Paradigm

Capital

We don't ascribe to theview you shouldn't meetwithmanagement to avoid

being “sold.” A personalconnection gives us abetter understanding ofwhat's going on, allows ustojudgemanagementmoredirectly and even can giveus some influence—all ofwhich we considernecessary to invest withconviction.

—RandallAbramson,TrapezeAssetManagement

My style is to meet withmanagement each quarterandbasicallyask the samequestions. There can begood reasons for differentanswers,butIwanttoseeaconsistency of answers.Also critical is a passionfor the business—awill towin—which you can onlyjudge by sitting across thedesk.—ThomasBrown,Second

CurveCapital

RedFlagsFew things are as frustratingforaninvestorasthesenseofbeingmisledbymanagementand subsequently caught offguard by what appears to bevalue-destroyingbehavior.Asaresult,topinvestorscanbeaskeptical lot when dealingwith management and are

particularly sensitive to redflags that may signalmanagement's propensity fornon-shareholder-friendlybehavior.

***

I started my career doingcriminal defensework andlearned a lot from havingmy clients lie to me andhaving to see through that.

That's been invaluable indealing with corporateAmerica.—EdwardStudzinski,Harris

Associates

There's justahugeamountof skill in exposition. Partof being a wise person isresisting the other person'sexpository—to knownonsense when you see it.If you're like me, you can

conceal your contempt forthe person even as theyspeak.—CharlieMunger,2006WescoAnnualMeeting

WhenIstartedinresearch,I had one of the worstcharacter traits an investorcan have—I was a“believer.” Iwas toooftenseduced by charismaticCEOs and by concept

stocks, where the productor service made a lot ofsense but there turned outto be cost, competitive orother reasons it wouldnever succeed. I learnedthe hard way to be askeptic aboutmanagement's—and myown—ability to forecastwithprecisionwellintothefuture.

—FrançoisParenteau,

DefianceCapital

Meetings [withmanagement] tend to bepromotional and I'm asucker for a charismaticCEO.Early inmycareer ImetwithDaveThomas,thefounder and CEO ofWendy's. He was anincrediblyniceguyandhetold me over lunch allabout this pita-sandwich

concept they were rollingout. I came back to myportfoliomanagerandsaid,“YouhavetobuyWendy's,this pita thing is going tobe big.” This was in 1996or1997andthelaunchwasaflop.That'soneofthelasttimes I went to meetmanagement.Wedodevelopanin-depthlist of questions formanagementaspartofour

research, focused ongetting direct answers thathelp us understand themechanics and personalityof thebusiness. I also findearnings-call transcriptsquite useful, particularlytheQ&Asections.Readinga lot of them, across anindustryandovertime,cangiveyouadecent senseofwhat'sreallygoingon.—EricCinnamond,Intrepid

Capital

One acid test I use issimply whether in talkingabout their business andtheexternalenvironmentinwhich they operate, aretheydescribing realityas Iperceive it? There'ssurprisingly often adisconnect there, wherethey either aren't owningup to potentialmissteps or

recognizing externalchallenges. When thathappens, you just cannotgive them your capital tomanage.—MatthewBerler,Osterweis

CapitalManagement

Several years ago I madean investment inCannondale, the bikecompany.I'macyclist,soIknew and liked the

product. Iwent tovisit thecompany around the timethey had decided theyneeded to diversify bymanufacturing all-terrainvehicles(ATVs).TheCEOthenwasapilot,asamI,soI find myself with himflying thecompany'splanetovisitthenewATVplant.I test-ride the ATVs andfall in love with theproduct. I was so

impressed by everythingthatIwasn'tascarefulasIshould have been inanalyzing whether gettingintotheATVbusinesswasevenagoodidea.Itwasn't.Not long thereafter thecompany ended up beingtakenprivate, theCEOgotkicked out and the equityendedupbeingworthless.Itell that story because it'salways important to

remember the risk thatyour judgment can becompromisedwhenyougettooclosetomanagement.

—FrançoisParenteau,DefianceCapital

I've been fooled manytimes by being tooimpressed by executiveswhoarearticulateandhavedone well in the past. I'velearnedtobehumbleabout

my own opinions and relymore on the opinions ofpeople who aren't biasedand have known themanagement personally orprofessionally for a longtime.

—EdWachenheim,GreenhavenAssociates

We look for certainbehavior patterns inmanagement that are

consistentwithanefficientand prudent guardianshipof our assets. Ifwe visit afan manufacturer in Texasand the CEO meets us atthe airport in his Lexus,spends five hours with us,andthentakesusouttoanexpensive restaurant andbuys$300bottles ofwine,that is suggestive ofsomebody who isn't asprudentaswewouldlike.

We try to meetmanagement of all thecompanies we own, but Imust say that over theyears I've become moreskepticalandlessbelievingof people. I don't reallywant toknowor like thesepeople any more than Ineedto.Wegenerallythinkit'smore interesting to talktoindustrysalespeople,ex-salespeople,andcustomers

of the company's productsto truly understand what'sgoingon.—CarloCannell,Cannell

Capital

One red flag is whenmanagement sits downwith us and right off asks,“What do you think iswrong with our shareprice?” Any implicit orexplicit focus on the share

price rather than thebusinessisabadsign.Thismay sound funny comingfrom an investor, but wealso don't like to seemanagements spending aninordinate amount of timeat investor conferences.The value-add to thebusiness is likely to bemuch higher by spendingthe time with customersandtheirownemployees.

We're also not fans of thelavish executive officesuite. It's not their money.We basically want thecapital we as shareholdershave entrusted tomanagement to be treatedwithasmuchrespectaswetreat the capital that hasbeenentrustedtous.—EdwardStudzinski,Harris

Associates

We care a lot more aboutwhatmanagementisdoing,which is very welldocumented, than whattheyaresaying.Icanlearneverything I need to knowabout management bylooking at the numbers. Ican see how conservativethey are. I can comparethree years of shareholderletters and see if they arediscussing problems

openly and addressingthem. If a company isn'tdiscussing any problems, Idon't believe what they'resaying. I can see ifdisclosure is complete andeasy to understand. If Ihave to call to getsomething importantexplained, there'ssomethingwrong.I have yet to hear amanagement teamwarn of

anexistingproblem,thatifnot resolved would resultin a dramatic drop in theshare price. Given thatthat's exactly what I mostcareabout,Ibetterdoalotmore than listen tomanagement to form myopinions.—RobertOlstein,Olstein

CapitalManagement

Management is clearly a

potential resource, but youalwayshavetoconsiderthesource—it can be likeasking a bartender if youneedadrinkor abarber ifyouneedahaircut.—CarloCannell,Cannell

Capital

It comes down to doingbusiness with people youtrust. We pay carefulattention to all

managementcommunication. Does theCEOwrite the shareholderletter himself or herself?Do they tell you whenthey've been right andwhen they've beenwrong?Do they talk about what'sdifficult about thebusiness? Do theyarticulatehowtheyallocatefree cash flow, and do sowith an owner mentality?

Are the key benchmarksconsistent? We worryabout companies that oneyearfocusyouonadjustednetoperatingEPS,thenthenext year on EBITDAmargin and the year afterthatonsomethingelse.—AdamWeiss,ScoutCapital

We put a lot of emphasison how managementcommunicates. All

shareholdersareentitled tocandid, timelycommunication frommanagement and when it'slacking,it'sprettyobvious.You can be two-thirds ofthe way through ashareholder letter and itmay be so full ofconsultant-speak that youhave no idea whatcompany it is or whatindustry it's in. That leads

us to wonder whethermanagement is reallythinking aboutshareholders as owners ofthe business, who deserveclear and completeinformation so they canmake important decisionsasowners.We'realsoleeryofmissionstatements that getsidetracked talking aboutvarious stakeholders and

obligations a company hasto the community. Thosethings are important, butonly in the context ofmaximizing the long-termbusinessvalue.Ifyoudon'ttreat employees fairly,you're not going to havethelaborforceyouneedtomaximize business value.Ifyoudon'ttreatcustomersfairly, you can't maximizebusiness value. We get

concerned when thosetypesof thingsarelaidoutas independent objectivesratherthanjustpartofwhatmanagement should do tobuildlong-termvalue.How managementcommunicates aboutmistakesisveryimportant.Nooneismistake-free—asinvestment managers,about 40 percent of thestocks we buy end up

underperforming themarket—and I'd beconcerned about anycompany whereshareholdercommunication doesn'tinclude a candidassessmentofmistakes.

—BillNygren,HarrisAssociates

I'm particularly averse tothe gobbledygook that

passes as communicationfor some managers. Arethey thinking clearly andlogically about problems,or just repeatingbuzzwords?—JohnOsterweis,Osterweis

CapitalManagement

Wehopetoaddsomevalueis in assessing thecoherenceofmanagement'sstrategy, how they're

making capital allocationdecisions, where they'reputting specific emphasisandhowthey'remeasuringsuccess. An inability orunwillingness to articulateallthatisaredflag,asisafocus on the ends ratherthan themeans. Youwantto be confident thatdecisions are being madeoutof thegoodanalysisofa set of probabilistic

outcomes, not hope orambition.—BradSinger,ValueAct

Capital

Some of my biggestdrubbingshavecome fromnot responding quickly toinconsistencies in whatmanagementissayingovertimeorindifferentforums.Changing stories are ahugeredflag.

—RobertLietzow,LakewayCapital

Most turnarounds involvemaking tough decisionsabout the portfolio ofbusinesses.Wespenda lotof time looking at eachbusinesswithinacompanyandhowwethinkitsvaluecan be maximized. We'resuspicious of managementsaying they can fix

everything.—LloydKhaner,Khaner

Capital

I have made the point inthe past with Coca-Colaaboutthedangerofhavingmanagement that knowsthe business side cold butdoesn't understand theproductanditsrelationshipto consumers. The bestmanagers bring both skill

setstothetable.—MorrisMark,MarkAsset

Management

Thehardestthingistofindmanagement that actuallyobjectively behaves inshareholders' interest asopposedtotheirownlong-term interest. It's not whatthey say, it's what theyactuallydo.Alotofpeopletell a good story on

shareholdervalue,buttheirbehavior belies that. TakeSPX Corp., the industrialcompany that came outwith this elaboratedescription on how theywere focused on EVA[EconomicValueAdded] ...untiltheydidn'thittheirtargets and then the boardchanged the criteria andgave management theirbonusesanyway,saying“it

wasn't their fault, theeconomy was bad, whyshould they get penalizedfor that?” So you'relooking for managementsandboardsthatactuallyactin shareholders' interest,and there aren't many ofthem.—BillMiller,LeggMason

Funds

Whetherwe're investing in

New York, Zurich, orKuala Lumpur, we doeverythingwecantoinsurethat the people to whomwe've entrusted our capitalwake up in the morningfocused on how to makemoney for all shareholdersand that they're good at it.A lot of that is just seeingwhat they've accomplishedand how they've behavedin the past, but their

incentives are also critical.You want to seemanagement own realequity in the business,without the “heads I win,tailsIwinbigger”typesofcompensation packagesthat have been handed outovertheyears.

—DavidWinters,WintergreenFund

Thereisnowaytomakea

good deal with a badperson.It'sthecharacterofthe people you go intobusiness with that willfundamentally determineyour investment returnsand your ability to sleepwell and eat well in themeantime. If you're notcomfortable with thepeopleinvolvedbecauseoftheir prior conduct andhow they've treated

shareholders, you'reprobably not going to becomfortable with yourinvestmentresults.Itakeitto heart and use it as ascreen for potentialinvestments.—ThomasRusso,Gardner

Russo&Gardner

When a company hasintegrity issues, there's nofirm ground. If somebody

is willing to do themedium-size crime youknow about, there's noparticular reason theywouldn't have done thebigger crime you haven'tfoundoutaboutyet.—WallyWeitz,WeitzFunds

There's reallynosubstitutefor direct communication—looking people in theeye, gauging the tone of

their voice, trying to readthe level of energy andenthusiasm they have. Wespoke not long ago withmanagement of onecompanyandaskedif theywere still on target withtheirprofitabilitygoalsandthe answer started, “Welll,yeahhhh . . . .”, whichclearlydidn'tsoundgood.—AmeliaWeir,Paradigm

Capital

CATALYSTSAlmost as important asidentifying the extent towhicha stock isundervaluedis assessing what can makethat misjudgment by themarketgoaway.Afterall,theproverbial “50-cent-dollar”thatvalue investors seekwillproduce a very different

investment result if the gapbetween price and valuecloseswithinoneyear,orifittakes 10 years. For thatreason, most—but not all—successful investors putemphasis in their analysis onthepotentialcatalyststhatcantrigger an enhanced marketappreciation for a company'sbusinessanditsshares.

***

Ourstrategygoesunderthegeneral category of event-driven. We're valueinvestors looking formispriced securities—atany level of the capitalstructure—with specificcatalysts that should helptrigger a narrowing of thegap between the marketprice and our estimate ofintrinsicvalue.The basic idea, which has

probably been bestarticulated by SethKlarman, is that if yourinvestment is morepredicated on an eventoccurring, that transfersrisk away from thevagaries of the market tothe specifics of theparticular investment. Thatdoesn'tmeanyou'll alwaysmake a lot of money ifyou're right about the

event, but it helps clarifytheanalysisandallowsyouto arrive at firmconclusions.We do have traditionalinvestmentsbasedmoreona broad-based analysis ofthe business, but even inthose we like to havespecific catalysts to track.In the case of Wal-Mart,for example, we werefocused mostly on the

company slowing downexpansion—reducingspendingonnewstoresandacquisitionsandgivingthatmoney back toshareholders.Itcanbeabitfuzzy to determine exactlywhenaneventlikethathas“occurred,” but ourjudgment that it hasoccurred is usually whatstarts us down the road toselling.

—TimothyMullen,VNBTrust

Since the crisis there arefewer fundamental long-term investors in themarket.It'sbots,ortraders,playingagameonthenextquarter's earnings, orpeople making thematicmacrobets.Asaresult,themarket is assigning lessvalue to the durability andconsistent growth of cash

flow,which iswhyqualitystocks have increasinglybecomecheap.Formostofyour readers investing inahigh-quality company thatis 30 percent undervaluedandcancompoundvalueat15 percent over a three-yeartimehorizonisagreatinvestment, but for yourtypical traderit'smorelikekissingyoursister.That has also caused a

change in the marketdynamic.Theplaybookforfundamental investors hasbeen to value businessesbased on expectations forgrowth and profitabilityand buy them when thatvalue is much higher thanthe current stock price.There were guardrails inthe form of lots of otherinvestors doing the samething that kept valuations

in check while you werepatiently waiting to beproven right. Withoutenough of those types ofinvestors, however, theguardrailshavebeenblownout. That means thequality-value stockworking through somenegative fundamentaldevelopmentcantradewaythrough what you couldimagine on the downside,

and the low-quality stockstill doing okay can blastway beyond yourassumption of economicfairvalueontheupside.You could say, “Gee,doesn't that just creategreater opportunity?” Yes,butitcanextendthetimeittakes to get paid andcreates much more risk toshorter-term performance.That'sbeenachallengefor

us. We've had to askourselves if our job as ahedge-fund manager is tofigure out the value ofbusinesses,or tofigureoutwheretheytradeinayear.I know we're good at theformer. The latter isdifficult and requires adifferent skill set injudging things like near-term earnings versusexpectations and changes

ininvestorperceptions.On the long side, we'repayingmoreattention thanbefore to the presence ofthings that can create achange in investorperception. We're thenoverweighting the stockswith the quality valuewe've always emphasized,butwherewealsohavethehighest confidence we'llsee a change in investor

perceptionoverthenext18months. Those highest-conviction ideas will be 4to 8 percent positions,while the good businesswith a cheap stock butwehave no idea when itworks, that's probably a 2percent position. Too higha weighting of those lattertypes of positions canmake you reallyunderperform for longer

thanweorareinvestorsarecomfortable.—RickySandler,Eminence

Capital

The catalysts we look forcanbecompany-specificormore macro. It could beany number of things—new management, areorganization, buyingback stock, a new productlaunch, the resolution of

litigation.Itcouldalsobeacall on a specific sectorturningup.We're just trying to pushback against the naturalpropensity of valueinvestors to be early—there's just noway aroundthe fact that if you're waytooearly,you'rewrong.

—WilliamNasgovitz,HeartlandAdvisors

We're generally of theschool that “a bargain thatstays a bargain is not abargain.” We may buysomething just because it'scheap,butit'sveryunlikelyto be a core positionwithoutadatapointortwo—like earnings exceedingexpectations or an assetsale—thatwe think shouldmovethestock.—CurtisMacnguyen,Ivory

Capital

We're selecting forcompaniesthatareenteringepisodes of their publiclivesinwhichthey'regoingto be transformed. We doboth the fundamentalvaluation work as well asan analysis of theprobabilities of successful,value-unlocking outcomes.We tend not to focus on

short-term opportunities inwhichwemayhavenorealedge,oronverylong-term,buy-and- hold-foreverinvestment themes.There'sa medium term where therisk/reward can be quitehigh if we stick to ourvalue-plus-catalystdiscipline.

—GaryClaar,JANAPartners

Given our emphasis onimproving valuations,catalysts tend to beimportantus.Thecatalystscan be things like asuccessful new-productintroduction, theonsetofanew product cycle, achange in seniormanagement, thedivestiture of anunderperforming division,or simply better financial

performance. There mustbe identifiable events thatwould cause rationalexpectations for thebusiness to improve,resulting in a highervaluation.—BrianBarish,Cambiar

Investors

We think it's difficult tohave a reliable view ofevents beyond 12 to 18

months, so we focus onspecific investmentcatalysts that can movestocks toward theirwarranted target pricesover the next 12 to 18months. We've identifiedfive primary catalysts—management, restructuring,problem fixing, newproducts, and pricingflexibility—thatwebelievecan consistently take

advantage of pockets ofinefficiency in the market.Larger-cap stocks areusually priced relativelyefficiently,butwe'vefoundthis focus on catalystshelpsusidentifywhentheyaren't.—JerrySenser,Institutional

CapitalLLC

Withlargecaps,regressiontothemeanseemstowork

often enough after thingshavegonebad,butinsmallcaps we believeidentifiable catalysts—likemanagement changes,restructurings, or maybeindustry consolidation—increase the odds ofwinning.—PrestonAthey,T.Rowe

Price

For lower-quality

businesses, we put moreemphasis onwhether thereis a catalyst or not. Ifsomething ischeapbut thebusiness dynamics aren'tgreat, time can be yourenemy unless you see aclear catalyst for value toberecognized.—JeffreyTannenbaum,Fir

TreePartners

We sometimes make a

distinction here betweenblue-chip companies andless-than-blue-chipcompanies. For example,our purchases of Googleand Johnson & Johnsonwere probably a bitcatalyst-lightandhadmoreto do with our view thatnegative perceptions ofeachwould turnoutnot tobe as negative or long-lasting as the market

seemed to fear. Withsomewhat lesser-qualitynames, we typically wantmore definition around thecatalystor inflectionpoint.It's one thing to sit awhilewith J&J in your portfoliothan it is some lesser-qualitycompany.—JohnOsterweis,Osterweis

CapitalManagement

If there's a disparity

between price and value,we like toknowwhen thatmight close up so we canfigureoutourexpectedrateofreturn.Havingsaidthat,some situations are justout-of-favorandcheapandthere is no catalyst otherthan a change in people'sperceptions, which usuallyhappens within two orthree years.Whenwe finda cheap situation with no

catalyst,we'lllikelywantitto be available at a lowerprice than one that doeshaveacatalyst.—JoelGreenblatt,Gotham

Capital

In general we're notobsessedwith seeing near-termcatalysts—ifthoseareclear, thestockisprobably30 percent higher. But itobviously matters when

things return to normal, sowe judge everything basedon an internal rate ofreturn. If we can'treasonably expect a returnto normal in both earningsand the multiple paid onthose earnings over aperiod that produces anIRR from today's price ofat least 20 percent, wetypically consider the riskof itbeingavaluetraptoo

high.—LeeAtzil,PennantCapital

We rarely count on thecatalysts most people liketo talkabout;one,becauseyou set yourself up fordisappointment if theydon't materialize, and two,you can get too caught upin a stock's “story” and belessdrivenbythenumbers.

—JeffKautz,Perkins

InvestmentManagement

There's the perception thathaving specific catalystsfor all your positionsmitigatesrisk,wheninfactwe believe the opposite istrue. If there's an obviouscatalyst, there's anexcellentchancethat it'satleast partially priced intothe stock, which increasesyour risk in the event it

nevershowsup.Aslongasthe potential return in aninvestment is significantenough, and the potentialdownside is limited, we'reokaywithdeadmoney.

—TuckerGolden,SolasCapital

We really don't pay thatmuch attention to whysomething is undervalued.If we buy companies in

which shareholders' capitalcompoundsata20percentrate of return over areasonable timeperiodandwe pay a below-averagemultiple for it, ourinvestorswilldoextremelywell.—ChuckAkre,AkreCapital

Management

We focus first on goodbusinesses, with high

returns on capital, barrierstoentryandsignificantfreecashflowgenerationoveracycle. If you're right aboutthe business, time shouldbeyourfriend,socatalystsarenotimportant.

—CharlesdeVaulx,InternationalValueAdvisers

In our experience, it cantake a lot longer than forvalue to be realized than

we expect, but that it'staking longerdoesn'tmeanwe've made a mistake. Ifthe market hasn'trecognized the value wesee and the company iscontinuing to increase itsintrinsic value, that'swhenwe'dbebuyingmore.—RicDillon,DiamondHill

Investments

GETTINGITDONE

Sometimes lost in thediscussion of the vastquantities of information aninvestor can look at inresearching an investment isanappreciationfortheeffort,diligence, and creativityrequired to unearth thatinformation. Knowing whatyou need to know tomake a

decision is obviouslyimportant, but equallyimportant is that theinformation you acquire iscomplete and accurate. Thisdoesn'tjusthappen,andmanyinvestors look to distinguishthemselves by the breadthand depth of theirinformation-gatheringprocess. How credibly theymake that case, and deliveronthatpremise,isavaluable

indicator of how successfultheyarelikelytobe.

***

We're big believers in thatPeter Lynch quote, that“thepersonwhoturnsoverthe most rocks wins thegame.”Wealwayssaythatpeople who know whatthey're doing can get 80percent of the story in no

time, just by lookingthrough the financials.Butit'sthatlast20percentthatrequires tremendous effortandthatisgoingtosetyouapart, or not. That's thedetective work, the sitevisits, the channel checks,thebackgroundchecks,thelegal research—all thethingsthatmayormaynotgive you unique insight,but which you have to do

well to get any kind ofedge.—ScottHood,FirstWilshire

Securities

We take all the computerscreening we do veryseriously, but that's theeasy part. The harder partisgoingthroughthepublicdocuments, reading callearnings transcripts, andspeakingwithmanagement

and people outside of thecompany who can shedlight on the business—allin an effort to makeconclusions about thesustainability of thebusinessand its cash flow.How leveraged is theincome statement to upsand downs? Does thecompany have muchcontrol over its pricing? Istheremarginupsideversus

peers or are marginsthreatened by newcompetition? Is theretechnologyrisk?HowdoesEBITDA cover interestexpenseinadownturn?Allofthisisthehardworkof securities research, forwhich there's no substitutefor rolling up your sleevesand going at it. [Companyco-founder] HowardBrowne was fond of

saying, “No one everlearned anything bytalking,”andwestilltrytotake that to heart in howweapproachourresearch.

—JohnSpears,Tweedy,BrowneCo.

I learned early that youshouldnevercutcornersinresearch, even when youthink you can. It's likeremembering to bend your

kneesintennis.—TimothyMullen,VNBTrust

Inthefieldresearchwedo,we're not trying to assesswhether sales are going tobeup6percentratherthan4 percent next quarter, butfocus more on things likethe quality of thecompany's products orservices relative to thecompetition, how they

conduct themselves, thepricing trends in theindustry,andwhethertherearematerialshiftsgoingoninmarketshare.Everyone probably saysthis,butwejustdon'tthinkyou can underestimate theimportance of speaking tonot just a few,but a lotofcustomers, suppliers,competitors, and people inall levels of the company.

We're constantly trying totriangulate and confirmwhat we hear or seeelsewhere. If returns oninvestedcapitaltellusit'sagreat business, we alsowant to hear fromcustomers about why theyvalue the company as asupplier and expect tocontinue to do so. If thecompany expects toincrease market share, we

want to hear directly fromcompetitorswhytheydon'tthink that will happen.Taking short cuts in duediligence, for whateverseeminglydecentreason,isjusta recipefordisaster inourview.

—RobertWilliamson,WilliamsonMcAreeInvestmentPartners

Often there are specific

issues central to our thesisthat we need to betterunderstand. To ownOracle, for example, weneeded to believe that itwas integrating its manyacquisitions in a morecustomer-friendlywaythanjust ramming its ownproducts down acquiredcustomers' throats, whichwas a concern of theStreet's. We also had to

believe that itsmaintenance-revenuestream was sustainable,which if so, made itpossibly the single mostdefensive business I'veever looked at. These arethetypesofthingsyoucanonly really address in thefieldandwewouldn'thavebeen comfortable owningthe stock in volumewithoutdoingso.

—RickySandler,EminenceCapital

I want to talk directly topeople installing solarpanels, or buying andselling a certain kind ofshoe,or takingclassesatafor-profit college at night.It'sonethingtoreadasell-side report or go to aconference,but it'sanotherto understand first-hand

how decisions are reallybeing made about theproducts and services soldbycompaniesinwhichyouwanttoinvest.Iwanttodothat type of thing myselfratherthanreadnotesfromsomeone two years out ofbusinessschool.—ShawnKravetz,Esplanade

Capital

I'm still amazed by the

thingsyou'llhearorseeona company visit. Wevisited one company inFlorida that madesimulatorsforpilottrainingand amusement rides andheard all about the longleadtimebetweenthestartof contract negotiationsand product delivery,including nine months orsoformanufacturing.Lateroninthedaywetouredthe

manufacturing facility andof the 12 assembly bays,only two had anythinggoingon.Thatwasn'tabigendorsement of thecompany'sprospects.—ScottHood,FirstWilshire

Securities

We want to learn frompersonalexperience.Everyspring I give everyone inmy firm$500 toopen two

accountsatlocalbanksandthen report back on theexperience. I'm a bigbeliever that a company'ssuccess is about executionand the hundreds of littlethings that one companydoes better than another.Wewanttounderstandthatfor the companies weinvest in—is theparty linewe're hearing actuallywhat's taking place in the

branches? In the badcompanies, there's anenormousdifference.—ThomasBrown,Second

CurveCapital

This is an old story, but agreat example ofwhenwedid learn something waswhen Bill Smithburg ofQuaker Oats boughtStokely-Van Camp, whichowned by Gatorade. We

couldn't understand thepricehewaspaying,whichseemed completely out ofbounds. When we finallygot an audience with him,he explained that theeconomics worked forQuakertopay1xrevenuesfor any strong regionalbrand that it could flowthrough its nationaldistribution system. It wasobviousandsimpletohim,

but we hadn't figured thatout. That changed thewhole way we looked atbranded food companiesand led us to invest inNabisco,whichgotboughtout, General Foods, whichalso got bought out, andothers.The lesson there is howimportant it is to get outthere are talk to people. Ifyou spend all your time

with your models andspreadsheets, you're likelyto miss somethingimportant. You need tounderstand how theeconomics work for thepeoplewhoaremakingtheactual decisions and whenyoucomeacrosssomethingyou didn't know that hasbroadapplication,itcanbeveryuseful.—ClydeMcGregor,Harris

Associates

Peter Lynch's greatestinfluence, which stillpervades Fidelity, is thatyoupickup thephoneandcall companies.At theendof the day, if you haven'tspokentoafewcompaniesin existing positions or onnew ideas, you go home afailure. That's a gooddiscipline—you should

spend your day talking tooperators, not to WallStreet.—JeffreyUbben,ValueAct

Capital

We spend time speakingwith competitors, the onegroupwithavestedinterestintellinguswhyourthesisis wrong. Before webought [used-car retailer]CarMax in 2001, wewent

through Sundaynewspapers from everymarket they're in andvisited car dealersadvertisingagainst theminthe paper. We'd describehowCarMaxwasgoing toinexorably take marketshare and the local dealerwas eager to argue whythat was wrong. I'd muchrather hear why our thesismight be wrong at this

pointthanforthemarkettotell us after we own thestock.

—BoykinCurry,EagleCapital

One thing we try to do inindustryduediligenceistofind the “guru.”Getting tothe truth can really beaccelerated by finding thehandful of folkswho trulyunderstand a business or

industry. A deep databaseof relationships withindustry experts is a keyvalue-addtothatprocess.—JeffreyTannenbaum,Fir

TreePartners

Because of digitaltechnology, informationflows much faster and ingreater volume. Thatdoesn't mean theinformation is better—

misinformation travelsfaster too—but there'smore to digest andsynthesize.—MorrisMark,MarkAsset

Management

Wework very hard to getas much information aspossible, but it's hard towin the information armsrace. There are alwayspeople who will know

things you don't. Investingis about the conclusionsyou draw from theinformation you have. Justbecausesomeonespeakstoseven store managersinstead of the five wespeak to doesn't meanthey'll make a betterinvestment decision.People in industries haveas many or more biasesthaninvestorsdo,andoften

draw circular conclusions—for example, thecompany is bad becausethestockisbad.We focus on uncoveringinformation that helps usunderstand theprobabilities of what canhappen. Beyond that, toomany opinions can oftenconfuse things more thanhelp.—BrianGaines,Springhouse

Capital

We'vehadbadexperienceswhere we've tried to doscuttlebutt research, suchasoverweightinganecdotalevidence given to us bysomeone in the valuechain. We've alsooverweighted a toxicresponse to the currentmanagement team whenwe shouldn't have. For us,

and for most people, it'svery hard not to overvalueinformation that you thinkyougetfromsomekindofspecialized source.We trytokeepthatinperspective.When the investmentdecision hinges on one ortwo critical questions, andyoucangetthosequestionsanswered if you makesome phone calls, we'llclearlymake thecalls.But

mostofourideasaren'tlikethat.

—ZekeAshton,CentaurCapital

As the saying goes, theplural of anecdote is notevidence.

—MichaelMauboussin,LeggMasonFunds

I love the intellectualchallenge of investing—

there are always newquestions to try to answer.But it's important toremember that you don'tactuallyhave toanswerallthe questions you askyourself.It'slikebeingableto take a test in schoolwhereyoucananswerany10questionsofyourchoiceona100-questiontest.Youanswer only those youknowwellandignorethose

that are very difficult toanswer. That's whatinvestingisallabout.—MurrayStahl,Horizon

AssetManagement

ORGANIZINGPRINCIPLES

While they spend much oftheir time critiquing how

other businesses are run,money managers have theirown businesses to run aswell. Not surprisingly, theytypically have strong viewson how best to organize andmanage their research andanalytical functions. Onecommondecisionpointistheextent to which researchanalysts are generalists wholookeverywhereforideas,orspecialistsfocusedonspecific

industry sectors. Alsofrequently addressed is theenvironment created aroundthe research and analyticalprocess, how team membersare selected, and how they'remeanttointeract.

***

We break the world intogeographic regions, butwithin those regions we

want our analysts to begeneralists looking acrossallindustries.Partofthatisso people can apply abroad knowledge ofbusinessmodels,industriesand markets to everycompany they analyze. Italsoallowspeopletomorenaturallygravitatetowherethe opportunity is rightnow. If you're a generalistyoucanmoreeasilyignore

banks if they don't lookinteresting,while the bankexpert will inevitably findone bank or another theywant to buy. As CharlieMunger says, “To themanwithahammer,everythinglookslikeanail.”

—DavidSamra,ArtisanPartners

We like being generalists.We haven't owned any

healthcare formore than ayear,butnobody feels likethey have to pushhealthcare ideas, or thattheir bonus is threatened,because they're the personfocused on healthcare.Ideas rise to the top onlyontheirmerits.

—ChristopherGrisanti,GrisantiBrown&Partners

Given that what we're

lookingforisclearandhasbeen consistently applied,wecangiveouranalystsagreat deal of freedom inidentifying and pursuingideas. They know that ifthey can't explain whysomething is at a discounttovalue,why thatvalue isgoingtogrow,andwhyweshouldbecomfortablewithmanagement, they justdon't bring the idea to the

table. While what we'relooking for is tightlyconstrained, we don'tconstrain where analystscan look. If two peoplewant to pursue an idea,regardless of the industry,that's fine. Is it awaste ofresourceswhentwopeoplefind something interesting,when that probably meansitactuallyisinterestingandthetwoofthemworkingit

outtogethermakesitmorelikelywearriveattherightconclusion?

—BillNygren,HarrisAssociates

We have a total of sevenanalysts, including myself,and we believe wheninvestment teams havemore than 10 people theystart to break down. Egosgetintheway,peoplestart

to specialize, and you justcan't have the quality ofcollective discussion wethinkisnecessary.—PatEnglish,Fiduciary

Management,Inc.

Ourportfoliomanagersarealso analysts, with allcoverage responsibilitysegmented by industry, upand down the market-capspectrum. There's leverage

in bringing what youalready know to anincremental new idea. IfI'm looking at a small-capsoftware firm, I shouldhave a good sense of thecompetitive environment,for example, includingwhat Microsoft, Oracle,and SAP are doing in thearea. If I'm looking atMicrosoft, I should knowits strengths and

weaknesses as well as thenew technologies it's upagainst in any givenmarket. A generalisthaving to learn things likethat for the first timemaynot recognize change andopportunityasquickly.We'recognizantoftheriskthatpeoplelosesightoftheforest from the trees, soeach analyst covers twovery different industries. I

cover software andmachinery. Someone elsefollows healthcare andenergy. This should makeus less likely to lock ontoone way of thinking andless apt to recommend thebest house in a badneighborhood just becauseit'swherewelive.—RagenStienke,Westwood

Management

Inanidealworld,I'dliketobe more selective in theU.S.andtakeadvantageofmore opportunities outsidethe U.S. That will onlyhappen if we have thebottom-up ideas thatwarrant a place in theportfolio. To increase ourchances of finding those,we've changed how weorganize our internationalefforts. I used to think it

was more important tohaveindividualsectorteammembers in the sameoffice, so they couldmoreeasily learn from eachother and compare notes.Now we're putting morepeople on the ground,closer to the companiesthey track, in order toimprove the quality andfrequency of their externalrelationships.

—LeeAinslie,MaverickCapital

Anextensiveknowledgeofa business improves yourability to recognizepatterns and draw usefulinsights, a prerequisite tohavinganinvestmentedge.Beyond that, I'd argue thatexpertise is critical whenthings inevitably happenand you either need the

conviction to stick withyour thesis or the wisdomto recognize that it'schanged and reactaccordingly. Steppingoutside of areas we knowwell just seems too muchlike dancing through aminefield.—ShawnKravetz,Esplanade

Capital

If I believed having 10

people rather than 52wouldallowustobemoresuccessful, we'd quicklymake that transition. Butwith the specialization ofthepeoplewe'recompetingagainst today, I think it'svery difficult to have ameaningful edge withoutsignificant depth andexpertise.Weshouldknowmore about every one ofthecompaniesinwhichwe

invest than any other non-insider. Consistentlypickingwinners and losersrequiresextremelyin-depthknowledge of operatingbusinessesandtheindustrydynamics.Thattakeswork.

—LeeAinslie,MaverickCapital

We recently readGroupthink, Irving Janis'classicstudyofhowsmall,

cohesive groups of verysmart people can makereally bad decisions, suchas getting deeper intoKorea,theBayofPigs,andVietnam.Themainpointisto make sure you have aculture that questionseverythingandvetsoutallthe decision alternativesbeforezeroinginononeofthem.One of the personal

insights I gained from thebook is the value ofplaying one's cards a bitcloser to the vest early inthe decision-makingprocess. I have a habit ofspeaking my mind all thetime, but in the earlierstages of research that canset a direction that I andothers may unconsciouslyanchor on, closing off afuller exploration of

alternatives. The last thingyou want to do is shutdownpeople'sinitiative.

—AdamWeiss,ScoutCapital

My analysts are nowsaying, “I know you'regoingtohatethis,but…”.That's a great thing. Ifmyinitialreactionistohateit,so is themarket's,and thatprobably means it'ssomething we should look

atmoreclosely.—JeffreyBronchick,Cove

StreetCapital

There's a virtuous cycle inpeople having to defendchallenges to their ideas.Any gaps in thinking oranalysis become clearpretty quickly when smartpeople ask good, logicalquestions. You can't be agood value investor

without being anindependent thinker—you're seeing valuationsthat the market is notappreciating. But it'scriticalthatyouunderstandwhythemarketisn'tseeingthevalueyoudo.Thebackand forth that goes on inthe investment processhelpsyougetatthat.—JoelGreenblatt,Gotham

Capital

AtourTuesdaymeetingananalyst will give a shortsummary of why hebelievestheideameetsourcriteria and then everyonearound the table tries toshootholes in itandprovethat he's wrong. You haveno friends in that meeting—everyone is trying toprove thatyou'remakingamistake. We're trying to

identify as high apercentageofourerrorsaspossible, before we've lostanymoneyonthem.

—BillNygren,HarrisAssociates

I refer to our investmentcommittee meetings as“Fight Club,” but there's arespectful way of valuingyour colleagues while atthe same time questioning

everyword that comesoutoftheirmouths.

—AdamWeiss,ScoutCapital

We have three analysts,including myself, and forevery idea we pursue indepth,twoofuswillmakethe purchase case and onemakes the case for sellingthe stock short. There arebehavioral biases that cankick in when you pursue

what you think is a goodlongidea,andbyexpresslytasking one person withdeveloping what theintelligence communitycalls the “alternativecompeting hypothesis,”we're looking to minimizethe risk of missingsomething.Wewant to beclear upfront about whatcould go wrong, theprobabilities attached to

those scenarios and theresulting downside to thestockasaresult.—JeffreyBronchick,Cove

StreetCapital

A major risk-managementstepinourresearchprocessisapeerreviewwithinourresearch groups. After ananalystworksupanideaheor she presents it to theothers in the group, who

evaluate and challenge allthe downside and upsideassumptions being made.While they may not knowthe specific industry orcompany, they will likelybe quite current on thebusiness models andfundamental drivers of thebusiness.Weliketosayit'sa loteasier tocrawloutofhole if you stop diggingearly—here we're bringing

asmuchcollectivewisdomto bear as we can to keepus from even picking uptheshovel.—RagenStienke,Westwood

Management

The risk among anygroupof investors is that theyonly pay attention to whatthey already agree with.That's limiting anddangerous.

—MichaelMauboussin,LeggMasonFunds

Always ask yourself whatare the arguments on theother side. It's bad tohaveanopinionyou'reproudofif you can't state thearguments for the otherside better than youropponents. This is a greatmentaldiscipline.—CharlieMunger,2006

WescoAnnualMeeting

[Tiger Managementfounder] Julian Robertsonwas always adamant aboutseeking out the oppositepoint of view and thenbeing completely honestwith yourself in decidingwhether your analysisoverrides that. That'ssomething we try topracticeeveryday.

—RobertWilliamson,WilliamsonMcAreeInvestmentPartners

Inmarkets,everyone tendstoseethesamethings,readthe same newspapers andget the same data feeds.Theonlywaytoarriveatadifferent answer fromeverybody else is toorganize the data indifferentways, or bring to

the analytic process thingsthat are not typicallypresent. One researchsource of ours is a firm inHong Kong calledGaveKal, which has aregularfeaturetheypublishcalled, “What we see andwhat we don't see.” Theysay.“Here iswhatwesee,namely all the dataeverybody else sees, butnow here's a systematic

look at relevant thingspeople are not talkingabout, what they're notthinking about, what theother side of the issuemight be.” That's veryimportant.—BillMiller,LeggMason

Funds

Wepayalotofattentiontodottingouri'sandcrossingourt'swhenitcomestothe

fundamentals of findingopportunitiesthatare“safe,cheap and good,” becausewe think itmakes it easierto reframe things in new,flexible ways. Oneproblem with valueinvestors is that they canoften become ideologues.Butthere'sabigdifferencebetween focusing on thebasics and being anideologue. We've found

thatyouhavetoconstantlychallenge your ways ofthinking and re-educateyourself to remainsuccessfulasaninvestor.—MitchellJulis,Canyon

Capital

The last step in ourresearchprocessistoinvitein a Wall Street analystwho is a bear, and theycome in andmake a pitch

whywe shouldn't buy thisstock.Wewanttoseeifthereason they don't like it isif theyseea realstructuralflawinthebusinessthatwedidn't pick up on, or if it'sjust that they don't knowwhat's happening.Most ofthe time they're negativejust because of “noearnings visibility,” whichisWallStreet languagefor“I don't really have a clue

what's going to happennext.”

—RichardPzena,PzenaInvestmentManagement

I guess it was my goodfortune to work withseveral egomaniacs duringmy career, and I promisedmyself that when I startedmy own business that I'dcreate a much differentenvironment than what I'd

experienced. It wasn'tgoing to be all about meand we weren't going totreat people likecommodities. We try tohave an inclusiveenvironment and treatpeoplewell andwithgreatrespect.—BarryRosenstein,JANA

Partners

It'simportanttorealizethat

thebrain isn'tprogrammedlike a computer, and thatevery individual canapproach problems andissues in a unique way.Even at my age, I try toremainflexibleandopentonew ideas and ways ofapproaching things. Thatkeeps me from being afrustrated pedagogue andalsoallowsmetogetmorefrom the individual

strengthsofthepeoplewhoworkforme.

—SpencerDavidson,GeneralAmericanInvestors

We evaluate ourselves onrollingfive-yearperiods.Ifa portfolio manager hasone great year, it doesn'tfactoratallintohowheorsheispaid.Thatcouldjustbe a randomevent. I thinkit'sactuallyastretchtosay

fiveyearsislongenoughtobe relevant, but I realizenot everyone has the sametimeframes.—RicDillon,DiamondHill

Investments

I do not hire people Iwould not want as friendsor as neighbors. I workwithpeoplewhomakemylife easier.You can'tworkwith people who make

yourstomachgrind.—WarrenBuffett,2005meetingwithWharton

students

I really think that webenefited from startingwith good young people,who begat more goodyoung people. Weeventually devised testingthat all applicants had totake.Westillgivethattest,

which takes about three orfour hours. It is partaptitude, but alsopsychological. It sort ofemanated from our havinga few people over timewho just didn't have thefirepower to do the job—it's tragic when thathappens, because it's nottheir fault.Sowedesignedthese tests to better avoidthat.

The testwasalsodesignedtoshowwhatkindof teamplayer the person was andtheir competitiveness. I'vefound that most goodmoney managers are greatcompetitors.Ithinkthatallhelped us pick goodpeople. Whether it helpedas much as having greatyoung peoplerecommending more greatyoung people, I don't

know.—JulianRobertson,Tiger

Management

It'simportanttohirepeoplewith diverse experiencesandviewpoints,whichyoudon'tnecessarilyget ifyoujusthirestraight-AHarvardMBAs. Getting goodgrades and having courageare not the same thing.Being really smart and

having good judgment arenotthesamething.Nooneshouldbewinnowedoutsoearlyinlife.—SusanByrne,Westwood

Management

We have in the past hiredsmart young analysts rightoutofbusiness school,buthave concluded that's notfor us. We're looking forpeople who have been

around long enough toknow who they are asinvestors and the type ofenvironment inwhich theydotheirbestwork—they'renot still trying differentapproaches on for size. Ifyou want to maintain aresearch-driven, collegialand long-term-orientedculture, there's no betterway than by only hiringpeople who share those

values.—WhitneyGeorge,Royce&

Associates

It'swonderfultobetrusted.Some think if we just hadmore compliance checksand process, virtue wouldbe maximized. AtBerkshire Hathaway, wehave a subnormal process.Wetrytooperateinawebof seamless trust, deserved

trust, and try to be carefulwhomweletin.—CharlesMunger,2007WescoAnnualMeeting

CHAPTER7

GettingtoYes

A long-ago mentor, in abusinessotherthaninvesting,used to like to make one ofhis favorite points bydescribing how he could

create the most popularrestaurant inNewYorkCity.He would hire the best realestate experts to identify theideal location and then paywhatever it took to acquirethe property. He'd spare noexpense inhiringworld-classarchitects and designers tobuildout thespacewithonlythe highest-quality materials,fittings and furnishings. Hewould staff and outfit the

kitchenunderthedirectionofchefs who he had poachedfrom the world's finestrestaurants by allowing themto name their price to comeonboard. Once the doorsopened,he'dofferfour-courseprix-fixe menus, includingwine, for $9.99 each, withtips and valet parkingincluded.“Voilà,NewYork'shottest restaurant is born,”he'dsay.

Anextreme example, to besure, but the point stuck:Business is all about whatyou pay forwhat you get. Ifcosts toproduceare toohighrelativetowhatyou'repaid—no matter how sublime theproduct or service—you willultimatelyfail.This same basic principle

applies to investing.Throughcreativeanddiligent researchyoumay uncover fascinating

companies in wonderfulindustries. Through brilliantandincisiveanalysisyoumaysee unfolding for a companypositive events that meremortals would miss. But allof that is for naught if youpay too much for a stockrelativetowhatyouget.Priceobviously matters—thecheaper it is relative to whatyou believe a company isworth,thebetter.

This section is about howsmart investors concludewhether the price they'repaying for a stock issufficiently cheap relative tothe value they believe theywill receive through theirresulting partial ownershipstake in the company.Whilethere are clearly commonelements in how investorsascribe value, we've beenstruck over time by the

varietyofvaluationmeasuresthey utilize and how theyapproach and answer thequestion, “What's cheapenough?”

CASH(FLOW)ISKING

There are some prevalentthemes in how smartinvestors approach valuation,

the primary one being theirfocuson the future streamofactual cash that the companyis expected to generate aftertaking in all revenues andpayingoutallexpenses.

***

Ithasalwaysmadesensetometorelyfarmoreoncashflow than reportedearnings. When I was in

graduate school, mybrother-in-law hiredme todosometemporaryworkata canning company. Oneprojectwastogothroughapile of invoices and pulloutanythingthat lookedatall like a capital purchase,even for things like tiresand other pretty basicrecurring expenses. Ifinally asked why I wasdoing that and he said the

CFO wanted to capitalizeanything that remotelylooked like capitalspending so they couldwriteitoffovertime.The lesson in that for mewas that a cleveraccountant can makefinancial statements saywhatever he wants in theshortterm.Thatconclusionhas only been reinforcedovertime,especiallyasthe

differing tax regimes andaccounting conventionsyouseeoverseascanmakecomparisons based onreported net income evenmoremeaningless.

—DavidHerro,HarrisAssociates

Earnings are basically anegotiatednumberbetweenmanagement and theauditors, subject to

considerable manipulation.Cash flow—earningsbefore depreciation andamortization and afterworking-capital changesand either maintenance ortotal capital spending—ismuch less subject tomanipulation and just amuch better measure ofcorporateprofitability.Atthesametime,freecashflow is what allows

companies to increase thevalue of the business—from making capitalinvestments, to makingacquisitions, to payingdowndebt, tobuyingbackstock or paying dividends.Companies that producefree cash flow also attractpotential buyers, eitherfinancialorstrategic.

—JohnOsterweis,OsterweisCapitalManagement

We askwhat our expectedrate of return would be ifwe owned the wholebusiness, which isessentially taking pretaxfreecashflowanddividingit by the current enterprisevalue.Forpretax freecashflow we look at normalearnings before interest,taxes, depreciation andamortization, less

maintenance capitalspending. In thedenominator, we adjustenterprise value by addingcontingent liabilities andsubtracting any kinds ofhidden assets we find. Ifafter all adjustments wecanseeamid-teensrateofreturn, we're veryinterested.

—StevenRomick,FirstPacificAdvisors

We've always done verywell when we can usesixth-grade math on thebackofapostcardtoshowhow inexpensivesomething is relative to itsfree cash. Once we startgetting more sophisticated—trying to provesomething rather than seeif we can disprove it bykilling the business—we

getintotrouble.We're looking to pay 10xfree cash flow or less,period. If you find thoseand you can't kill thebusiness, you should bebuyingalldaylong.

—BruceBerkowitz,FairholmeCapital

We want to see at least a10 percent free-cash-flowyield and a 6× or less

multipleofenterprisevalueto next year's earningsbefore interest, taxes,depreciation andamortization [EBITDA].Forenterprisevalueweusethe current market valueplus theestimatednetdebt12monthsout.Most of the companies inour universe generally livewithina rangeof6× to8×EBITDA. The idea is to

identify companies havingsome earnings or othertrouble that leave themtrading at the low end ofthe valuation range. If ouranalysis is right that thedifficulties are temporary,we get two boosts: fromearnings recovering andfromthemarketreactingtotheearningsrecoveringandmoving themultiple to thehigher end of the range.

We believe that dynamicgivesallourcorepositionsa very high probability ofat leasta50percent returnwithintwoyears.Attheendofthedaywe'retryingtobuycompaniesasif we were buying a $10million office buildingacross the street. We doour homework on thetenants and the leases inplace and make sure it's

financed in a way thatproducesa10percentfree-cash-flowyield.Theideaisto increase equity bypayingdowndebtwith thefree cash flow and also tobenefit from the assetappreciating over time.With stocks, if you focuson companies with around10 percent free cash flowyields and highlypredictable, sustainable

franchises, you protectyour downside and setyourselfupfornicecapitalappreciation.

—AlexanderRoepers,AtlanticInvestment

Management

Our valuations are basedon estimated EBITDA 12to18monthsout.Wedon'tlook out further becausewehavelittleconfidencein

our ability to forecastbeyond that and becausewe're most interested inwhat thebusiness isworthtoday. The art in thevaluation is arriving at theappropriatemultiple to puton the cash flow.We lookat private-markettransactions and publiccomps, adjusting up ordown from thosebasedonthings like the profitability

of the business, itspredictability,theprospectsforgrowth,andtheamountofleverage.

—JamesShircliff,RiverRoadAssetManagement

We look at the securitiesanalysispartofwhatwedoin the way people look atvaluing a bond. Ignoringthematuritydate,whatyouneed to know is the price,

the coupon, and thereinvestment rate. Itwouldbe crazy to value a bondknowingonlytwoofthosethings and we look atstocksthesameway.For price, we look atenterprise value, becauseyou need to take intoconsideration all the callson the earnings that aresenior to you as an equityholder.Wealsotrytomark

thebalancesheettomarketbyadjustingforthingslikeunderfunded pensions orreal estate on the books atcost.Asacoupon,we'relookingat owner earnings, whichadjusts GAAP earnings toarrive at the cash flowyou'dhaveatyourdisposalas an owner. There aremanyadjustmentstomake,but the most important is

accounting for thedifference between theinflation-adjusted amountof capital a companyspends to maintain itscompetitive positioncompared to its reporteddepreciationlevels.The third key item is therate at which ownerearningscanbereinvested.This is the hard part, butobviously enormously

important to anyinvestment thesis. If youlook out 5 to 10 years, aswetypicallydo,thatreturnon incremental capital isgoing to be far moreimportantthantheearningsyield you get in year one.That's why the businessanalysisissoimportant.—ChristopherDavis,Davis

Advisors

What gets our interest iswhen a target company'sshare price goes down tothe point where the free-cash-flow yield—EBITDAminus real capitalspending, minusincremental workingcapital, divided byenterprisevalue—isatleast10percent.The reason we have do atleast cursory work on 100

companies per year is thatit is reallyhard to find thethree or four that inaddition to the 10 percentfree-cash-flowcoupon,canalso generate growth infreecashflowofatleast10percent per year. In mostvalue situations, too muchof the company's revenueis tied to mature andoftentimes decliningproductlines.Butwhenwe

can see 6 to 8 percentorganic growth combinedwith margin gainsproducingdouble-digitfreecash flow growth, that'sinteresting.If we can buy 10 percentcurrent coupons and if thecoupon grows at 10percent, the math says wewill generate an annual 20percent unlevered return.That's the target for each

position we hold and it'swhat we expect out of theentireportfolio.—JeffreyUbben,ValueAct

Capital

We're trying toownthingsthat look like value stockswhen we buy them, butwhich turn out to begrowthstocks.Sowetrytobuild a portfolio ofbusinesses with two

primary characteristics.The first is that, even intimes of stress, theunderlying income-producingassetsarestrongenoughtomaintainavaluefloorfortheinvestment.Inother words, the companyischeapbasedonwhatwecan be fairly certain ofnow. The secondcharacteristic is somechange going on that is

unrecognized by themarket and likely to bevery valuable in the outyears—afreecalloption.We generally want toinvest at a price where ifourgrowth thesis is totallywrong,we can still expecttoearnatleastan8percentnominal cash-on-cashreturn. That's roughly inline with what the overallmarket is likely to return,

so we should match thateven if none of the freeoptionspayoff.

—BoykinCurry,EagleCapital

The first thing we do isnormalize what we thinkthe company's earningspower is. A lot goes intothat, but it essentiallymeans looking atwhat thebusiness has traditionally

been able to generate overtime and adjusting forvarious factors that mightmake it more or lessattractive going forward.We then estimate thepercentageofthosenormalearnings that the companywill keep after things likecapital spending andinvestments in workingcapital, resulting in a freecash flow number we can

divide by the currentmarket value to get a freecash flowyield.On top ofthatwe'lladd inflationandthe annual growth in freecash flow we expect inorder to arrive at ourestimated rate of return,whichwetypicallywanttobeatleastintheteens.By focusing on forwardrates of return, it keeps usmore centered on the

fundamentals of thebusinessanditscashflows.We aren't counting on ortrying to figure out whatsomeoneelsemightpayasaP/Eorcashflowmultipledowntheroad.

—StephenYacktman,YacktmanAssetManagement

The metric we care mostabout is what we callreinvestment cash flow,

which is essentiallyearningsbeforeinterestandtaxes, plus depreciationand amortization, minusmaintenance capitalspending. We look outthreeyearsandwanttoseethe reinvestment yield thecompany earns increasingrelative to its enterprisevalue. Then using adiscounted cash flowmodel, we calculate a

warrantedvaluethathastobe at least 50 percentgreater than the currentmarketprice.—JoeWolf,RSInvestments

We'reprimarilyfocusedonfree cash flow yield,which, after taxes andmaintenance capitalspending,wewanttobeatleast 8 to 10 percent. Forfaster-growing companies

we accept a bit less, butthat'sthegeneralguideline.We tend to look atvaluation in layers. Thefirst layer is sort of a no-growth, as-is valuation,based on historicalperformance and how webelieve freecash flowwillrespondgoingforwardtoafew key variables. Thesecond layer looks at thefree cash flow yield after

incorporating operationalimprovements we expectthat don't require top-linegrowth. Finally, we buildin the opportunities forrevenue growth we see.Our goal is to be satisfiedwith the yield we'd getbasedonthefirstlayer,butobviously the thicker theother layers are, the betterthe opportunity. Goodthings can happen when

competent people areworking every day toimprove a high-qualitycompany's performance,whichweusuallylookatasfreeoptionson theupside.It'smaybeabitboring,butour objective is tocompound at a minimumof10percentperyear.Youdo that over 20 years andyou increase capital byalmost seven times. That's

rare enough that whenpeopleactuallydoit,you'relikelytohearaboutit.—PatrickMcNeill,Alatus

Capital

We'reessentiallywillingtopay for the current cashearnings power. It varies,but ifwe're paying a pricethat results in at least a 7percent maintenance freecashflowyield,webelieve

we're paying only forwhat's being generatedtoday, getting for free theability of the businessmodel to grow free cashflow at a rate significantlyahead of the market. Welook to make money in acoupleofways.Thefirstisthrough compounding ofthe company's intrinsicequity value at 20 percentor more per year.

Secondly, if we're right inidentifying this type ofbusiness earlier than otherinvestors, we should getpaid over time frommultipleexpansionaswell.—JoergDiedrich,Pennant

Capital

It'snotexactlyreducibletoa bumper sticker, but thekeytoourapproachisfree-cash-flow total return. We

lookatfreecashflowyieldplus expected growth infree cash flow, comparedto the market-implied rateof return. Take Amazon:the free cash flow yield isaround 5 percent, but thefree cash flow growth rateis20to25percenteasy.Sothat'sa30percentfreecashflow total return versus, atmost, the 8 to 10 percentyou'll get on the overall

market.Ourview is that itdoesn'ttakeamathematicalgeniustofigureoutthat30percent isgoing tobeat10percent if you have anytimeonyourside.—BillMiller,LeggMason

Funds

Basically we have toanswer three questions: Isthestockmispriced,whyisit mispriced, and what's

going to make themispricinggoaway?Ifwecan't adequately answerthose questions, we eitherhaven't done enough workor it's probablynot agreatidea. To answer the firstquestion, we arrive at afundamentalvalueforeachcompany we analyze,which is essentially theprice at which its cashflows or asset values

provide an adequate, risk-adjusted, cash-on-cashreturn. For a moderate-growth business withmoderate leverage in anormal interest rateenvironment, that returnover time would beroughly 15 percent peryear. Against thatfundamental value, wetypicallywantourshortstobe at least 30 percent

overvalued and our longsto trade at a 30 percentdiscountorhigher.—CurtisMacnguyen,Ivory

Capital

I'vealwaysbelievedthatasan investoryouhave tobecomfortablewithanumberof different valuationapproaches andmethodologies, and thatpart of the art of investing

is to recognize whichapproach is mostappropriate in differentsituations. The metric wetend to look at mostfrequently is sustainablefree cash flow yield—inotherwords,freecashflowafter the capital spendingnecessary to maintain acompany's competitiveposition relative to thecurrent market price.

Acrossmostbusinessesweconsider that a consistent,important measure ofvalue.

—LeeAinslie,MaverickCapital

MULTIPLEANGLES

While somemeasure of cash

flow relative to the currentmarket price is the mostcommon valuation metricused by leading valueinvestors, they frequentlyutilizeanumberofadditionalmeasuresofvalueinformingtheir judgments. Thisapproach has strong researchsupport, including that ofWhat Works on Wall Streetauthor and money managerJamesO'Shaughnessy,whose

multi-decade researchindicates that stocks thatscreenwellonacompositeofvalue-based factors—including price-to-book,price-to-earnings, and price-to-cash-flow—perform muchbetter over time than thosescreening well on any oneindividualfactor.

***

We try to use multiplemethodologies to establishacompany'sintrinsicvalue—discounted cash flowmodels, private marketvalues, and market-basedmultiples compared topeers and the company'sown history. We thinkcoming at it frommultipledirections can give us ahigher level of confidencein our ultimate estimate of

value.—TimothyBeyer,Sterling

CapitalManagement

We won't buy if we don'tseea35percentdiscounttoour current estimate ofintrinsic value, which wearrive at in a variety ofdifferent ways dependingon the company. Ideallywe're runningadiscountedcash flow model, cross-

checked against where webelieve something shouldtrade based on othermetrics like price toearnings, price to cashflow, price to net assetvalueorasumoftheparts.We think at least a 35percent discount gives usenough margin of safetythat we can be wrong andnotgetkilled.—SteveMorrow,NewSouth

Capital

The metrics we use todetermine value are prettymuch what you'd expect.We do private-market-value analysis usingdiscounted future cashflows and by looking atbreakup values. At thesame time we like stocksthat are statistically cheapon a traditional

price/earnings basis. Wefocusoncompaniestradingat a 40 percent or greaterdiscount to our privatemarket value or no morethan 13x our estimate ofnext year's earnings. Wehave to have one or theothertobuy.

—JohnRogers,ArielInvestments

We like looking at

multisegment businesseswhere it's a bit morecomplicated to analyze allthepartsandthere'snotanobvious answer to thequestionofwhat theentirecompany is worth. In thiscontext, we pay a lot ofattention to private-marketvaluesofeachsegmentandtrying to understand howunderperforming segmentsshouldbevalued.

—PeterLangerman,MutualSeriesFunds

We'll estimate what wethink earnings can be fourtofiveyearsout,applythecurrent multiple to thoseearnings,andthenseewhatthe price would be ifdiscounted back to todayusing a 20 percent annualrate. If the price todayimplies a discount rate of

more than 20 percent peryear, we're interested.We're not even looking atwhat we think can happennext year, because that'salready fairly accuratelybuilt into the stock price.Wealsodon'tusuallycounton multiple expansion—although it would be greatif it happened—becauseyou really can't estimate amultiple five years out

unless you have a goodideawhatinterestrateswillbe then, which is notsomethingIknowanythingabout.—MurrayStahl,Horizon

AssetManagement

THEINFORMED

BUYERValue investors fromBenjamin Graham on downhave stressed the importanceof looking at equityownership not as theshuffling of papers to betraded, but as a partialownership interest in anongoing business enterprise.Alogicalextensionof that inarriving at what a stock is

worth is the frequent focusamong accomplishedinvestors on what theybelieve a knowledgeablebuyer would pay for theentirebusiness.

***

In ballpark terms, we liketo be a buyer when thecurrent share price is nomore than 60 percent of

our estimate of businessvalue,which is thehighestpriceacashacquirercouldpay for the entire businessand still earn an adequatereturn on their investment.The words are allimportant. By focusing ona cash buyer, we're tryingtoseparatepeoplewhoarepaying real money fromthose who might overpaywith their own overvalued

shares. The focus onadequatereturnsallowsforthe possibility that thebuyer has some way toextract synergy from thepurchase. Especially whenyou're looking at small- tomid-cap companies, themaximumvaluemaycomefrom a buyer who willintegrate the business intoa larger organization.We're not just looking at

the maximum price of agiven company in itscurrentcorporateformasapublicentity.Why60centsonthedollarto buy rather than 50 or40? Over long periods oftimestockstendtoperformbetter thanotherassetsdo,andthemorestringentyouare about what you'llaccept themoredifficult itbecomes to field a

portfolio. We've foundover our history that at 60cents on a dollar, we'vebeenableatanygiventimetofieldarelativelyfullandwell-diversified portfolioof ideas. If we buy right,thediscountcloses,andthevalue of the $1 we buytoday goes to $1.20 or soover the next two or threeyears, we have thepotential to double our

money.Thatkindofmakessensetous.

—BillNygren,HarrisAssociates

Intrinsicvaluetousmeansthe price that aknowledgeable buyerwouldpayforabusinessinits entirety in cash today.Any knowledgeable buyerwill recognize and takeinto consideration whether

current earnings are toohigh or too low, based onthe cyclicality of thebusinessandwhere it is inthe cycle. Similarly, wedon't want to capitalizeearnings streams that aretoo high or too low, butfocus invaluationonwhatthe cash flow of thebusiness is somewherebetween the extremes.Because the future is

uncertain, we don'texaggerate theprecisionofthe values we come upwith.—AbhayDeshpande,First

EagleFunds

Wetrytofigureoutwhatarational, informed buyerwould pay for the wholebusiness.We'd expect thatkind of buyer to base theprice on how much cash

the business wouldgenerate over the next 15to 20 years in excess ofwhat's needed to run thebusiness, so true free cashflow.Weuseastandard12percentdiscountrateasthehurdle rate that buyerwouldwanttoearn.—WallyWeitz,WeitzFunds

Ingeneralwewanttoseea35 to 40 percent discount

from what a prudent manmaking an acquisitionwould pay for the entirebusiness. We put it thatway because sometimes,such as in 2006 and 2007,acquisitionsarebeingdoneat levels we considerimprudent,sowedon'tusethem in calculatingintrinsic values. If you'refairly conservative invaluing the business and

then demand a 40 percenthaircut off of that, youshould have a prettyhealthymarginofsafety.—RobertWyckoff,Tweedy,

BrowneCo.

Webasicallyfocusonwhatasomewhatknowledgeablebuyer, expecting areasonable return, wouldbe willing to pay in cashfor theentirebusiness.We

put a lot of emphasis oncomparabletransactionandmarket values,crosschecked againstvaluation measures likeenterprise value to EBIT.We'llgenerallyonly investwhen the EV/EBITmultiple is in the range of8×to15×—thelowendforbusinesses, using WarrenBuffett's terminology, thatmight be more

questionable, while thehigh end is for businessesthataremorecomfortable.

—Jean-MarieEveillard,FirstEagleFunds

We're not P/E buyers.We're not P/E-to-growth-rate buyers.Andwe're notEV/EBITDA buyersbecausewethinkovertimethat the D and A inEBITDAare real expenses

you need to account for.We look at currentoperating income dividedby enterprise value as our“caprate,”andwewant tobuywhen that's15percentor more and sell when itgoes to7 to8percent. I'mtryingnottobuyhopesanddreams, but the here andnow. The layman'sway tothink about it is if youcould buy the whole

company and—beforefinancingandpaying taxes—earn15centsonadollarinvested, that's a prettygooddeal.Ifthehopesanddreams come true, all thebetter.

—JayKaplan,Royce&Associates

Theunderlyingprincipleiswhat someone would payin an arm's-length

transaction for the entirebusiness.Weusuallyarriveatthatbyapplyingwhatweconsider to be theappropriate multiple toestimated EBITDA oneyear out, adjusted for thebalance sheet. To enter aposition,wewant to see a30 to 40 percent discountto our intrinsic-valueestimate.Wetrynottofoolourselves that just because

webuilt a spreadsheet thatallofthisisveryprecise—we'remakingestimatesandthinking about things thatareunknown.Buttherearecasesinwhichourlevelofconfidenceintheestimatedearnings or in themultipleis higher. The moreconfidentweare, themorelikely we'll find a 30percentdiscountsufficient.The less confidentwe are,

the higher the discountrequired.Inourexperiencea portfolio of stocks withthose typesof entrypointswill generate an attractivereturn over time. We willnotberightoneverystock,wejustneedtoberightonaverage.—AndrewJones,NorthStar

Partners

MODELBEHAVIOR

In the investing world writlarge, there is an extremelywidevarianceintheextenttowhich money managersautomate their valuation,assessment, buying andselling decisions.At one endofthespectrumarethosewhorely heavily on discounted-cash-flow models and other

defined valuation parametersto drive portfolio decisionsexecuted by computeralgorithms that respond tochanges inmarket prices. Attheotherendofthespectrumareinvestorswithadecidedlyhealthy skepticism ofcomputer models and thecertainty and precision thattheyimplyexists.Mostoftheinvestors we've interviewedfallsomewhere in themiddle

—rigorous in their use ofmodels to assess valuationand make trading decisions,butalsorelyingonexperienceand intuition to overrule thesystemwhen theybelieve it'swarranted. As we've saidmany times, there is no oneright approach, but everysuccessful investor we'vecomeacross isquite adept atdescribing where automationends and intuition begins in

hisorherapproach.

***

Models beat humanforecasters because theyreliably and consistentlyapplythesamecriteriatimeafter time. Models nevervary. They are nevermoody, never fight withtheir spouse, are neverhungover fromanighton

the town, and never getbored. They don't favorvivid, interesting storiesover reams of statisticaldata. They never takeanything personally. Theydon't have egos. They'renot out to prove anything.If theywerepeople, they'dbethedeathofanyparty.People on the other hand,arefarmoreinteresting.It'sfar more natural to react

emotionally or topersonalizeaproblemthanit is to dispassionatelyreview broad statisticaloccurrences—and somuchmore fun! It's much morenaturalforustolookatthelimited set of our personalexperiences and thengeneralize from this smallsample to create a rule-of-thumb heuristic. We are abundle of inconsistencies,

and although this tends tomake us interesting, itplays havoc with ourability to successfullyinvest.—JamesO'Shaughnessy,

O'ShaughnessyAssetManagement

Anidealstockaccordingtoour model would beinexpensiveonanabsolutebasis, relative to its peers

andrelativetoitshistory.Itwould be supported byhigh-quality earnings, asmeasuredbythingssuchascash flow relative to netincome, capital spendingrelativetodepreciationandearnings-estimatedispersion. It would befinancially secure, asmeasuredbythingslikethelevels of cash andoperating cash flowversus

liabilities, the operatingreturn on assets, and theratio of shareholders'equity to total assets.Finally, it would be in themidst of an upswing inbusiness operatingmomentum and investorsentiment, as indicated by,say,share-pricemomentumand earnings-estimaterevisions.—PaulVeZolles,WEDGE

Capital

We have a sophisticated,proprietary model that wehaveshown tobea sourceof alpha by valuingcompanies and judgingwhere they are in theirearnings cycles. That's thescienceofwhatwedoandis quite systematic andrepeatable.Theartofwhatwedoisin

the interpretation of thatdata and deciding what toactuallybuyandsell.Hereyou need to rely onexperience, judgment andcontinuouslearning.Isthatrepeatable as the peoplechange? If you pick theright people, teach themwell, and give them theexperiencenecessarytoactontheirown,wethinkso.

—RonaldMushock,

SystematicFinancialManagement

With our quantitative andmore automated approachtobuying,we'rejusttryingto take as many of thebehavioral foibles off thetable as possible. Thinkabout it in terms of theS&P 500 index, which isactually a not-so-greatinvesting strategy because

all it says is “Buy bigstocks.”Thereasonitbeats70 to 80 percent ofconventionally managedfunds is not because it's agood strategy, but becauseit's a strategy that'sreligiously adhered to. Itdoesn't panic, have secondthoughts, or becomejealous of what its next-door-neighbor indexowns.The key to its long-term

success is an unwaveringimplementation of aninvestment strategy. We'reusing the same logic, butwith what we believe arebetterstrategies.—JamesO'Shaughnessy,

O'ShaughnessyAssetManagement

To arrive at an intrinsicvalue we forecast cashflows out five years, and

thendiscount the first fouryears back to the presentandadd to that thepresentvalue of the fifth year'scash flow after applying amultiple to it. The settingof thatmultiple,ofcourse,is very important and iswhere we have the mostdebates in our approvalprocess. There arequantitativeandqualitativeaspects to it. We'll maybe

startwithpeermultiplesorthe multiples at whichdeals have been done, forexample, but that's not theonly input because everycompany is different. Wealsotakeintoconsiderationthings like the consistencyof the business, itsfinancial strength, and theoperating prowess of themanagementteam.

—DavidHerro,Harris

Associates

We're trying to find 20 to30 long investments, runbymanagement teams thattrulyunderstandthecostofcapital and capitalallocation, where webelieve based on adividend-discount modelthatwe're paying 60 to 70cents on the dollar todayand that that dollar can

grow at an equity rate ofreturn.Ifyoucanbuya60-cent dollar and over threeyears that dollarappreciates 10 percent peryear and the discountcloses, the stockwillmorethan double. Youobviouslywon'tdo thatonevery position, but if youhit that on half yourpositions on average anddon't lose any money on

the other half, you'll earn13to14percentperyear.—JonJacobson,Highfields

Capital

Our discounted-cash-flowcalculation then producestwo prices. Our buy priceis the price at which thecash flows are beingdiscounted to produce ourrequired real return of 8percent. Basically, the

company is priced lowenough toallowus toearnin excess of the market'sexpected return. Our sellprice is the one thatdiscountsfuturecashflowsat 6 percent, meaning thevaluation no longer allowsus to earn an expectedreturn greater than themarket's.—BernardHorn,Polaris

Capital

Our goal is to create adetailed financial modelthat estimates cash flowavailable to shareholdersover the next five years.Withthatmodelwe'reableto calculate the presentvalueofboth the five-yearcash flows and a terminalshare value, calculated byapplying an estimatedterminal multiple to our

year-five cash flowestimate.Wediscountboththose values back to thepresent using a requiredrate of return, whichreflectstheriskinessofthecash flows due to thingslike industry cyclicality,competitive threatsand therate of technologicalchange. In today's interest-rate environment, requiredrates of return for most

companies we analyze arefrom 8 percent to 12percent.

—ChrisBingaman,DiamondHillInvestments

Wedothesamediscountedcash flow analysiseveryone does, but themost important variable—and the one that mostimpacts theanswer—is thegrowthrateyouassumefor

the business. LeeCoopermanalwaysused tosay that if you got thatright, youwere 90 percentthere. I've alwaysconsideredthattobetrue.—MorrisMark,MarkAsset

Management

If you're buying high-quality businesses at whatyou think are discountedprices, you can be a little

bitwrongonyourintrinsic-value estimates and stillmake money. If you'veever done aDCF analysis,youknowhowvariabletheresults can be with smalladjustments in things likeoperating leverage ordiscount rates.Wewant tobuy only when the sharepriceis50to60percentofour calculation of intrinsicvalue, but our qualitative

judgment of the business,management, and riskinvolvedwillplayabiggerrole in the positions wetake than whether thisstock is at 58 percent ofintrinsic value and thisotheroneisat54percent.

—BrianBares,BaresCapital

We'renotbigfansofDCFmodels because of thegarbage-in, garbage-out

risk. I don't know if lunchwillbegoodlaterontoday,so how am I going toforecast a company'searnings five or ten yearsout?Mostofourvaluationworkfocusesonwhatacompanywouldbeworthtodayinanarm's-length transaction.The best sources for that,of course, are comparablerecent deals.We also look

at how valuationmultiplesonagivencompanyor thesum of its parts match upagainst historical andcompetitivecomps.

—DavidWinters,WintergreenFund

We try to avoid falseprecision when we do ourvaluation work. We don'tknow what earnings aregoing to be next year and

we don't believemanagement teamsthemselves can know thatwith any great precisioneither.Whatwe can try todo is estimate thenormalized economicearnings power of abusiness and then put areasonable multiple onthose earnings, based onthe characteristics of thebusiness—i.e.growth,need

for capital, competitiveposition—and relative towhat'shappeningout therein the real world ofmergersandacquisitions.

—CurtisJensen,ThirdAvenueManagement

I'm still more back-of-the-envelopewhen itcomes tovaluation. To me it allcomes down to theassumptions you're

making.Ifthey'recorrect,aback-of-the-envelopecalculationworksperfectlywell. If they're not,sophisticated modelingisn'tgoingtohelp.

—RobertKleinschmidt,TocquevilleAsset

Management

I was brought up in thebusiness to be skeptical ofbig, long-term discounted

cashflowmodels,sothat'snot an important part ofhowweinvest.

—StevenTananbaum,GoldenTreeAsset

Management

Discountedcashflowtousis sort of like the Hubbletelescope—you turn it afraction of an inch andyou'reinadifferentgalaxy.There are just so many

variablesinthiskindofananalysis—that'snotforus.

—CurtisJensen,ThirdAvenueManagement

PLAYINGTHEODDS

Consistent with valueinvestors' emphasis on whatcangowrongwithanygiven

investment, they typically intheir valuationwork assess avarietyofpossibleupsideanddownside value scenariosand, implicitly or explicitly,assign probabilities to eachbefore making any finaljudgments.

***

We'reveryfocusedonhowmuch money we can lose.

What's the hard assetvalue? What protectiondoes the balance sheetprovide?Westresstest thebusiness using draconianassumptions and comparethe worst-case scenariowith what we predict willactually happen. We want$4 to $5 of upside forevery $1 of downside.We'vefoundovertimethatif you marry improving

returns on invested capitalwith an asymmetric riskprofile, the odds of losingmoneyarelow.—JoeWolf,RSInvestments

I'll say it in a way thatimpliesmoreprecisionandrigidity than we use, butwe also want to seepotential upside versusdownsideofatleast3:1.Ifat normalized earnings

levels in two years or sowe see an upside that isthree times the downsidewe could imagine in thenext year or so, we'reusually comfortable goingforward.

—StevenRomick,FirstPacificAdvisors

The prospective returnmust always be generousrelativetotheriskincurred.

Forriskierinvestments,theupside potential must bemany multiples of anypotential loss. We believethere is room for a few ofthesepotentialfiveandtenbaggers in a diversified,low-riskportfolio.

—SethKlarman,TheBaupostGroup

One lessonfrom2008wasthat we were guilty of

having a failure ofimagination on thedownside. We develop abase, high, and low casefor each business weanalyze and one practicaladjustment we've made isto make our low casessomewhatmore draconian.That comes into play inwhat we're willing to pay.We're more reluctant tobuyastockthatmightlook

attractive relative to thebase case if the downsidefrom the low case is toogreat. That's always beentrue—if the range ofoutcomes is wide, thatprobably means the cashflows aren't as predictableaswe'dlikeandwerequirea bigger discount—but it'sevenmoreofafocusnow.—WallyWeitz,WeitzFunds

In valuing companies,we're putting moreemphasis on therelationship between thecurrentpriceandtheworst-case scenario and—regardless of the potentialupside—aremore likely tosit and wait if thatdownside is material. In asideways market, cash isnottrash.

—DavidNierenberg,D3

FamilyFunds

It isn't human nature toviewthefutureintermsofa wide range ofpossibilities. We naturallythink in terms of what ismost likely to occur andimplicitly assess theprobabilityof thatscenariooccurring at 100 percent.That may sound reckless,but it's what most people

do and isn't a bad way tothinkaslongaslesslikely,but still plausible,scenariosdon'thavevastlydifferent outcomes. In theinvestment world,however, theyoftendo, somakingdecisionssolelyonthe most likely outcomecancauseseveredamage.In addition to what mightbe the business-as-usualcase, we also want to

identify four or fivescenarios that are differentfrom the recent past andanalyze the present valueof likely future cashgenerationunder each.Wecalculate an intrinsic valueand apply a probability toeach scenario. Our finalestimate of value is thevalue under each scenarioweightedby itsprobabilityof occurring. A key is to

capturelow-probabilitybuthigh-impact scenarios,primarily to see where thevulnerabilitiesare.

—BryanJacoboski,AbingdonCapital

Wecomeatvaluation in avariety of ways, but theprimary one is to assignprobabilities to three orfour different scenarios toarrive at an expected

outcome, which wecompare to the currentsharepriceinlookingforamarginofsafety.—MichaelKarsch,Karsch

Capital

Attheendofeveryquarterwegetareportshowingtheholdings we had in eachportfoliofiveyearsagoandhow those stocks haveperformedovertheensuing

five years. The goal is toassess the decisions wemade and whether theestimatesof intrinsicvalueuponwhichthosedecisionswere based were properlydone.One thingwe've learned isthat we often don't givecompanies enough creditfor the fundamentalstrength or weakness oftheir competitive positions

and business models. Thathas resulted in sellingwinners too soon, and inholding losers too longbecausewehaven'thadtheimaginationtoseehowbadthings could get. You cannevereradicatethosekindsofmistakescompletely,butit has made us moresensitive to both best-caseandworst-casescenariosinourvaluationanalysis.

—ChrisWelch,DiamondHillInvestments

We look back as far aspossible to inform whatwould be the worst-caselevels of revenues andmargins, and then applywhat we think are troughmultiples to the resultingworst-case earnings. If theworstcaseismorethan20percent below the existing

sharepricewewon'tbuyit,no matter how much thediscount is to our intrinsicvalue.—CharlesdeLardemelle,

InternationalValueAdvisers

We don't invest in thingsthat could be a coin flipbetweendoublingorgoingto zero. We want thedownside of every holdingtobenomorethan10to15

percent and the upside tobe at least 50percent.Thekey for us is to not bewrongaboutthedownside.—JonJacobson,Highfields

Capital

We don't invest in binarywin/lose situations. Adeep-value manager canquite openly accept thatsome of his holdings maygo to zero, assuming that

bigwinnerswillmorethanoffset the occasional bigloser. We don'tcontemplate losing tooterribly much on anyinvestment.—BrianBarish,Cambiar

Investors

One mistake valueinvestors can make is tofocus too literally on theabsolute difference

between an estimate ofintrinsic value and thestockpriceasthevaluationcushion. If the range ofpotential outcomes is verywide, youmay havemuchless of a cushion than youthink. One big reason wefocus on better-qualitybusinesses with greatbalance sheets is that thevariability in outcomes—and therefore the risk of

blowing through thevaluation cushion—islower.

—DanO'Keefe,ArtisanPartners

THEORIESOFRELATIVITY

Aninvestor'sattitudetowardsabsolute versus relative

measuresofvaluationisoftena function of how fullyinvestedheor she expects tobe. If holding a decentamount of cash is not anoption, for example, a focuson relative valuation againstother stocks is more likely.When cash is allowed tobuild,managersaremoreapttowaitforabsolutevaluationcriteria to be met beforeacting.Butevenholdingone's

cash strategy constant, viewson what constitutes actualvalue at any given time canvarywidely.

***

Here'showwe thinkaboutit: Say the S&P 500companiessellat15×nextyear's earnings, 3× bookvalue,11×cash flow,1.5×revenues, have anROE of

17 to18 percent and haveanticipated trend earningsgrowthof8percent.We'relookingforcompanieswithequal or superior growthcharacteristics that sell atdiscounts to the marketvaluation.—LeonCooperman,Omega

Advisors

We're basically willing topay average or below-

average valuations forcompanieswe believewillcontinue to have better-than-average performance.Relative to more elaboratevaluation disciplines youmay hear about fromothers, ours is relativelysimple. Only a smallamount of our returns arefrom being clever onvaluationwhenwebuy.—EricEnde,FirstPacific

Advisors

We've developed aquantitative model that'sdesigned to reflect theattractiveness of everycompany in our 1,000-company database basedon three factors: expectedearningsgrowth relative tothe P/E multiple (thehigher the better),valuation relative the

company'spasthistory(thelower the better), and thetrend in consensus WallStreet estimates (upwardmovement gives us moreconfidence).

—PhilipTasho,TAMROCapital

We rely on companies'historic valuation rangesand/or peer groupvaluations on traditional

measures like price-toearnings, price-to-book,and price-to-sales toidentify investment targetsand then project futurevaluationranges.Thebasicdiscipline is to buy in thelower quartile of thevaluation range and selltowards the upper end ofthelong-termrange.You do have to recognizeif a disruptive

technological or structuralindustry change isunderway or relative valuewill point you to a lot ofvalue traps. We're alwaysasking whether there's atransitory disruption to abusinessorwhether there'sapointofdiscontinuity, aswasthecasewithEastmanKodak. There are alsoanalytical checks to do onpast valuation levels. If

there have been periods ofhyper-normal valuations,such as technology andtelecom in the 1990s, youhave to ignore those datapoints.—BrianBarish,Cambiar

Investors

One of the big mistakesvalueinvestorscanmakeisto be too enamored withabsolute cheapness. If you

focus on statisticalcheapness, you're oftendriven to businessesserving shrinking marketsor that have developedstructural disadvantagesthat make it more likelythey're going to losemarketshare.

—BillNygren,HarrisAssociates

We generally avoid the

most deeply discountedstocks.Inanormalmarket,companies trading at halfof intrinsic value or lessoftendosobecausethereissomesignificantriskinthebusiness. Itmaybe a low-probability risk, but we'llsteerclearofhigh-severity,low-probability risks. Inourportfoliotodayweonlyhave one or two holdingsthat—after the fact—have

beenshowntofacemoreofabinaryoutcome.—TimothyHartch,Brown

BrothersHarriman

When I look at mistakesI'vemade—likebuyingthebest sub-prime mortgagelender in late 2006—they've primarily beenwhen I thought I wasgetting a great deal on ahouse,onlytofindoutlater

there had been a firesmoldering in thebasement. The obviouslesson is that things thatlook cheap aren'tnecessarilyso.—JedNussdorf,Soapstone

Capital

One distinction wegenerallytrytomakewhenbetting more on industrycycles is that something

should be cheap based onthe current numbers, notjust on what is considerednormalized earnings. Thatmakes it a moreconservative investmentwith even more upsidewhen the cycle eventuallycomesback.—AndrewJones,NorthStar

Partners

We focus on absolute

value, trying to resistreaching for relative-valuejustifications just becausewe have the cash. Relyingon relative valuation ishow you end up payingsilly prices for houses,Internet stocks, andanythingelseinlife.—PeterKeefe,AvenirCorp.

Itrytoownbusinessesthatare inexpensive in an

absolute rather thanrelative sense.No positionIowntodaytradesatmorethan 15× my estimate ofthe next 12 months'earnings. The onlycompanies I own at morethan 12× earnings are inbusinesses that I think areamong the best in theworld.The problem I've found inpaying higher multiples is

that you can have adifferentiated view on thebusiness fundamentals andbeabsolutelyright,but therisk is higher that themultiple contracts andtakes away your positivereturn.Thatdoesn'thavetohappen, of course, but Iwant to credibly believethe multiple trajectory isbiased upwards, even ifthat's not the primary

reasonI'minvesting.—JedNussdorf,Soapstone

Capital

We firmly believe noinvestment issowonderfulthat it can't be ruinedby atoo-high entryprice, soonour discount-to-cash-flowstocks we will not paymore than the marketmultiple on forwardearnings.Wewanttoavoid

the temptation of makingrelative valuation bets—say, finding a softwarecompanyattractivebecauseit'sonly30×earningswhenthegroupsellsat40×.

—ChristopherGrisanti,GrisantiBrown&Partners,

Whatyou'reunlikelytoseeus invest in is somethinglike The CheesecakeFactory when it's at 30×

earnings. At that leveleverybody knows it's agreat story and, when itcomes down to it, the betyou're making is whetherornotthebusinessgrowsalittle faster or for a littlelonger than people expect.Those are not the types ofcallswelooktomake.

—BrianGaines,SpringhouseCapital

A fair price today is onethat should allow us overtime to realize on ourinvestment the same levelof compound annualgrowth we expect in per-share book value, earningsorcashflow—whicheverismost appropriate for thecompany at hand. Whatthat tries desperately toprecludeispayingsomuchthat the business can do

extremely well but thestock price goes nowhere,which can happen asbusinesses inevitablymature and valuationmultiplesshrink.What that meanspractically to us is that ifwe find a business thatmeets all our criteria andwepaynomorethan14to15×trailingearnings,we'renot going to be wildly off

on price. For any numberof market, industry, orcompany-specific reasons,it's been my experiencethat we'll episodically getopportunities to pay thesekindsofprices.—ThomasGayner,Markel

Corp.

We look out two to threeyears at what a companycan earn in a normal

economy if ourexpectations for changeplayout.Wedon'tlookatashorter period because somany other investors aredoing that that it's muchmorecompetitive.Lookingoutmuchfurther than that,theuncertaintiesgoupandthus our ability to predictgoesdown.We then apply a valuationmultiple anchored on the

averageS&P500P/Eoverthe last five decades ofaround15.8×.Weconsiderthat a fair valuation for anaverage company. Takinginto consideration thingslike the balance sheet, re-turns on capital, growth,barriers to entry andmanagement quality, we'llgo up and down from15.8× to come up withwhat we believe is an

appropriate multiple andapply it to our EPSestimate.For a stock tobeinteresting,wewant to seeat least 50 percent upsidefrom today's price to thatfairvalue.

—EdWachenheim,GreenhavenAssociates

I'm amazed at howcommon the relativevaluation argument is. But

youshouldn'tforgetthatallthat argument may betellingyouisthatbondsoranother asset class mightsuck, not that equities aregreat. It's like going toCinderella's house andmeeting the two uglystepsisters and being toldyou should be happy todate one of them.Personally, I'd rather waitforCinderella.

None of that stops peoplewho want you to buyequities fromtalkingabouthow much better they aretoday than bonds. “Whatelse am I going to do?” isnot the most compellingreason for doingsomething. If there'snothing to do, do nothing.It'snotthatdifficult.Absolute standards ofvaluation get you away

fromtheideathatyouhaveto be doing something,which goes all the wayback to Ben Graham. Hewaslookingatallelementsofthecapitalstructureinaveryunconstrainedfashion,but was fully prepared toholdcashwhen therewereno opportunities. Todaywith the rise of specialistmandates and passiveindexing, so many people

want to be fully investedall the time. I'd argue thathas caused our industry alotofproblems.

—JamesMontier,GMO

PULLINGTHETRIGGER

Timing may not beeverything, but it's certainly

ofkeenimportanceinmakingtheultimatedecisiontobuyastock. That decision canengender any number ofcaught-up-in-the-momenttypes of emotions—exactlywhat reasoned, rationalinvestors try hard to avoid—and the vast majority of thetime will be deemed inhindsight as having beenexcessively early or late. Inmakingthefinalbuycall,the

best investors strivemightilyto maintain the same patientand careful process that gotthem to thatpoint in the firstplace. Some find virtue in ateam-based approach topulling the trigger, othersargue that too many cooksspoilthebroth.

***

One of my favorite

investingquotesofalltimeis from Joe Rosenberg,Loews Corp.'s chiefinvestment strategist formany years, who said thesecrettooutperformanceisto “have opinions atextremes, and wait forextreme moments.” We'rewilling to wait for theperfect pitch rather thanswing at things that lookpretty good. It's not that

hard to find pretty goodvalues, it'smuch harder tobepatientandonlybuythegreatones.

—ChrisMittleman,MittlemanBrothers,LLC

Onceweact,weforfeittheoptionofwaitinguntilnewinformation comes along.As a result, not acting hasvalue. The more uncertainthe outcome, the greater

may be the value ofprocrastination.—PeterBernstein,inAgainst

theGods

In a world in which mostinvestors appear interestedin figuring out how tomakemoney every secondandchasetheideadujour,there's also somethingvalidating about the value-investing message that it's

okay to do nothing andwait for opportunities topresent themselves or topay off. That's lonely andcontrary a lot of the time,butremindingyourselfthatthat'swhat it takes isquitehelpful.

—SethKlarman,TheBaupostGroup

Much of our research andanalysis involves

identifying companieswe're willing to buy andthe prices at which we'llbuy them. If the marketisn't offering up thosecompanies at those prices,we sit and wait. Clientssometimes get anxiousabout that, but we try toremind them we get paidforresults,notactivity.—SteveLeonard,Pacifica

Capital

Youobviouslyhave to getyour analysis right to be agreat investor, but successalso comes down topatience. We think ofourselves a bit like a lionlying in wait. There areplenty of gazelles runningaround, but we can't runafter them all, so we waitfor one to get within 125feetbeforewego.Not150

feet or 200 feet, but nomore than125.Sometimesthemarket offers up thosegreat kills and we try ourbesttobereadyandtotakeadvantagewhentheycomealong.

—FrançoisParenteau,DefianceCapital

In a typical year, theaverage large-cap stockfluctuatesabout50percent

from its low to its high. Ifyou've done yourhomework and you'repatient, more than enoughopportunities to buy willcomealong.

—DonaldYacktman,YacktmanAssetManagement

As Graham, Dodd, andBuffett have all said, youshould always rememberthat you don't have to

swing at every pitch. Youcan wait for opportunitiesthat fit your criteria and ifyou don't find them,patiently wait. Decidingnot to panic is still adecision.

—SethKlarman,TheBaupostGroup

I've never considered it alegitimate goal to sayyou'regoingtoinvestatthe

bottom. There is no priceotherthanzerothatcan'tbeexceededon thedownside,so you can't really knowwhere the bottom is, otherthan in retrospect. Thatmeansyouhavetoinvestatother times. If you waituntil the bottom haspassed, when the dust hassettled and uncertainty hasbeen resolved, demandstartstooutstripsupplyand

youendupcompetingwithtoomany other buyers. Soifyoucan'texpecttobuyatthe bottomand it's hard tobuyonthewayupafterthebottom, that means youhave to be willing to buyon the way down. It's ourjob as value investors,whatevertheassetclass,totry to catch falling knivesasskillfullyaspossible.—HowardMarks,Oaktree

Capital

Youmust buy on thewaydown. There is far morevolume on the way downthan on the way back up,and far less competitionamongbuyers. It is almostalways better to be tooearlythantoolate,butyoumust be prepared for pricemarkdowns on what youbuy.

—SethKlarman,TheBaupostGroup

[SAC Capital's] SteveCohen thought it was thesilliestthingintheworldtotry to capture the first andlast part of a stock'smove—those were the mostdangerous parts ofinvesting. For me, I'd liketocapturemoreoftheearlypartof themoveandleave

the latter part forsomebody else. In general,if you're right on thefundamentals and cancapture the big, fatmiddleportion of a stock's move,you're going tomake a lotofmoney.

—RobertJaffe,ForceCapitalManagement

I'mavalueguyatheart,sowouldratherbuyearlythan

late. The problem withbeing late is that you'realready paying for theturnaround itself, so youhave to count much moreontheturnaroundresultingin sustained revenue andprofitgrowth.—KevinO'Boyle,Presidio

Fund

A common expression weuse around here is the

Chinese one, “to haveknown and not to haveacted, is not to haveknown.” We try to fightagainst statements like“this would be a greatinvestment if it was 10percent cheaper.” That's awussy conclusion becauseyou can't be wrong: If itgoes down, you can sayyou knew it was tooexpensive. If it goes up,

you can say you knew itwasagreatinvestment.Butif you know it's a greatinvestmentyoushouldbuyit.—ChristopherDavis,Davis

Advisors

When we were buyingCoca-Cola years ago, I'dlay out for other investorsonepartofourthesis—thatenormous demand in

emerging markets couldeventuallyturnCokeintoagrowth stock again—butmany of them just weren'tinterested. “Tell me againin a coupleofyears,” theysaid. If we're comfortablethat value will compoundoveralongperiodoftime,wethinkit'snotproductiveto try to time so preciselywhentogetin.It'stoohardand you often end up

missingout.—BoykinCurry,Eagle

Capital

Sir John Templeton, whoalways argued for buyingduring periods ofmaximum pessimism, hadoneofthebestmethodsforkeepingemotionoutoftheprocess.He used to do hiscalculations of intrinsicvalue when there wasn't a

lotgoingoninthemarket.He'dthenplaceamarginofsafety on those intrinsicvalues and place buyorders with his broker at,say, 40 percent below thecurrent market price. I'msureafairamountofthoseordersnevergot filled,butif there was an enormousdislocationinthemarketorin an individual stock, theorder would fill.

Psychologically, that kindofprecommitmentisaverypowerful tool tohelpus inperiods of emotionalturmoil. If you look atsomething when it's justgone down 40 percent,you're probably not goingtowanttotouchitbecauseit just warned on earningsorsomethingsimilar.—JamesMontier,Société

Générale

In general, we try toconstantly remindourselves that when anindustrygoes south, thingsoften get worse than youexpectandstaybad longer—there's usually plenty oftimetofindthebottom.

—JohnDorfman,ThunderstormCapital

Our primary mistake in

2008was buying too soonwhen the market startedcrackinginSeptember.Mytakeaway: Sometimes it'sbesttolettheotherguytryto pick the bottom. Inselloffslikethat, therewillbeplentyofroomtogetinontheupside.—CarloCannell,Cannell

Capital

Many value investors will

buy the cheap companywhen there's just aturnaround story attachedto it, butwepatientlywaitfor the fundamentals toimprove first. Thephilosophy works becauseinvestors underreact toboth positive and negativechangesinfundamentals.Ifa company has chronicallyunderperformed, investorsdislike it, don't trust

management, and won'tgivethemthebenefitofthedoubt. When thingsimprove, it takes a longtimeforpeopletobelieveitand incorporate theimprovement fully intoexpectations andvaluations.Ifweseealltheingredientsof a sustainableturnaround,we'll buy afterone quarter of good

earnings, allowing ourclients to benefit from theslow rebuilding ofconfidence that will bereflected in the stockpriceovertime.

—KevinMcCreesh,SystematicFinancial

Management

Youhave tobereasonablyearlyandweofcourseloveto get in at the absolute

bottom, but so long as ourvaluation work indicatesenough upside and we'reconfident in management'sability to execute, we'llinitiate a position evenafterarestructuringiswellunderway or a problem isalreadyonitswaytobeingfixed.—JerrySenser,Institutional

CapitalLLC

The potential efficacy ofcombining value andmomentum factors hasalways been a consistentthemeofmyresearch.OurTrending Value strategystill identifies the bestvalues in the market, withtheadded twist that it thenchooses from that narrowlist the stocks that haveincreasedthemostinpriceoverthepastsixmonths.In

otherwords,we're lookingatstocksthatarestillreallycheap, but the market hasstarted to take notice. Iwasn't surprised that itworked—incorporating anelement of pricemomentum can counteractvalueinvestors'tendencytobuy too early and fall intovalue traps—but I'll admitthat I was surprised howwellitworked.

—JamesO'Shaughnessy,O'ShaughnessyAsset

Management

Valuation predominates inour models, but we dobelieve value managersunderweight positive[shareprice]momentumintheir portfolios. Theobvious reason is thatstocks with positivemomentum are often

overpriced, but whenthey're not, we think itspresence helps us avoidvalue traps. We'll ignoremomentum if there'ssufficient value-basedjustification, but if ourawareness of the effect ofmomentum indicates weshouldbuylaterratherthansooner,wewill.—PaulVeZolles,WEDGE

Capital

Onethingwemaydoabitdifferently from others isthatoncewe'veidentifiedastock as something inwhichwe're interested,mytwo partners and I will allseparately look at thevaluation and arriveindependently at what wethink we ought to pay,based on the potentialupsideand,as importantly,

thepotentialrisk.Whenwereachdifferentconclusions,that leads to a veryimportant back-and-forthaswetrytofindameetingof the minds. Weabsolutely believe the enddecision is better as aresult.—JonathanShapiro,Kovitz

InvestmentGroup

We have three people in

chargeof theportfolioandwe require unanimity on astock in order to buy.That's not to say we haveto feel equally stronglyabout something, but agreat thing about havingdifferent intuition is thatwe're lessapt toskimoversomething importantbecause we're looking atthingsthesameway.

—ChristopherGrisanti,

Grisanti,Brown&Partners

We'veneverthoughtitwasa good idea to demandunanimous agreement inmaking a buy decisionsbecause the bestinvestmentideastendtobesomewhat controversial.The risk in forcingunanimous agreement inany committee structure isthatyoutoooftenweedout

yourbetterideas.—BillNygren,Harris

Associates

I've sat on buy-listcommittees whereeveryonehadtoagree,andwhile it soundscomfortableandprudent,itdoesn't work. Every goodidea with a creative orprovocative angle,somebody's not going to

like it. You end up withideas that don't offendanyone,whicharen't likelytobeverygood.—ScottSatterwhite,Artisan

Partners

PARTThree

ActiveManagement

CHAPTER8

ThePortfolio

The majority of the populardiscussion about stockinvesting focuses on “Whatare you buying today?”There's no question, of

course,thatintelligentbuyingdecisionsareaprerequisitetosuccessful investing. Butthere's also no question thatsmart buying isn't at allsufficient to insure success.Equally important are theless-sexy aspects of equityinvesting involved inportfolio construction andmanagement. How arepositions sized? How manypositions are held? How

actively are holdings traded?How are portfolio risksassessedandwhatefforts aremade to mitigate them? Ishedging a part of thestrategy? Is shareholderactivism? Finally, among themost vexing topics aninvestor must address: HowdoIdecidewhentosell?These more nitty-gritty

aspects of equity investingagainhighlight thevarietyof

strategies and methodsemployed by otherwise like-minded investors. While thespecifics will differ, whatshouldn'tvaryistheinvestor'sability to articulate in detailhowtheportfolioismanagedand why. Based on ourexperience, fuzziness here—relative, say, to describingone's buying discipline—is awarningsign.

CONCENTRATIONVERSUS

DIVERSIFICATIONOne of the most basicelementsofportfoliostrategyisdetermining thenumberofpositions to hold. While thesubject of much analyticalresearch over the years—about which accomplishedinvestors are typically well-

versed—the question of howconcentrated or diversifiedone's portfolio is oftenappears driven as much bypersonal experience, comfortlevel, and “feel” thananythingelse.

***

When Warren lectures atbusiness schools, he says,“I could improve your

ultimate financial welfarebygivingyouaticketwithonly 20 slots in it so thatyou had twenty punches—representing all theinvestmentsthatyougottomake in a lifetime. Andonce you'd punchedthrough the card, youcouldn't make any moreinvestments at all.” Hesays, “Under those rules,you'd thinkcarefullyabout

whatyoudid,andyou'dbeforced to load up on whatyou'd really thought about.So you'd do so muchbetter.”It's not given to humanbeings to have such talentthat they can just knoweverything abouteverythingallthetime.Butitisgiventohumanbeingswhoworkhard at it—wholookand sift theworld for

amispriced bet—that theycan occasionally find one.And the wise ones betheavily when the worldoffers them thatopportunity. They bet bigwhen they have the odds.And the rest of the time,they don't. It's just thatsimple.

—CharlieMunger,PoorCharlie'sAlmanack

Thestrategywe'veadoptedprecludes our followingstandard diversificationdogma. Many punditswould therefore say thestrategy must be riskierthan that employed bymore conventionalinvestors.Wedisagree.Webelieve that a policy ofportfolio concentrationmaywelldecreaseriskifitraises,asitshould,boththe

intensity with which aninvestor thinks about abusiness and the comfortlevel hemust feel with itseconomic characteristicsbeforebuyingintoit.

—WarrenBuffett,1993BerkshireHathawayShareholderLetter

Value investors shouldconcentrate their holdingsin their best ideas; if you

can tell a good investmentfrom a bad one, you canalsodistinguishagreatonefromagoodone.

—SethKlarman,TheBaupostGroup

In our separate accountswe typicallyhold10 to15securities. In ourpartnership we're typicallymore concentrated, withthe top five positions

making up about 65percentoftheportfolio.If I didn't have partners,ourconcentrationwouldbeeven higher. You knowhow much of WarrenBuffett's partnership heldinAmericanExpresswhenhe bought it after theDeAngelis salad-oilscandal?40percentorso.A company compounding

capital at way above-average rates,when Ihavegreat confidence that willcontinue and the valuationismodest,Iwanttoholditatasizewhere itcanhavea material impact on theportfolio. The rationale isthatsimple.—ChuckAkre,AkreCapital

Management

Wetypicallyhave15to20

positions. Our generalfeeling is that if we don'tlike something enough toowna5percentpositioninit, we should wait to findsomethingelse.Putanotherway, if the only way youcan feel comfortable aboutanideaistoownlessofit,to my mind that tells yousomething about thequalityoftheidea.—AndrewJones,NorthStar

Partners

We're deliberatelyconcentrated on 10 to 14investments, for tworeasons related to time.First, it takes considerabletimetolearnenoughaboutacompany, itspeople,andits industry todevelopandmaintainaproprietarylevelof insight information, orknowing more than the

Street. The second relatesto our focus on activism:pushing for change atcompanies takes a lot oftime.IwillsaythatIhaveinthepast fallen intowhat I calltimetraps,whereI'vespenttoo much time trying toresolve probleminvestments. We will pickour battles, but usuallywe'rebetteroffhelpingour

best investmentsmaximizeopportunitiesthantryingtoperform brain surgery ondogs.

—DavidNierenberg,D3FamilyFunds

Owning fewer than 15stocksI'dhavemoreriskofbeing wrong with onecompany than I'd like. Atthe same time, if I owned30to40stocks,experience

tells me that roughly halfwouldbemyfavoritesandother half would eitherhave less upside potentialor more risk. Rather thanforce myself to make thatchoicebetween lessupsideand more risk, I wouldratherjustlimitthenumberof individual holdings to15 to 20. Most managerswould buy the stockswithmore risk rather than give

away upside, which canoften offset whateverbenefit they think they aregetting from greaterdiversification.

—EdWachenheim,GreenhavenAssociates

We're not playing aprobability game, whereyou invest in 100businessesanddofineif70ofthemsucceedand30do

poorly. We're trying toselect 25 to 30 businessestoownandwecountonallof them doingwell over afive-yearperiod.—TimothyHartch,Brown

BrothersHarriman

We think there areprofound researchadvantages inconcentration. This is aworldofverysmartpeople

and you can't enter thatmarketplace without aprofoundly humble viewabout how you're going towin. For us, concentrationand depth of researchallows us to go to bed atnightandfeellikewehavea defensible source of ourreturns.

—AdamWeiss,ScoutCapital

We ideally hold 25 to 35

positions, with a coreholding at around 5percent.Thatgivesusmostof the free lunch ofdiversification and allowsus to maximize return byowningonlyourbestideas.There's also a humanelement to limiting ournumber of positions. With25 to 35 stocks, our entireinvestment team knowsevery company and can

have a clear opinion on it.With100 stocks, you can'tdo that. The portfoliomanager can only knowhow well each individualanalyst is doing by theperformance of his or herpicks, as opposed toevaluating the decisioninputs. Suddenly, thereality of reviews andcompensation force you tolook at that performance

over shorter time periodsthan you should. Theanalyst knows that, ofcourse, so then startsworrying about whetherWal-Mart's same-storesalesnextmontharegoingto disappoint, rather thanwhether the company iscreating long-term value.So we think a long-termstrategy just works bestwith no more than 35

stocks.—BoykinCurry,Eagle

Capital

Wetypicallyhold30to35stocks. We cap any oneposition at nomore than6percentoftheportfolio,butwe won't put anything inthe portfolio at less than a2 percent position. Settingthingsupthiswaykeepsusfrom being distracted,

makes us dig that muchharder for truly interestingideas, and forces us tomakeactivedecisions.Anyone holding is tooimportant to let slide if it'snot working, and there'salwayshealthypressureonexistingholdingsfromnewideas. We want to takeaway the drag of inertia,whichcanbeverystronginhumanpsychology.

—MarikoGordon,DarumaCapitalManagement

We're fairly concentrated,withabout70to75percentofourcapitalinourtop20positions,soweknowwhatwe own and don't need alotofstatisticalanalysis tofigure out where we'reexposed. We thinkconcentration is the key tobig performance, but we

alsohavenodesiretohaveouryeardependononeortwo thingsworkingout,sowehavegenerallykeptourlargest positions at 5 to 8percentof totalcapitalandmake sure those bigpositions are notparticularly speculative orhighlylevered.

—GaryClaar,JANAPartners

Our view is that toomuchdiversification in manycases reflects the fact thatthe portfolio manager isn'tdoing the work to fullyunderstand the businesses.Ifyoudotheworkandfinda great business run bygreat managers at a greatprice,thatoughttoexpressitself in the size of theholding within yourportfolio. It's uncommon

for us to go above 10percent on cost in a givenname, but we've heldappreciated positions ashigh as 20 percent of theportfolio. We generallydon't think you can havetoomuchofagoodthing.—PeterKeefe,AvenirCorp.

When we see competitorsholding 75 to 100positions, with 75 to 100

percent annual turnover,we'reeitherveryimpressedwith their ability to keeptrack of 150 or morecompanies . . . or we'reskeptical of their ability tocredibly follow that manycompanies.We don't haveanywhere near that manygoodideasinayear.—EricEnde,FirstPacific

Advisors

Given that our funds areconcentrated both in theabsolute number ofpositions we hold and inthe number of industriesthat are represented, it'snaturalforourperformanceto be lumpy. If thealternative is beingconsistent but mediocre,we would much prefer tobestreakybutgood.—WallyWeitz,WeitzFunds

Diversification is animportant part of our riskmanagement. Averageindividual positions rangefrom 1 to 2 percent, withthelargestcorepositionsat4to5percent.In15years,we've had three positionsthat got as high as 8percent, two that workedout very well and one,Tyco,thatwasadisasterat

thetime.Animportantpercentageofthe firm's total capital isour own money and we'rejust trying to do what wethink is intelligent in ahighly uncertain world. Idon't know how some ofthese young hedge fundguys do it, being 160percent gross long and 40percent net long. I'm notquestioninganybody,butif

you're running a lot ofcapital, to be that grosslong you have to eitherhave enormous positionswhereyougiveupliquidityor you have to have anincredible number ofpositions, too many tofollow effectively. Ourlevel of diversificationreflects our unwillingnesstomake suchgiantbetsorto give up liquidity. We

could liquidate ourportfolioin48hours.—LeonCooperman,Omega

Advisors

With six analysts and theamountofmoneywehave,[50 to 60 positions] hasturned out to be what wefeel we can best manage.It's not more concentratedout of prudence andhumility. There's always a

chance we'll be wrong onanygivenidea.

—SpencerDavidson,GeneralAmericanInvestors

Part of our rationale [forholding more than 300positions at a time] is justthe practical reality ofrunning $8 billion in asmall-cap strategy—withthatmuchmoney,youcan'thold 50 stocks without

moving well out of small-cap range for many ofthem.Another practicalconsideration is ourinvestor base, which isretail investors and largeinstitutions. Performanceobviously matters whentheychooseT.RowePriceto run their small-capassets, but they also wantto be comfortable that the

portfolio isn't going toblow up. For manyinvestors volatility is theenemy of rationalinvestment decisions, sothelessvolatileweare,themore likely our investorswon'tsellatthebottomandbuy at the top. Runningwith the level ofdiversificationwehave,thestandard deviation of ourreturnshasbeenlowerthan

that of our benchmarkRussellindex.Philosophically, I findbroad diversificationmakes it easier to be acontrarian. We made themistake in 2007 of buyingsome housing, recreationalvehicle, and mobile homestocks after they fell 50percent, which clearlyturnedouttobetooearly.

Butbecauseofthewaywerun the portfolio and ourrecognition of the risksinvolved, we never madethose holdings, inaggregate, more than 3percent of the portfolio.While that particular out-of-favorbethasn'tpaidoff,it hasn't hurt us mucheither. As long as thepotentialupsideishigh,weshould be making those

types of investments andthey can make a realdifferencewhentheywork.—PrestonAthey,T.Rowe

Price

Small-cap stocks bydefinitionaremorefragile,more likely to have onedominant product or onekey executive or one bigcustomer. Strange thingshappen, so you have to

diversify no matter howmuch you may loveindividualnames.When something strangehappens inoneof Johnson& Johnson's or GE'sbusinesses, it's a roundingerror to the overallcompany. Ina small-cap itcanblowitup,soyoudon'twant to be overly exposedinanyonename.—WhitneyGeorge,Royce&

Associates

Concentration and microcapsdon'tmixwell, sowetypically own around 100names,with a big positionbeing3 to4percentof theportfolio. Tiny companiesare by definition morevulnerabletocatastropheifsomething goes wrong, sowetrytolimitthepotentialdamage from that by

owningalotofthem.I'vehadpeopleaskifwe'respreading ourselves toothin by owning so manypositionsata time.What Ianswer is that there's anenormousdifference in theeffort required to follow abig company than a smallcompany. I'd argue that aportfolio of 20 large-capcompanies, each of whichis in five or six distinct

businesses, is moredifficult to keep track ofthan 100 small companiesthat typically operate in asingle niche.An IBMor aDisney can have a singlefootnote longer than a lotoftheentireannualreportsIlookat.

—PaulSonkin,HummingbirdValueFund

Ourlevelofdiversification

[130–140 positions] is justspreadingtherisk.Itservesus well during downturns,which was certainlyreinforced in 2008. I thinkit also makes us lessemotionally attached toideas and more willing toadmit we're wrong, whichis important for anyinvestor.

—TomPerkins,PerkinsInvestmentManagement

Our flagship mutual fundtoday has 300 stocks.Buying things when theymeet the valuationcharacteristics that haveworkedforusinthepastisourselectionmethodology,period. It's not aboutpicking the best 5 percent,10percent,or20percentofthose—Idon'tknowwhichonesthoseare.

We've done a distributionanalysisofourwinnersandlosers: 18 percent of ourstockshavelost50percentor more, while 25 percenthave made 250 percentpercentormore.Themathhasworkedinourfavorbyexposing ourselves to asmany multibaggers aspossible that meet ourvaluation criteria at theoutset, and then patiently

waiting.—JohnBuckingham,Al

FrankAssetManagement

While we've generallyavoided being hurt byunderhanded executives,that risk is always thereand it's far morepronounced if you'rerunning a concentratedglobal portfolio. A secondreason we're more

diversified[withup to150stocks]isbecauseIbelievea lot of our alpha comesfrombeingintherightsetsof companies rather thanthe right specificcompanies. If we get thethemes right, we'll do aswell, with lower volatility,owningmore names ratherthanfewer.—OliverKratz,Deutsche

AssetManagement

The knock on funds asdiversified as ours is thatthey're index-huggers,whichgiventhegeographicbreadthofwhereweinvest,isnotatallthecaseforus.I know the argument thatyou should only own yourbest30or40ideas,butI'veneverprovenovertimethatIactuallyknowinadvancewhatthoseare.

—Jean-MarieEveillard,FirstEagleFunds

THESIZETHATFITS

A corollary to thedetermination of how manypositions generally to hold ishow to size those positionsrelative to each other.

Tolerance levels for largerpositionsizesobviouslyvary,but even the mostconcentrated investors atsome point typically respecttheadmonitiontonotput toomanyeggsinonebasket.

***

Webelieve in constructingtheportfoliosothatweputour biggest amount of

money in our highest-conviction idea, and thenwe view the other ideasrelative to that. We findthings that we think areexceptional onlyoccasionally.So ifwefindsomethingthat isreallysetup, where we think it'smispriced, where we havea good understanding ofwhy it's mispriced, wherewe think the mispricing is

very large and the overallrisk is very small,we takean outsized position tomake sure we giveourselves the chance to bewell compensated forgettingitright.

—DavidEinhorn,GreenlightCapital

We're in the camp thatthere just aren't that manygood ideas and when we

identify one, we want tomake sure it can have ameaningful impact onperformance. The biggestholdingsarethoseinwhichwe have the mostconviction, which is afunction of several things:thesizeofthediscount,thepotentialforintrinsic-valuegrowth,havingaclearandstronglyheldvariantview,identifying a meaningful

catalyst or catalysts,liquidity, and the extent ofthe positive impact onportfoliodiversification.—SteveMorrow,NewSouth

Capital

Perfect investments havethree layers of return. Thefirst layer is theshort-termreturntowhatI'dcallstaticintrinsicvalue.Thesecondone is when the business,

strategy, and managementturn out to be what youthink they are and there'sreal value creation. Thethird layer, if you're reallylucky, is when the marketgets so excited that itdiscounts more and moreof the future into thepresent.The big homerunsareusuallythere.Ialwaystrytofindatleasttwolayersofpotential,but

it's also important torecognize when you putsomethinginyourportfoliowhetherit'saone-layeroratwo-layer name. Youshould make a two-layernameabiggerposition.—LisaRapuano,Matador

CapitalManagement

We're looking for a totalannualreturnofatleast25percent,withpositionsizes

adjusted for the degree ofdifficulty. For a givenexpected internal rate ofreturn, the lower theoutcome's expectedvolatility, the higher thepositionsize.Wecreateanestimated risk-adjustedInternalRateofReturnforeverything and thenallocatetheportfoliobasedonthat.

—StevenTananbaum,

GoldenTreeAssetManagement

In holding around 40stocks at a time, we'retrying to get theappropriate balancebetweendiversificationandputtingmostofourdollarsin the names we like thebest.Asapracticalmatter,it's difficult to find 40names that you really like.

The lion's share of yourexcess returns will comefrom a few names—thetrick is identifying whichthose will be and placingbigger bets on them. Ourclientstypicallyrequirewelimit maximum positionsizesto4percent,butevenwith that restriction itmakes a big difference inresults over time if yourlargest positions

outperform.—PaulVeZolles,WEDGE

Capital

Our position sizes are setbased on how well eachcompany fits our threeinvestment criteria[valuation, businessquality, and balance sheetstrength]. If it clears eachhurdlewithflyingcolors,itwillbeatthetopendofthe

portfolio in terms ofposition size. If, say, it'scheap and the businesseconomics are fine, but itjust clears the hurdle onfinancial soundness, itwillbe at thebottomend.Thatgives a risk/reward profileto the entire portfolio—it'sperfectly fine that ourdeepest-discount stocksmay not be our biggestpositions.

—GeorgeSertl,ArtisanPartners

Our positions tend to beequally weighted. Weknow there are potentialerrors in the portfolio,which we'd obviouslyavoid if we could predictwhat they were. Since wecan't,weassumethefutureerrors are randomlydistributed, which is a

primary reasonwe equallyweightthepositions.—BernardHorn,Polaris

Capital

My view is that whateveredge I have comes morefrom knowing where toshop than knowingspecifically which of theitemsIbuywillbethebest.So I maintain roughlyequalstakestoreflectthat.

—RalphShive,WasatchAdvisors

For each position wedefine a downside price atwhich the stock wouldtrade if everything aboutour thesis turned out to bewrong.Indecidingwhetherto put something into theportfolio, we'll assignprobabilities and look attheexpectedvalue,but the

downside is particularlyimportant in sizing theposition.We don'twant tolose more than 100 basispoints in return inanyoneposition, so if ourdownside is 20 percentbelow the current price,say, we'd put on no morethana5percentposition.—CurtisMacnguyen,Ivory

Capital

Our calculated downsideprice is extremelyimportant in how we sizepositions. We limit eachposition to a maximumrisk, measured in basispoints, to our downsideprice. In other words, if astockwent to itsdownsideprice, we don't expect thefundtoloseanymorethanthe maximum risk we'vedefined for that particular

position.—JeffreySmith,Starboard

Value

Being concentrated doesn'tmeanwe'll just takethe15best ideas we have andplug them into ourportfolio. Because of thatlevel of concentration, thecompanies we choose willoverall likely be lesscyclical, with more stable

underlying businessmodels. We at the marginwill be less apt to holdnames with higherexpected values if thatcoincideswithmuchlargerdownsiderisk.—LeeAtzil,PennantCapital

In periods of rapid changein liquidity and economicconditions, the odds thatwe're simply wrong about

ourestimatesofcompanies'near-termfundamentalsarehigher than average. As aresult, we're more focusedthen on maintainingflexibility—through cashlevelsandbuyingpower—and in sizing our betsaccording to the medium-to lower-confidenceenvironment we're in. Wewon't necessarily makefewer bets, but they'll be

smallerinsize.—LarryRobbins,Glenview

Capital

What tends to happen isthat as the market getsmoreexpensivewetakeonmore, less discountednames, and when themarket is less expensive,we'll have fewer namestradingatbiggerdiscounts.At the market peak in

2007,forexample,weheldabout 40 names in ourlarge-cap portfolio and theoverall price-to-value ratiobasedonourestimatesgotto 82 percent. The otherextreme was March 2009,when our weighted-averageprice-to-valueratiogotdownto40percentandwe concentrated theportfolioin18names.—C.T.Fitzpatrick,Vulcan

ValuePartners

Ourfundusuallyhas40to60 positions. The actualnumber at any time isusually a function of howpriceythemarketis:Whendiscounts are larger, thefullweightstendtobe2to4 percent; when discountsaren't as large, positionsizes are more like 1 to 3percent.

—EricCinnamond,IntrepidCapital

Iwill not putmore than 5percent of the portfolio inany stock, and we usuallydon't have more than 2.5percent.EarlyinmycareerI had 20 percent of myportfolio in Johnson &Johnson just beforeTylenol was laced withpoison.My objective is to

produce an above-average,long-term return, and IthinkIcando thatwithouttaking that kind ofconcentration risk. Thingshappen.If I really knew the beststock in my portfolio I'dput 100 percent of theportfolio in it, but I don't.[Financial columnist] DanDorfmanonceaskedmeinan interviewwhat the best

and worst stocks were inmyportfolio.Itoldhimtheworst stockwasConverse,the shoe company, whichhedutifully reported inhiscolumn. It got taken overtwo days later, up 50percent.—RobertOlstein,Olstein

CapitalManagement

Our not letting singlepositions get to more than

5percentoftheportfolioisa function of having seenthe stocks of too manygood companies fall off acliff as a result ofsomethingoutof left field.One example I like to useis whenMerck announceditwaspullingVioxxoffthemarket in 2004.Youwenttobedwiththestockat$45and woke up with it 25percent lower. I'll give up

some of the upside youmightgetfromanoutsizedposition in order to bebetterprotectedfromariskyou couldn't possiblyforesee.

—RobertKleinschmidt,TocquevilleAsset

Management

COGNIZANCE

OFCORRELATIONA portfolio's level ofconcentration ordiversification can clearly gobeyond just the number ofstocks held, alsoencompassing how aptholdings are to move inconcert as a result ofmarketmoves or broadermacroeconomic and industry

trends.Tosomeinvestorsthisis critical input into theportfolio's risk/return profile,while to others it's only apassingreference.

***

We have what we call arisk-bucket model. Welook at the sensitivity ofeach of our holdings toseveral macroeconomic

factors: Is it economicallysensitive or recessionresistant? Is it hurt orhelped by increases inenergy prices or interestratesor thedollar?Does ithavepoliticalorregulatoryrisk? By assigningpositions to anyappropriate buckets, wecan better understand theextent of the risks we'retakingonaportfolio level.

Therearen'tanytriggersorlimits, but we need toknow our exposure tothings likewidening creditspreadsorahigherdollar'simpactonexports,andthenbe comfortable with thatexposure.Thiscomesmostinto practice when we'reconsideringanewbuyandwant to know its potentialimpact on portfolio riskanddiversification.

—SteveMorrow,NewSouthCapital

We tag every stock in ourportfolio formore than 40possiblespread-riskfactorson which stock prices candiverge dramatically. Thefactors include commonones like sector exposure,market cap, liquidity,leverage, and dividendrates, and maybe less

obviousoneslikeexposuretoChinaortheconstitutionoftheshareholderbase.Atany given time, forexample, we'll know that16percentofourlongsand13percentofourshortsarein highly leveragedcompanies.We'llknowourexposuretocompaniesthatshould perform well in aninflationary environmentversusthosethatwon't.

Wefocusonmanagingthespread risks between ourlongsandshortssothatwedon't have significantexposure to unintendedbets. We want our returnsto derive from our skill asanalysts and not from allthe other factors that cancreate price volatility. Inotherwords,thegoalisforour longs and shorts tomove relatively in sync

with each other while wewait for fundamentalcatalysts to revalue ourlongs upward and ourshortsdownward.—CurtisMacnguyen,Ivory

Capital

We're keenly focused onhowourholdingslineupascyclicalornoncyclical.Wehave a lot of macroconcerns, but it's difficult

to translate those into aninvestment strategy whenour investment horizon forindividual stocks doesn'tmatch up particularly wellwithhow themacro issuesmay play out. Our base-case position is that theU.S. economy will sustaintepid growth through thedramatic deleveragingprocess the country isgoing through. But that

mayplayoutinarelativelyorganized fashion over 20years (witnessJapan),or itmaycauseaseverecrisisinone to two years (witnesswhat'sgoingoninEurope).Ourapproachinthefaceofall that has been to keepthe portfolio somewhatbalanced between cyclicaland noncyclical exposures,while being tactical inmoving toward or away

fromeither.—TimothyBeyer,Sterling

CapitalManagement

I never pay attention tosector or industryconcentrations—I don'tbelieve it's a reliable toolfor diversification. Enronand the banks that lent toEnron were in entirelydifferent sectors, but theirfortunes were tied by that

relationship. If I ownNestle,amIgeographicallydiversified by holding acompany that has itsheadquarters inSwitzerland but earnsalmost none of its revenuethere?I do pay attention tocodependencies ofoutcomes betweencompanies and think truerisk reduction comes from

purchasing securities thatare inversely ornoncorrelated. Forexample, owning naturalgas producers, whichbenefit from a rise innaturalgasprices,andalsoholding natural-gas-basedutilities thatbenefit fromaprice fall would reflecthedging for inverselycorrelating outcomes. Anexample of noncorrelation

is the relationship thatmostly exists between theeconomic climate and thevolumeofsecuritiestradedon exchanges. While theeconomic climate mayimpactmany securitieswehold, the success of thepublicly traded exchangeswe own is largelyindependentofit.—MurrayStahl,Horizon

AssetManagement

We pay attention to end-market diversification,within our companies andacross the portfolio. Onelargeholdinginacompanywith five separate globalfinancial businesses isprobably more diversifiedthan five holdings insimilar regional bankstocks.Our goal is to ownbusinesses with

uncorrelated enough endmarkets that we cancontinue growing theintrinsic value of theportfolio in any kind ofmarket.

—BrianBares,BaresCapital

Long/short funds typicallydon'tblowupbecausetheymade a bunch of wrongfundamental stock picks.They blow up because

they're overexposed tocorrelated sectors, or theyown too many leveragedcompanies, or they havetoomanyilliquidpositions.Theseareexplanationsyousee all the time in funds'letters to investors. That'sexactly what we try toavoid.

——CurtisMacnguyen,IvoryCapital

Our rule is to ownsomething in every sector,in part to avoid missingsomething importantbecause it's out-of-sight,out-of- mind. We're not aslave to our benchmark—the Russell 2000 ValueIndex—butItypicallydon'tgo much below half, ormuch above twice, theindex weighting in anysector.I'vefoundthatgives

us plenty of room to beatthe index, while avoidingthe type of relativevolatility that makes mostinvestorsnervous.—PrestonAthey,T.Rowe

Price

We have sector limits, atplus or minus 10percentage points from thepercentage weighting ofthe 10 S&P 500 industry

sectors. That gives us theflexibility to zero outsectorsthatarelessthan10percent of the index—likeutilities and telecom today—or overweight fairlyheavily in sectors we findattractive, such as energy.But it does put limits onhow under- oroverweighted we can be,which we think providesprudent diversification and

riskmanagement.—DanielBubis,Tetrem

Capital

One of our biggestmistakeswastenyearsago,going too heavily intoemerging market closed-end funds, which wereselling at 25 to 30 percentdiscounts. When theRussian debt crisis hit, theNAVs got hammered. It's

oneofthefirstlessonsyoulearn: be diversifiedenoughthatifthat1-in-100event happens, you don'tblowup.—PhillipGoldstein,Bulldog

Investors

In our flagship domesticand international productswe do not hold individualpositions over 5 percentand will not have more

than30percent inanyonesector. Historically,whether it was energy inthe 1980s, technology inthelate1990s,orfinancialsmore recently, when asinglesectorapproaches30percent of our portfolio orof the market that signalsthe end rather than thebeginning of greatinvestmentperformance.—JerrySenser,Institutional

CapitalLLC

We cap a given industry'sexposure at 25 percent ofthe portfolio, which is acheckontheinnatelackofhumility we often have asinvestment managers.Owning five or six 4percent positions in anindustry is a good, strongbet, but also isn't bettingthehouseonhowsmartwe

are relative to everyoneelse.—JeffreyBronchick,Reed,

Conner&Birdwell

People tend toassume thatthe only form of activeportfolio management isthrough relativelyconcentrated portfolios.Wethinkthere'sanequallylegitimate form of activemoney management in

running a diversifiedportfolio that has nothingtodowiththebenchmark.

—CharlesdeVaulx,InternationalValueAdvisers

Wedon'tbenchmarkatall.I don't care if we ownalmost no financials and Idon't care if we own anexcess amount of energy.We'll go where we thinkthe value is and let the

weightings fallwhere theymay.

—StevenRomick,FirstPacificAdvisors

We've purposely avoidedbasing our bonuses onperformance againstbenchmarks. We're alwaysrunningintomanagerswhosay they're unable to lookat certain stocks becausethey don't fall within a

prescribed benchmark.They tell us, “I can't takethe risk. If I buy it and itgoes down, I'll have towrite all sorts of memosexplaining it, and I'll getless bonus because myportfolio went down morethanthebenchmark.”—BernardHorn,Polaris

Capital

You can understand why

many succumb to thepressure to hug the index,sotospeak.Butwebelieveifyougodowntheroadoftrying to make sure you'llnever domuchworse thanthe index, you're almostinsuring that you'll neverdo well enough to justifyyour compensation as anactivemanager.

—BillNygren,HarrisAssociates

Theonlywaytoaddvalueas an activemanager is tobe persistently differentthan the index. We tellprospective clients that iftheir main goal is tominimize standarddeviationaroundtheindex,save money and buy anindexfund.—JeffreyBronchick,Reed,

Conner&Birdwell

CHAPTER9

PlayingtheHand

Fundamental value investorswill aggregate toward thelower end of the activity

rangewhen it comes to day-to-day trading in theirportfolios. The primaryreasons the stocks they favorare undervalued—marketneglect, company-specificoperating troubles, anout-of-favor industry—tend to besituations that workthemselves out over longerperiods of time, makingpatienceavirtue.Thatsaid, theembraceofa

traditional buy-and-holdmentality—particularly in amarket that in recent yearshas been characterized byhighshare-pricevolatility—isby no means universal. Asmuch as we all would lovefor subsequent events toconform beautifully with ouroriginal expectations, thatrarely happens, and the bestinvestors can well articulatehowtheyprepareandexecute

their responses. Some,throughactivism,looktotakethe resolution of outstandingorevolvingissuesthatimpactshareholder value more intotheirownhands.

TRADINGMENTALITY

Wedon't knowwhat kind ofinvestor poker legend

Amarillo Slim (born ThomasAustin Preston) was, but wehave often found investinginsightinhismusings.Oneofour favorite quotes: “Theresult of one particular gamedoesn't mean a damn thing,and that's why one of mymantras has always been‘Decisions, not results.' Dothe right thing enough timesand the resultswill take careof themselves in the long

run.” As important as thedecision to buy a stock is,eventsdictatethatavarietyofnewdecisionsbemadeaboutthat stock during yourownership of it.Whilemanyinvestors'frequentlyconcludeas those events unfold thatdoing nothing is the rightdecision, others see activelytrading around positions ascentraltotheirsuccess.

***

Our turnover is usually inthe low teens—last year itwas 8 percent, versus anaverageforsmall-capvaluefunds followed byMorningstar of around 70percent. This is driven bythe belief that if you'vetruly done your upfrontresearch well, you shouldhave the patience and

couragetoletideaswork.Idon't believe you canexplain70percentturnoveror more without assumingpeople are buying manythings they don't reallyknow and dumping themwhen they get a negativesurprise.We'renotimmuneto missing things, but itsrare that unexpected riskscomeupsoquicklythatwereverse course before the

thesis has had a chance toplay out. This obviouslyonly works if you pay theright price going in, to thepoint where the downsideistrulylow.—PrestonAthey,T.Rowe

Price

Ourturnoveristypicallyinthe single digits. It's greatwhen something goes up50percent inayear,but if

you sell it you've gottransaction costs and taxesand then need to find anincrementallybetteruseforthe money. We've neverbeen very good attrimming and adding and,ifwe're rightaboutbuyingthe long-termcompoundingmachineswewant to buy, it doesn'tmake much difference. Ingeneral, we think a lot of

trading around positionsovervalues what you thinkyoucanknow.—ChristopherDavis,Davis

Advisors

It's just very hard to tradein and out of positionssuccessfullyover the long-term. It's only possiblewhen you can haveunusually high confidencein the precision of your

intrinsic-value estimate.The most common reasonwe sell is whenwe find abetter opportunity—thatnaturally takes us out ofsome higher-valued stocksthatmightbemostpronetoacorrection.

—BrianBares,BaresCapital

Wetrytotakeapagefromthe Weizmann Institute, aleading scientific research

center based in Israel.Weizmann has a world-classreputation,aresultoftheir having the largestpatent and royalty streamofanyacademicinstitutionintheworld.Ifyoutalk tothe scientists there, theybelieve very strongly thattheir success comes frombeingabletodotheirworkwithout having to worryabout how their science

will translate tocommercial profit—eventhough in the end it quiteoftendoes.Byfocusingonlong-term goals, theyeliminate day-to-daydistractions and are morelikely to work throughproblems that inevitablyarise.Wewant tohave a similarmindset. We know ourinvestors are going to

worryabouttheirportfoliosovershorttimeperiods,butweexplaintothemthatwewon't. We try to look atshort-term marketgyrations as nothing morethan opportunities tosmartly enter or exit aposition, subject tovaluation andfundamentals.

—StevenRomick,FirstPacificAdvisors

Wepractice theTaoistweiwu wei, the “doing notdoing' as regards ourportfolio. We are mostlyinert when it comes toshuffling the portfolioaround, with turnover thathas averaged in the 15 to20 percent range. Manyfunds have turnover inexcess of 100 percent peryear, as they constantly

react to events or try totake advantage of short-term price moves. Weusually do neither. Webelieve successfulinvesting involvesanticipating change, notreactingtoit.—BillMiller,LeggMason

Funds

We're constitutionally setuptobeinactive,following

the Warren Buffett ideathat you should alwaysjudge how you're doing inanygivenyearrelativetoifyou'd done nothing. Aslong as we've made gooddecisions and ourinvestmentcasesareintact,that creates a bias forinactivity.—DonNoone,VNCapital

One lesson borne of

experience is that the bestcourseininvestingisoftento do nothing. Given thepropensitymostofushavefor tinkering, that's a hardlessontoapplyinpractice.EdwardStudzinski,Harris

Associates

We have a five-yearaverage holding period.Particularly in a volatilemarket like today's,people

are trying to zig and zagaheadofeverymarketturnthatthey'rehopingtheycanforecast with scientificprecision.We like to plantseeds and then watch thetrees grow, and ourportfolio isoftenkindofaportraitofinactivity.That'skeptusfrommakingsharpand sometimes emotionalmoves that we eventuallycometoregret.

—MatthewMcLennan,FirstEagleFunds

Wesetanupsidetargetforeach holding,which is notthe maximum expectationwe have, but the level atwhich we reasonablyexpect tobeable to sell inthe future. When we'reright, we'll generally holduntil the shares reach thatupside. The reality is that

wecan'tdothelevelofduediligencewewantoneachidea and also turn theportfolio over quickly byconstantlytradingoutgoodideasforbetterones.Sowetypically hold companiesanaverageoffiveyears.

—StevenRomick,FirstPacificAdvisors

We believe the mostimportantcontributortothe

long-term investmentperformance of thecompanies we own isearnings growth, not achange in valuation.Because growth is drivenby earninghigh returns oncapital and successfullyreinvesting cash flow, wetend to be very long-terminvestors—our averageholding period runs aboutseven years—in order for

this virtuous process tobearfruit.—EricEnde,FirstPacific

Advisors

To compound returns at ahigh rateovera long time,it's going to happenbecause a relatively smallnumber of your stocks goupmassively.Ifwe'rerighton the long-term trends,our bias is to stay with a

trade for many years toallow that to happen. Wetry to avoid getting itchyeverytimesomethinghitsanew high—a stock thatgoesupalotovertime,bydefinition, is frequentlyhittingnewhighs.—JohnBurbank,Passport

Capital

Given the tax implicationsof selling, the cost of

trading, and the challengeof getting two appraisalsright,JohnTempletonusedto havewhat he called the100 percent rule, meaningthe upside should be atleast twice as high beforeswapping out one positionfor what you consider amore attractive one. Wesimilarly want to improveour position materiallywhen we trade an

undervaluedbusiness.—MasonHawkins,SoutheasternAsset

Management

It'salwaysbeenfairlyeasyfor me to stay focused onthe long term, butwith 30years' experiencereinforcing the importanceof that, it's easier to staypatient. In 2008 thatpatiencedidn'tservemeso

well. When the problemsstarted to get attention,conviction that thingswould be fine in themedium to long term keptmefromtrying to time thecycle. In the short term, alot more selling wouldhave been a good idea.Hopefully that was a one-in-50-yearevent.—RobertRobotti,Robotti&

Co.

Buy and hold shouldn'treally be part of a valueinvestor's vocabulary. Allweknowispriceandvalue—if price meets value,whetherinthreemonthsorthree years, there's nojustification for just sittingthere.

—CharlesdeVaulx,InternationalValueAdvisers

One thing I learned from[Tiger Management's]Julian Robertson is theconcept that there are noholds. Every day you'reeither willing to buymoreat the current price or, ifyou aren't, you shouldredeploy the capital tosomething you believedoes deserve incrementalcapital. I sometimes hear,“Ifmy target price is $45,

why should we sell at$43?” The answer issimple—Ibelievewe havebetter uses for that capitalthan getting the last fewpercentage points in themovefrom$43to$45.We distribute every daysomething we call theSheet of Shame. It showsour ten largest losses,cumulatively from theinception of the position,

year-to-date, month-to-date, and yesterday. It's away of focusing ourattention on what's notworking. There are onlytwowaystogetsomethingoff the Sheet of Shame—which people are eager todo—either eliminate theposition or increase theposition and be right,earning some of the lossesback.

—LeeAinslie,MaverickCapital

We'repaid tomeasureriskandreward.Butevaluatingrisk and reward is acontinuous process, notonce a year or once amonth. So our percentageholdings of names in ourportfolio will run up anddown based on relativeattractiveness.

Forexample,wemay loveStock A as a long-terminvestment. We buy it atthestartof theyearat$30andwithinless thanayearit's up 50 percent. We'rejust as excited about thethree- to five-yearprospectstodayaswewere—infact,probablymoresobecausewe'veseenthatourthesis is on track. But thegrowth isn't at as

reasonableapricenow.Soinacompany like this thatweknowwell,wethinkit'sright by our investors tobuy low and sell high asoften as possible. It's hardworkandwerunuptradingcosts, but we believe overtime it dampens volatilityand adds return, and that'sourjob.—LarrryRobbins,Glenview

Capital

We've taken amore activeview [since 2008] onadjusting position sizes sothey best reflect our levelof conviction and returnexpectations. We're not atall becoming markettimers,butwe'remuchlessapttodaytoleta5percentposition throughappreciation become an 8percent position unless its

prospective return hascommensurately improvedas well.We've also scaledback the maximumposition size we'recomfortablewith to 8 to 9percent of the portfolio,from 12 to 13 percent orhigherbeforethecrisis.

—MichaelWiner,ThirdAvenueManagement

You always want to use

your capital as efficientlyas possible and I thinkwe're fairly good at sizingpositions based on therevaluation opportunitiespresent. A lot of valueinvestors may buy at $20,buymore at $15, and thenwon't purchase anothershareallthewayto$40or$50. We're not afraid tobuy on the way up: If theprobability of being right

has gone up, theprobability-adjusted returncan improve even as thesharepriceincreases.—AlanFournier,Pennant

Capital

We generally expect tohold something for a longtime inorder to realize thevalue we believe is there.But one thing I learnedfrom[SACCapital's]Steve

Cohen is tobe sensitive towhen the market over-appreciates something inthe short term and toharvestsomeofyourgains.Markets inevitably react todata points that you don'tthink are truly relevant.Trading around that is aprofit opportunity andhelps you better managerisk.

—RobertJaffe,ForceCapital

Management

When I started in thebusiness, a stock mightmove25centsiftherewasa sound reason. Today,there's too muchinformation out there andpeoplearemisusingit.Thiscreates short-termvaluation extremes, whichyou should often act on.Buyandholddoesn'tmake

asmuchsensewhenstocksare hitting price objectivesquickly. If we buy at $10with a two-year objectiveof $15 and the stockreaches $14 within twoweeks,we'renotdoingourjobifwedon't takemoneyoffthetabletobuyanotherstock with a 30 percentdiscountrightaway.—RobertOlstein,Olstein

CapitalManagement

2008 was really quiteprofound for me as aninvestor. It increased myresolve to hold onlycompaniesIdeeplybelieveinbecauseyouneverquiteknow when forces outsideof your control set off atidal wave across marketsthat shakes everything toits foundation. During acrisis, the less conviction

youhaveaboutsomething,themore likely you are tohandle it poorly and themorelikelythecompanyinquestionisvulnerable.I have put forever to restmy longstanding profile ofnever selling anythingever. I am over that. Oneoutcome of this exercisehasbeentomorepointedlyquestion the enduringnatureofthestatusquoand

to not hesitate in reducingportfolioholdingswhentheuncertaintyistoohigh.—ThomasRusso,Gardner

Russo&Gardner

DEALINGWITHADVERSITY

Akeyoccupationalhazardofthe value investor's trade is

buying into a beaten-downstock that in relatively shortorder falls another 20 to 25percentinprice.Aslong-timevalue hunter Robert Olsteinof Olstein CapitalManagement puts it: “Whenyoubuyonbadnews,itoftendoesn't just stop on a dime;there'susuallymorebadnewsbefore things start to turn.Youcouldprobablymake20percentayearbytappinginto

my phone line and shortingmy initial buys of everystock. That's how good I amattiming.”Discerning between timing

mistakes and just plainmistakeswhensomethinghasgone against you is a top-of-mind issue for mostsuccessful investors. SaysRichard Pzena of PzenaInvestment Management:“Making the right decisions

at these moments adds morevalue,inmyopinion,thantheinitialbuydecision.”

***

We're going to makeanother decision whenwe'redown25percentinaposition. Did we justcompletely blow it? Arewe right, but themarket isjust insane? Or is it

somewhereinbetween?I believe the biggest wayyou add value as a valueinvestorishowyoubehaveon those down 25 percentsituations. Sometimes youshould buy more,sometimes you should getout, and sometimes youshould stay put. I've neveractually looked, but weprobably hold tight 40percent of the time, and

split50/50betweenbuyingmoreandgettingout.

—RichardPzena,PzenaInvestmentManagement

I'm catching a fallingsword in almost everysituation I'm in, and I'mtrying to figure out if it'sfalling from the 2nd flooror the 10th floor. But mycapital base is big enoughand my appetite to stay

concentratedstrongenoughthat, if warranted, I canpatiently, over the courseof three to six months,make the price bottom bybuying a little stock everyday even as it's goingdown.—JeffreyUbben,ValueAct

Capital

When a stock movessharply after an earnings

announcement, thequestionIwanttheanalystto answer is whethersomething in today'searnings report impactedthe value of the companyin2015.Arewethreeyearsfrom now going to lookbackat today's earningsasa seminal moment in ourunderstanding of thebusiness and itscompetitive dynamics?

That can be the case, butmoreoften thannotwhat'sperceived as a bad quarterdoesn't impactthevalueofthe enterprise. That oftenmeans adding to existingpositions.

—WinMurray,HarrisAssociates

My threshold for pain ishigh as long as I believeI'm still right. Historically,

we've made a lot moremoney on the long sidewhenwhatwe thoughtwewere buying cheap wentdown another 30 percentbefore finally going up—wealwaysbuymoreifourthesishasn'tchanged.

—FrancoisParenteau,DefianceCapital

Duringdifficultperiodswehave always been willing

toaddriskastherestofthemarket is removing it byreducing valuations. Iremember sitting in myofficeonOctober19,1987,when the market wascrashing and getting a callfrom [Royce&Associatesfounder] Chuck Royce—who was one of mybrokerage clients then—asking me what stocks Iliked and why. I walked

him quickly through threeorfourofmybestideas,heasked a few questions thatmade it obvious he knewthe companies at least aswell as I did, and then hetoldme toput inorders tobuy10,000sharesofeach,with additional buy ordersof 10,000 shares for every1/8th of a point tick downintheprice.You can only show that

kind of resolve with greatconviction in your processand your discipline,whichincreases every time youcome through a toughperiod successfully. It'sthat process and disciplinethat is fully under ourcontrol—in the end, that'sallyoushouldreallyworryabout.—WhitneyGeorge,Royce&

Associates

We're a long-term, low-turnover manager, so theoffice routine doesn'tchange much [in badmarkets]. Outside theoffice may be a differentstory, say, with respect tosleep patterns and eatinghabits.Butwealways say,“When the going getstough, the tough doresearch.” One of my

biggest jobs is to keepeveryone focused. Don'tstareattherednumbersonthe screen—callcompanies, call industrycontacts to hear what'sreally going on, dig fornewideas,andjustlooktotake advantage of thevolatility.—JeffreyBronchick,Reed,

Conner&Birdwell

My mistake in 2009 wasthat in March—when Ishouldhavebeenbuying—I felt things werecompletely unraveling andstarted selling my longsand increasing my shorts.I'vespentmycareer tryingto think only for myselfand in this instance I wasso influenced by theexternal world that I blewit with the type of market

call I rarely make. All Iwantedtodowastakeriskoff the table, whenwhat Ishould have done wascancel my Bloombergsubscription and focus onthe businesses of thecompaniesweowned.Thatwould have been a farbetteruseofmytime.—CarloCannell,Cannell

Capital

It's the bias of theinformationagethatpeoplefeel isolated when they'renot in touch with what'sgoingon.Tomeit'sagooddiscipline to often say, “Idon't reallycarewhatgoeson in the market today.”Whenyoudo thatyoucanactually get somethinguseful done. Evensomething simple likesaying you'll only answer

e-mails in the morning, atlunch,andattheendoftheday sometimes can go along way toward avoidingunhelpful distractions thattendtoarise.We'reverybigonwhatwecall battle plans, in whichwe map out how we'llbehave at various pricepoints in the market. JohnTempleton used to talkoftenabouttakingthatkind

of pre-commitment downto the level of individualsecurities. Because you'vealready decided what youshould be doing, it allowsyoutofocusyourattentioninaveryusefulwaywhenthe market is falling topieces.

—JamesMontier,GMO

We have periodic devil's-advocatereviewsofallour

large holdings and aseparate analyst is chargedwith presenting thenegative case. It's morethan a debate society—thedevil's advocate shouldgenuinely believe thenegative argument is theright one. We obviouslymake plenty of mistakes,but thatdisciplinehelpsusreduce the frequency andseverity of them. In

investing, that's half thebattle.—EdwardStudzinski,Harris

Associates

If an individual positiondecreases by 10 percentfrom our cost, we conductaformalreview.Thefocusis on understanding whysomething has gone down.If the reason is that thesector is down, or

pessimism over a short-term trend has increased,we'll typically buymore ifwebelievethestoryisstillintact. If the reason thestock is down makes ourthesis wrong, we'll sell.What happensmore than Ithink people arewilling toadmit is that we have noreal idea why the stock isdown,which is aproblem.There's no pat answer for

those situations, but we'reapt to sell when thathappensaswell.

—ChristopherGrisanti,Grisanti,Brown&Partners

Aguidelinethat'shelpeduscontrol risk is to require afull reassessment of ourinvestment thesis whenwe've marked down acompany's intrinsic valueby roughly 15 percent or

more. If you have tomarkdown intrinsic value, youprobably made a mistakesomewhere. The questioniswhetherwhatcausedthemistake is lasting ortemporary, which deservesafreshlook.—SteveMorrow,NewSouth

Capital

Wehavearigidrulethatifa position is down at least

15 percent from our cost,weforceourselvestoeitherbuy more or sell. Humannature in such situations isjust to hold, but if ourconviction on the idea isintact,we'rehappytoseeitdown15percentsowecanbuy more. If that isn't thecase,wesell.Thedown-15percent positions in aportfolio aren't great, butthey're manageable. What

we want to avoid are thedown-15 percent ones thatturn into down-40 percentones—that's where youreally start to blow a holein your capital that's hardtogetoutof.—JoeWolf,RSInvestments

For stocks going againstus, we also have threetriggers that force adecision: if a stock moves

20percentormoreagainstus on a trailing 45-daybasis, ifa longcostsus25basispoints inamonth,orifa shortcostsus15basispoints in a month. It'salmost never a surprisewhen something getsflagged, but we forceourselves to decidewhether this is a greatopportunity or whetherwe'vemade amistake and

should move on. Themajorityofthetimeweendupaddingtotheposition.—SteveGalbraith,Maverick

Capital

Wedon'thavemany rules,but when a stock is downmaterially relative to itspeer group we assignanotheranalyst to formallyreview it and then forceourselves to buy more or

get out. Not surprisingly,the analyst who originallyrecommended the stock isthe last person to want tosellit.—JeffreyBronchick,Reed,

Conner&Birdwell

We have a formal reviewprocess if a stock declinesby20percentormorefromour original point ofpurchase. The analyst

responsible for the ideareviews it fully with theentire team,with everyonefocused on identifyingwhatwemayhavemissed.There'sno forcedactionatthat point, but if we dodecide to average down,we only do so once.Averaging downrepeatedly in stocks thatare tanking is a great waytodestroyaportfolio.

—BrianBarish,CambiarInvestors

We'vedoneresearchonallof our buy and selldecisions and—based on20/20 hindsight—isolatedhow each one adds ordetracts from the overallvalue of the portfolio.Wefoundthatwegenerallydidagoodjobofsellinglosersand of holding on to

winners. Where we didn'tdo so well was in buyingmore of things that werefalling in price—which isinteresting, given howmuch we as valuemanagers love averagingdown. We still have moreto learn about this, but Iwould say we've becomeeven more mindful whenlooking at whether to buyassomethinggapsdown.

—MarikoGordon,DarumaCapitalManagement

You have to be willing todouble down when youinvest in the types ofcompanies we invest in,where things often getworsewellbefore theygetbetter.Idon'twanttoleaveyou with the impression,however, that it alwaysworks. In the late 1990s I

had about a 12 percentportfolio position inSuperior National, a bigplayer in Californiaworkers' compensationinsurance. I increased mypositioninarightsofferingand it got as high as 20percent of my portfolio.When the workers' compbusiness in California fellapart, the company turnedouttobetooleveragedand

the shares went from $22to zero. The lesson wasn'tnot to be aggressive, butnot to be overweighted inanythingthat'ssoleveragedthatitreallyhastheriskofgoingtozero.—RobertRobotti,Robotti&

Co.

What's the definition of along-term hold? A short-termbuythatwentdown.

—JamesMontier,SociétéGénérale

We're big believers in thenotion that losers in thisbusiness are the ones whomake big mistakes andwinners are those whomake small mistakes. Forthat reason we try to beunsentimental about ourpositions,particularlythosegoing against us. We do

not average down after aposition gets hit, forexample. That'scounterintuitive to mostvalue investors, butbecause there is always afairchancewe'llbewrong,wedon'twanttocompoundmistakes. One reason Ithink indexes beat activemanagersis thatyouneversee an index averagingdown. If we're doing our

job, we can always findanother idea that gives usthe same potential upsideor better, and we'd rathergowiththat.

—JamesShircliff,RiverRoadAssetManagement

There's an interestingsection in Outliers, byMalcolm Gladwell, inwhich he describes howdisasters likeplanecrashes

or the Three Mile Islandnuclear accident are rarelybecauseofonebigmistake.They're more likely toresult from a series ofsmallmistakes, anyoneofwhich, if avoided, wouldhavekeptthedisasterfromhappening.Manyinvestingmistakes we'vemade havebeenincompanieswhereabunch of little thingswentwrong, which when added

together made a bigproblem. Those types ofsituations can creep up onyou,soI'dsayonelessonisto not ignore minorsetbacks and to be veryaware if they start to pileup.

—PaulSonkin,HummingbirdValueFund

Wedon'tinterpretmeaningin how stocks are priced.

People tend to think if astockfalls30to40percent,it must mean things areworse than they realize.We don't think that wayand just stay focused onour estimate of intrinsicvalue. It canhappen that astock falls 30 percent butwethinkthebusinessvalueis down 50 percent, sowesell. More often the stockprice falls 30 percent and

wethinkthebusinessvaluemay have fallen only 5 to10 percent, giving us anopportunity.

—ChrisWelch,DiamondHillInvestmentGroup

With investing, focusingonwhat'salreadyhappenedisgenerallyabadstrategy.The decision at any pointshould be only aboutlooking forward. Just

adjusting how you set upyourspreadsheetsandwhatyou track on reports couldhelpinthisregard.

—DanAriely,DukeUniversity

If someone has a materialpiece of information toshare about one of ournames, I always ask thatthey first step back andreviewwithmeourcurrent

shared viewpoint on thestock.Thathelpsusput incontext the importance ofthenewinformationandtobetterdiscuss theextent towhich it may alter ourconviction and/or targetstock price. Someonerushing intomyofficeandblurtingoutthelatestnewswithout putting it intobroader perspectiveincreases the possibility

we'll make a rash tradingjudgment.—MichaelKarsch,Karsch

Capital

Ihonestlydon'tfeelanyofthe emotional ups anddowns from the market'sday-to-day activity. I justdon't worry about short-termvolatility.

—EdWachenheim,GreenhavenAssociates

We lost some longtimeclients during the crisis,one of which delicatelyreferred to me as a“washed-up All-Star” asthe market was goingdown. It's not possible toavoid it eating at youemotionally when themarket is going againstyou.Onecritical thingI'velearned, however, is that

whenever I'm the least bitemotional, I don't makedecisions. We can all feelthe same emotions as thesmall investor—whenyou'reinthatstateofmind,don'tdoathing.—RobertOlstein,Olstein

CapitalManagement

Sometimes going for awalk or meeting a friendfor lunchwhen themarket

isdown200points isa lotbetter then staring at thescreen trying to figure outwhattodo.Youdon'thavetodoanythingandmostoftime you shouldn't. I'mabsolutely convinced thatregularly clearing yourmind helps you makebetterdecisions.

—AaronEdelheit,SabreValueManagement

Humorisanimportantpartofourculture.That'snottosaywe'recuttingupallthetimeorthatwe'reeventhatfunny, but in a deadlyseriousbusinesslikeoursifyou can't find humor inwhat you're doing, it'sgoingtokillyou.Havingasense of the absurd easestension and puts things inperspective when thingsare going against you.

Without that, people burnout or tend in theirdesperationtorollthedice.That's the last thing wewanttodo.

—RobertKleinschmidt,TocquevilleAsset

Management

When we buy a stock wewritedownexactlywhyweownit,whichweshouldbeable to lay out in three or

four sentences. To theextent those assumptionsare no longer valid, we'llsell regardless of howcheap it gets. We'refighting the naturaltendency to come up withnew reasons to ownsomething, for the simplereason thatwe've found inour post-mortem work onmistakes that one of thebest ways to lose money

over time is by owningstocks with changinginvestmentrationales.—RagenStienke,Westwood

Management

We tend not to averagedown. I think this is acommon mistake, whenyou don't realize there'ssomething out there you'remissingandyoucompoundthe problem. We've

instituted a soft stop-lossthat is triggered wheneverapositioncausesa1%losson the overall portfoliofromcost, say a5% initialposition falls 20% fromwhere we bought it. Wedon'tautomaticallysell,butthere's a high bar to keepsomething in the portfolio,letaloneaddtoit.At the end of the day,marketsaretooefficientto

totally ignore price action.Ifwe'regoingtobewrong,we usually know in thefirst year and can cut ourlosses. Better to admit itthenratherthanlater.—StephenGoddard,The

LondonCompany

One thing that helps usmaintain perspectivethrough difficult times isthatweoutlinespecifically

in writing what ourinvestment thesis is andwhatweexpect tohappen.If what is happening withthebusiness is in linewithourthesisandexpectations,that gives us theconfidence to stick withsomething or buy more ifthesharepricetanks.If subsequent eventsindicate our original thesisis wrong, we make every

attempt to ignore thetemptation to keep a stockbecause it's so cheap orbecause we can come upwithnewreasonstoownit.Thatrarelyworksoutwell.

—EdwardMaran,ThornburgInvestmentManagement

Our bias toward buyingand holding has at timesmade us too quick torationalize a problem that

hits one of our companiesas temporary and alreadypricedintothestock.Iftheproblem turns out to bemore long term andfundamental, it's likely notfully discounted into thecurrent price at all. We'vebeen blind at times tofundamental changes in acompany's businessbecausewethinkthequick25to30percentdropinthe

sharepricemakesthestocktoocheaptosell.One technique that helpsme avoid that is toregularly look at what weownandaskasobjectivelyas possible if we wouldbuy the exact sameportfolio if we werestarting over from scratchwith the same amount ofmoney. For positionswhere the answer is

probably no, the likelyreason is that thecompany's situation hasfundamentally changed,but I just haven't fullyadmittedityet.—FrancoisRochon,Giverny

Capital

When something spooksme, I should more oftentake advantage of theliquidity of the market to

getoutandfinishtheworkonwhateverthenewissuesare. If you determine theproblem is a big one, youcan avoid a lot of pain. Ifyou conclude the problemisonly temporary,youcanusually get back in at alowerprice.—DavidEigen,PostRoad

Capital

I've been at this long

enough that I can keepthings in perspective. BenGraham said it well: Hesaid to succeed in theinvestment business ithelpsifyou'resmartandithelpsifyouworkhard,butwhat's most critical tosuccess is that when youhave conviction, you stickwithit.The fact that you gothrough timeswhen you're

outofsyncoroutoffavor,that's good, you shouldexpect that and evenwelcome it. That's whereopportunitycomesfrom.Ifwe'd given up on ourconviction in early 2007[betting against financiallyvulnerable companies], wewouldhavemissed a hugeopportunity.Thatwedidn'twasagamechangerforus.

—PremWatsa,Fairfax

Financial

TAKINGASTAND

Shareholder activism hascome a long way from itsmodern rise in popularity inthe 1980s. Back then, saysone of today's foremostactivist investors, ValueAct

Capital'sJeffreyUbben,whatpassed foractivismwas littlemore than “buy shares todayand tomorrow throw a hissyfit.”Whilethatbasicstrategyhas not gone away, moreprevalent is a constructiveeffort over time to influencecompany management andboards to make changesmeanttoincreaseshareholdervalue.It'snotforeveryone—and one can certainly be a

successfulinvestorwithoutanactivist bent—but many ofthe best investors in thebusinesssee theirwillingnessto push for change whenappropriate as a valuablearrow in their investingquiver.

***

Most shareholders ofundermanaged or poorly

managed companies votewith their feet rather thanpush for changes inmanagement, boardcomposition, or strategy.So, poor managementpersists becauseshareholders aren't willingto do anything about it,which we think is anabdication of responsibleownership and fiduciaryduty. But even if big

shareholders have awillingness to take on apublic company, mostfirms don't have theexperience, resources orskillsettodoso.Wethinkthe fact that we have thatabilitywhenothersdon'tisabigopportunity.Theprivateequitybusinesswas built around takingover companies and doingwhat shareholders should

have gotten done. Mostprivateequity firmsdonotpossess secret sauce interms of managementexpertise—they'refinancialengineers. The amazingthing is that the sameshareholders who donothing toeffectchangeatapoorlymanagedcompanybeforeaprivateequityfirmcomes in to take over lineuptopayastupidmultiple

for the company when itcomespublicagain.—JonJacobson,Highfields

Capital

Michael Price [CEO ofMutualSeriesfrom1988to1998] was at the forefrontof shareholder activism.His and our attitudebecame that just selling ifyou weren't happy wasn'ttherightconclusion.Asthe

owners of the company,shareholders reallydeservefull credit for whatcompanies are worth. It'snot just our right, it's ourobligation todoallwecanto see that we get thatcredit.Forus,acontinuingdialoguewithmanagement—public or not—is animportant part of what wedo.—PeterLangerman,Mutual

SeriesFunds

What we try to do is buyhigh-qualitybusinessesataprice that is not reflectiveoftheintrinsicvalueofthebusiness as it is, andcertainly not reflective ofwhat the intrinsic valuewould be if it were runbetter. That allows us tocapture a double discount.That's a benefit we can

have over private equity.They can buy a companyand run it better to extractincremental value, butthey'retypicallypayingthehighest price in acompetitive auction, sothey don't get that firstdiscount.Wedon'tcontrol,but because we have atrack record of makingmoney for other investors,we can often exert enough

influence to make animpact.

—WilliamAckman,PershingSquareCapitalManagement

We absolutely want to beconstructively engagedshareholders. We have 10to15percentofourcapitalin each of our corecompanies, so I think it'simperative that we makeourviews,particularlywith

respect to capitalallocation, clear. For themost part, managementappreciates the faith we'replacing in their businessandinthemtogetthestockout of the valuation holeit's in. When managementis unresponsive, we worktochangethat.

—AlexanderRoepers,AtlanticInvestment

Management

The basic reason ourinvestment strategy addsvalue is that boardmembers are classicagents, not principals. Theinformation boardmembers get about whatshareholders want comesfrom the CEO. Howeverwell intended, boardmembers mostly lackenough fundamental

knowledge about thebusiness to challenge theCEO on the performanceof the business or newstrategies to create value.Almost always, they don'thaveenoughmoneyontheline to have the sense ofurgency we have asowners. It's a blueprint forinertia.—JeffreyUbben,ValueAct

Capital

We prefer a much quieterformofactivism,buteverynow and then we need todo more. To get on mysoapbox for a minute, I'dargue that theunwillingness ofinstitutional investors totake more of a standagainst poor managementor corporate governancehelped contribute to the

2008 crisis. Silence wasnot the best response tosome of the bad behaviorgoing on, particularly infinancials.

—DavidWinters,WintergreenFund

If you think about wherethe corporate system hasfallendownintheU.S.,it'swhentheactualcapitalhasgotten far removed from

the enterprise, and theagency relationshipbetween owners andmanagement has gotten sobroad and wide. That'swhenyouhavedisconnectsor conflicts of interest.Everything we do tries toshrinkthedistancebetweenthe capital and theenterprise.Activism to a large extentistryingtotruncateriskby

eliminating themisallocation of capital,which is less likely whenthose responsible truly actas if they're spending theirownmoney.Whenmakingadecisiononanewfactoryorproductlaunchorhiringplan,peopleshouldfeeltheweight of the capital theyare entrusted with.Understandably, given thecorporate form, many

people runningcorporations don't operatethatway.Sowhenthatisn'thappening, the ability toimprove those decisionsthrough activism is a keyway to create shareholdervalue.

—MichaelMcConnell,ShamrockCapitalAdvisors

If our capital base werepermanent, we'd probably

onlydoactiveinvestments.Butitisn't,sothefactthatIdon't ever want to beforced to sell an activeinvestmentinthecourseofan engagement means wealso need to hold passivepositions. Historically,around 55% of ourportfoliohasbeeninactiveinvestments,15%orsohasbeen in cash, and thebalancehasbeenpassive.

The 55% of our capital inactivist investments hasproduced more than 90%ofourreturns.Oneprimaryreason we're working hardto increase the amount ofpermanent capitalwe haveistodevoteasmuchoftheportfolio as possible toactivepositions.Doingthatshould enable us to earnhigherreturnsovertime.

—WilliamAckman,Pershing

SquareCapitalManagement

ATTRACTINGACTIVISTS'ATTENTION

Value investors frequentlyzeroinonsituationsinwhichacompanybyitsowndeviceshas veered off course,resulting in lagging

performance that isnonetheless perceived asfixable. Nonactivists andactivists alike count on thefixes being made, withactivists looking in variedwaystoshouldermoreof theloadtoinsurethathappens.

***

Every investor wants tofind well-managed

companies, withdefendable marketpositions, that generate alotoffreecashflowthatisreinvested intelligently.The problem is, thosecompanies typically don'thave valuations we canacceptasvalueinvestors.So we look for businessesthatqualifyonafewoftheideal characteristics andthat we think can improve

ontheothers.Inmostcaseseither the management islousy or the company hashad a very bad record interms of capital allocation.Tous,thosearetheeasiestthingstofix.—JonJacobson,Highfields

Capital

Ourintereststartsfirstwiththequalityof thebusiness.We're not looking for

trouble, for quick deals tobemade, for fixes,per se,orevenforboardseats.Webuy good businesses atgood prices, where we'rewillingtotakeontheshort-term risk—the near-termnegative data point—becausewethinkthelong-termgain is compelling. Ifthestockgoesup,welooklike traditional valueinvestorswhomadeanice

investment.But probably half the timethings don't work out thatway. We're 18 months in,withafullposition,andthestockiswhereweboughtitorlower.Butwe'veprovedout the industry structure,we've proved out ourinvestment thesis, and wereally believe in the asset.It's at that point we go totheboardandmanagement

and say we've been yourdefaultbuyer,weown5to10 percent of yourcompany, andwe'd like tobuymore butwewon't doso without a board seat.The stock isunderperforming, webelieve we have a deepunderstanding of yourbusiness, we have a deepknowledge of capitalmarkets, and we want all

the information that'savailabletoboardmemberstohelpcraftastrategythatcreates value for allshareholders.We don't pick fights. Butwhenthetraingoesoffthetrack, you need to dosomethingaboutit.—JeffreyUbben,ValueAct

Capital

Our front-end screening is

fairly automated, lookingat both performancelaggardsandwhereimpliedexpectations arepessimistic. We start withthe proposition that themarket is right about acompany's valuation. Ifthese assets, with thismanagement, with thisstrategy, in thisenvironmentareworth$20per share, can we identify

changes in thatcomposition that wouldmake the market valuemuch higher? Moretraditional investors mightstop there, butwe then trytofigureouthowlikelytheactionswe'veidentifiedareto be taken and over whattime frame, and, mostimportantly, how capablewe are of helping tomakethemhappen.

—RalphWhitworth,RelationalInvestors

Inthetypicalsituationthatattractsus,weengagewithmanagementinordertotryto get them to rein inspendingonfailinggrowthinitiatives, refocus on thegood core business,improvecashflow,andputin place a greater level ofdiscipline with respect to

returnoninvestedcapital.—JeffreySmith,Starboard

Value

If I learned anything as amanagement consultant, itwas the importance ofidentifying where abusiness has its greatestcompetitive advantage andthen focusing the growthand development of thebusiness on that nexus of

advantage. Companiesconsistently lose sight ofthat for a variety ofreasons, often resulting inwhat we call “de-worsification.” It's a verycommonissueforus.People issues are alsocommon. These are verydifficult decisions forcompanies to make, ofteninvolving many subjectiveand emotional variables.

Whennecessary,we try tobring a reasonable andrational approach todifficultdecisionsthatneedto bemade on both hiringandfiring.As market time horizonscontinue to shrink, thepatience we'll demonstrateto companies that aredisappointing us has beensimilarly telescoped.We'renotrudeorabusive,butwe

are expressing our pointsof view and buildingcoalitions to drive changeearlier, more frequentlyand perhaps moreforcefully thanwe have inthepast.

—DavidNierenberg,D3FamilyFunds

Invariably the companieswe zero in on have poorcorporate governance, but

we'refarmoreinterestedinhow the board makesdecisions than in the tick-the-box governance itemslike whether they have apoison pill or a staggeredboard. Not enough boardsthink of themselves asshareholderrepresentatives. Thatparticularlymanifestsitselfin setting compensationplans, which don't focus

enough on return oninvestment and often justreflect what managementwantsratherthanwhattrueshareholder representativeswould require. In virtuallyall of our companiescompensation is a centraltopicofdiscussion.

—RalphWhitworth,RelationalInvestors

Ourpreferencewouldbeto

have a constructiveconversation withmanagement leading to apositive resolution. I don'tthink going immediatelyfor the jugular, as someother activists do, is thebestwaytosucceed.Ifyouembarrass people andattack them personally,you're much less likely tohave a rational discussion.But we've made it clear

that we aren't going to goaway.—PhilGoldstein,Bulldog

Investors

Activists need the capitalbase, experience, andcredibility to followthrough—by buying thecompany or going on theboard to help fix it—ifsteps aren't being taken toaddress their concerns.

Youneedtobemorethanayeller and screamerwhosebiggest asset is that youdon't care what anybodythinksaboutyou.—JeffreyUbben,ValueAct

Capital

Thereisgrowingsentimentthat a shareholderperspective in theboardroom is helpful,whichwasnot the case25

years ago. I'd like to thinkwe've moved past thecorporate-raider phase andthatmostactivismtodayisdone professionally withthe interests of allshareholdersinmind.Companies have alsoincreasingly realized howunproductive it is to resistshareholder input. Whenactivists show up,management for the most

part behaves responsiblyand respectfully. Thatresults in healthy,constructivedialogueabouthow a company shouldoperate. That type ofdialogue is absolutely inthe best interest of allshareholders.—JeffreySmith,Starboard

Value

There'sacertaintrendiness

to activism, driven by thefact that the opportunitiesfor activism aren't alwaysthere. In the 1980s youheard a lot about it, butthenasvaluationschangedinthe1990syoudidn'thearmuch about it at all. Nowit's popular again, butwe've always considered awillingness to be active asjustanotherweapon inourarsenal.

—BarryRosenstein,JANAPartners

IwillsaythatIhaveinthepast fallen intowhat I calltimetraps,whereI'vespenttoo much time trying toresolve probleminvestments. We will pickour battles, but usuallywe'rebetteroffhelpingourbest investmentsmaximizeopportunitiesthantryingto

perform brain surgery ondogs.

—DavidNierenberg,D3FamilyFunds

Onemistakewemadewithour investment in BordersGroupwastakinganactiverole at the company'srequest. Given thedirection the industry washeading and how hard itwas to make anything

happen,itwasn'tworththetime and energy.Paraphrasing WarrenBuffett, when you findyourself in a sinking ship,sometimesthebestthingtodoistoswitchboatsratherthankeepbailing.

—WilliamAckman,PershingSquareCapitalManagement

We prefer to avoid publicconfrontations with

managementforthreemainreasons. First, we're ayoung enough companythatIdon'twanttoruntheriskofourentirereputationbeingtiedtoapublicbattlewith this or that company.Second, we've greatlybenefitedasinvestorsfromforming partnerships withour portfolio companies.We want to maintain thatsame access, which

requires that when we sitacross from managementthey understand we're aconstructive force and nota potential headache. Thethird thing is just from alegal perspective, being anactivist is very time-consumingandexpensive.Activists are, generallyspeaking, well researchedandwell informed in theirpositions and most of the

time are fundamentallyright. They may have anissue with the free ridersbenefitingfromtheirwork,butthegoodonesaredoingeveryoneaservice.—LarryRobbins,Glenview

Capital

I've got a full quota ofrighteousindignationandalot of things turn me offabout corporate America,

but I've never had thepersonality for beingconfrontational. I talk tomanagementat times,bothto complain and to offersuggestions, but I'mhesitant to be public orloud about it. If I pushedon an issue and someonecalled my bluff, I knowmyself well enough toquestionwhetherI'dfollowthrough with a lawsuit or

whatever the next stepmightbe.—WallyWeitz,WeitzFunds

We like to invest withmanagement that gets itandisdoingwhatwethinkthey should. Someinvestors want to buycheap stocks where thebusinesses are run bymorons and then forcethem to do something

different. That's not a badstrategy,butthat'snothowwetendtodothings.

—WayneCooperman,CobaltCapital

The fact is, when I feel Ihave to write a letter andmake noise, that almostalways means I've made amistake and the moreproductive use ofmy timeistosellandmoveon.

As a buy-and-holdinvestor, the perfectoutcome is when acompanyearnshighreturnson their equity capital foraslongasIlive.Icanholdand have the earningscompoundinatax-efficientway. So, as opposed toagitating for a fight, I'mbetter off hooking upwithpeople who are great atwhat they're doing—and

are going to keep beinggreatatitforalongtime.—ThomasGayner,Markel

Corp.

CHAPTER10

GuardingAgainstRisk

It's become commonpracticesince the financial crisis fornearlyallmoneymanagers—

and those looking to hirethem—to place significantemphasis on portfolio riskmanagement.Thisrenewaloffocus on risk is far lesspronounced in the best valueinvestors, for the simplereason that guarding againstthe unexpected has alwaysbeen at the core of how theythink about investing.Oaktree Capital ChairmanHoward Marks captured the

generalmindsetnicelyinthisexcerptfromoneofhismanyclassic investor letters, thisonefrom2009:[I]nvestors shouldn't planon getting added returnwithout bearingincremental risk. And fordoing so, they shoulddemandriskpremiums.Butat somepoint in the swingof the pendulum, peopleusually forget that truth

andembracerisk-taking toexcess. In short, in bullmarkets—usually whenthings have been goingwell for a while—peopletend to say, “Risk is myfriend. The more risk Itake, thegreatermyreturnwill be. I'd like more risk,please.”The truth is, risk toleranceisantithetical tosuccessfulinvesting. When investors

are unworried and risk-tolerant, theybuystocksathighP/EratiosandprivatecompaniesathighEBITDAmultiples, and they pileinto bonds despite narrowyieldspreadsandintorealestate at minimal “cap”rates.There are few things asrisky as the widespreadbelief that there's no risk,because it's only when

investors are suitably risk-averse that prospectivereturns will incorporateappropriateriskpremiums.Hopefully in the future (a)investorswill remember tofear risk and demand riskpremiums and (b) we'llcontinue to be alert fortimeswhentheydon't.The Baupost Group's Seth

Klarman puts it even moresuccinctly:

Things that have neverhappenedbeforeareboundto occur with someregularity. You mustalwaysbepreparedfortheunexpected, includingsudden, sharp downwardswings in markets and theeconomy. Whateveradverse scenario you cancontemplate,realitycanbefarworse.Guarding against risk is

built into every aspect of thebest value investors'strategies,fromtheideastheypursue, their buy and selldisciplines, how they buildpositions, how they structuretheir portfolios, how theymanage cash, and how theyhedge.

MARGINOF

SAFETYIn Chapter 20 of TheIntelligentInvestor,BenjaminGraham, the patron saint ofvalue investing, introducesthe concept of margin ofsafety. Warren Buffett hascalled this chapter andanother in the same book onresponding to marketfluctuations, “the two mostimportant essayseverwritten

on investing.” In its simplestterms, Graham writes thatmargin of safety comes from“a favorable differencebetween price on the onehand and indicated orappraisedvalueontheother,”addingthat“itisavailableforabsorbing the effect ofmiscalculations or worse-than-averageluck.”Echoing but also

broadening the concept of

margin of safety, most topinvestors today cite theinherent risk aversion theybuild into how they identify,analyze,andchoosepotentialinvestments—and, of course,what they pay for them—astheirfirstandmostprominentlineofdefenseagainstrisk.

***

Ourprimaryfrontierofrisk

management isn't widediversification, but thequality of the individualbusinesses, their balancesheets,andthepeoplewhorun them. In the financialcrisis the businesses weowned held up quite well,even if their stock pricesdidn't. That type ofvolatility is risk only ifyou're looking at a shorttime frame, which we

aren't.—ChuckAkre,AkreCapital

Management

People don't believebusinessqualityisahedge,but if your valuationdiscipline holds and youget the quality of thebusinessright,youcantakea 50-year flood, which iswhat2008was,andlivetotake advantage of it. We

incurred a markdown in2008, and it was arguablyjust that.Youmayhave toacceptabitmorevolatilitywith our fund than in along/short fund, but wefollowedadown2008witha very strong 2009 and2010 and would put ourthree-year returns upagainstanybody's.Thekeyis avoiding businesses thatget snuffed out at the

bottom.—JeffreyUbben,ValueAct

Capital

Margin of safety comesfrom as many places aspossible, but primarilyfrom the strength andsustainability of thebusiness model, lowvaluations relative to bookvalue or cash-flowmultiples,andundervalued

hard assets or other assetsonthebalancesheet.—JonJacobson,Highfields

Capital

At the heart of valueinvesting is the notion ofmean reversion, that bypayingalowmultipleonaconservative margin youcanwinwiththepassageoftimeasthevaluationofthebusiness and the margins

normalize.Whatcanbreakthat and cause meanaversion, though, arethings like fading businessmodels, expeditionarymanagement deployingcapital in a dilutive way,and adverse capital-structure contingencies.We make every effort toinvest only in the universeof companies where thoserisks of breakage are as

limitedaspossible.—MatthewMcLennan,First

EagleFunds

The consequence of ourinvestment style is thatweendup ingoodbusinesses,where the market isn'trecognizing how good thebusiness is or the level ofcash it generates. Thosetend to be fairly low-betastocks, so even thoughwe

have a relativelyconcentrated portfolio—with between 15 and 20longs at any given time—we haven't had very highvolatility.

—RichardVogel,AlatusCapital

Investing is often aboutknowing your strengthsand we've learned thatwe're better at spotting

profitable, unglamourous,undervalued companiesthan we are at identifyingtraditional turnarounds—by which I mean money-losing companies weexpect togetback into theblack.Asaresult,wesetaguidelineforourselvesthatnomorethan10percentofthe portfolio will be incompanies with negativetrailing12-monthearnings.

—JohnDorfman,ThunderstormCapital

I've always told people Ihave no idea what themarket's going to do orwhenreturnswillappearinthe portfolio. I don't thinkeither of those ispredictable. The best wecandotodayistofocusoncompanies with balancesheets to weather a credit-

constrainedworld,businessmodels thatwillbearoundfor years to come, andvaluations that are cheapenough to make the waitfor recovery worthwhile.That'swhatwecancontrol—the rest of it takes careofitself.—AndrewJones,NorthStar

Partners

Our primary defense

against risk, though, is toonly buy companies thatgenerate or are about togenerate excess free cashflow, after capitalexpenditures and workingcapital needs. Whenproblemsdevelop,andtheywill, free-cash-flowcompanies don't have totake on short-termstrategiesthatarenotinthelong-term best interests of

the company to survive.They can make strategicacquisitions when otherscannot.Theycanbuybacktheir stock and raisedividends. They also oftentend to be the companiesthatgetacquired.—RobertOlstein,Olstein

CapitalManagement

Given our number ofholdings[30to40]andour

low turnover, we candevote10timestheamountof time some others canspend on any givenposition, which means weshould know the businessbetter, reducing thepossibility that things aregoing to hit us from leftfield. That depth ofknowledge,combinedwiththe quality of thebusinesseswewanttoown,

is our primary risk-managementtool.—EricEnde,FirstPacific

Advisors

Long periods of prosperitytend to breedoverconfidence on the partofinvestors,whichleadstoa misassessment of risk.During times of excesses,weconcentrateonreducingrisk by holding uniquely

strongcompanies.—EdWachenheim,

GreenhavenAssociates

The most important waywemanageriskistoavoidsituations where creditrisks can overwhelm thestory. We'll take the riskthatour assumptionsaboutthebusiness turnout tobewrong in factor in timing,but we want to minimize

the risk that value isdestroyed or the storydoesn't even get a chanceto play out because of abalance-sheet crisis. Ifyouput our portfolios againstthose of other valuemanagers, we're typicallyin the lowest decile interms of aggregate debt-equityratio.—BrianBarish,Cambiar

Investors

After learning some hardlessonsduringthefinancialcrisis, we instituted a rulethatanyratiooftotalassetsto shareholders' equityabove 2.5 to 1 is anexception, which doesn'tautomatically mean wewon't buy it, but eachindividual position sizewill be limited and wewon't ever havemore than

10 percent of the portfolioin such exceptions at onetime. That's nothing morethan a recognition thatwhen you're wrong with aleveraged business model,the hit to the stock pricecanjustbetoofastandtoodamaging.—RobertOlstein,Olstein

CapitalManagement

BUILDINGAPOSITION

One way savvy long-terminvestorslooktomitigateriskis by being in no rush toestablishwhattheyconsiderafull position in a new idea.That the share price can runaway from them before theyarefullyinvestedisanirritantmostaremorethanwillingtoaccept.

***

A full position is 8 to 10percentofthefund'sassets,but we typically work ourway there over three orfour tranches.Ateachstepwe're either gaining moreconfidenceinthevaluationand our ability to make adifferenceorwe'renot.Forexample, we generally

don'tmeetwithcompaniesuntil we own a stake, sothat's the first step oncewe've taken a position.Aswe gauge their responseandvalidatewiththemandelsewhere how we'relooking at valuation, we'lleithersell,buymore,orsiton it to gather additionalinformation. Working intopositions this way helpsmanagerisk.

—RalphWhitworth,RelationalInvestors

We often take R&Dpositions in stocks [beforecompletely finishing ourresearch]. Action adds asense of urgency to thework—there are so manythings to look at in thisbusinessthatthingscanfallthrough the cracks unlessyouforceyourselftofocus.

Having capital on thebooksdoesthat.When we find out thecompany's a bad businesspartner,therearestructuralindustry issues we didn'tknow about or maybethere'sanearningsmisswedecide isn't a short-termevent—thenwe'll sell. Butif every step of the wayyou get more excited bywhat you uncover, those

are the companies thatbecome 5 percent, 6percent,7percentpositionsintheportfolio.—RickySandler,Eminence

Capital

We like to live withsmaller investments in acompany for three to sixmonths before making afull commitment. It givesus an opportunity to even

better understand thecompany and its businesswhile getting to knowmanagement and whetherwe'reallonthesamepage.Sometimes the stock popsquickly and the valuationgets too high, or we losesome conviction on theattractiveness of thebusiness, or it becomesclear that managementand/or the board is not

interested in developing apositive relationship. Wevery infrequentlypurposefully pick a fight,sowe'll justmoveon.Ourgoal is that by the timewe're ready to commit totaking a 10 percent-plusstake in a company weknowthebusinesscoldandhave bonded withmanagement so that we'rereallyinittogether.

—JeffreyUbben,ValueActCapital

Given that we're oftenbuying into the teeth of astorm,it'srarethatwefeelwehave to establish a fullposition right away.Whilesomestocksmayrunawayfrom us, we believe we'vebeenhurt lessby that thanwe've benefitted fromaveragingdownasideasin

which we have highconviction first getcheaper, or by adding topositionsasour convictionin the business andmanagementgrows.—PeterKeefe,AvenirCorp.

After taking a relativelysmallposition,we'lllooktofurther establish ourrelationshipwith theboardand management, which

should allow us a deeperunderstanding of both theorganization and thebusiness.Managementwillsaythebusinessisgoingtodo this based on howthey'remanaging it, and ifthathappens,that'shelpful,and if itdoesn't, that'salsointeresting. The analyticalprocess is highly iterative,which we consider a keywaytomanagerisk.

—JeffreyUbben,ValueActCapital

I've never been sodisciplined that I hold offbuyinguntil100percentofthe work is done. Aworkbench position getsbuilt into a core positiononlywhenwehavelittleorno question about thebusiness, people andreinvestment opportunities.

It takes time to learn howthe business model reallybehavesandI'vealsofoundthat it usually takes a longtime to understand whenmanagementisreallygood.Many of the times IthoughtIknewrightaway,Iwasdeadwrong.—ChuckAkre,AkreCapital

Management

CASHMANAGEMENTHow much cash an equityinvestorcanholdinhisorherportfolio is often limited bythe terms of engagementagreed upon with investors.When that's not the case,opinions still vary widelyamong top investors on theextent to which cash is avaluable risk mitigator, or

evenastrategicasset.

***

Wedon'tmanageour cashbalance in a strategicway.Part of that is a businessdecision: people hire usbecause they believe weknow how to find greatunloved companies, notbecausewe'reclevergoingin and out of cash. Part of

it is also just realistic. Asmuch as I'd love to be incashwhen themarket getshit,Idon'tbelieveIcangetthat consistently right overtime.Andifyoumakejusta couple big mistakes ontiming,itcankillyou.

—JamesShircliff,RiverRoadAssetManagement

By having a high cashbalance, one is suggesting

that he has some wisdomorknowledgeabout timingthemarketforwhichheorshe should becompensated. I have noneofthat.—CarloCannell,Cannell

Capital

Manyvalue investorshavea very particular view ofwhen thingsarecheapandwhenthey'reexpensiveand

they should hold cash.They portray holding cashasarisk-reductionmethod.My view is that's justtaking on a different risk.You're betting there isgoing to be regularcyclicality and things aregoing to get cheap againandyou'regoingtobeableto buy them. But if thatdoesn't happen as youexpected, you're screwed.

You'llendupliketheguysthat have been bearish for20yearsanddon'thaveanyassetsanymore.—BillMiller,LeggMason

Funds

We have opinions onoverall risk that impactwhatweown,butweneverhave an opinion on themarket. I've always foundenough companies that

meet our standards, so weremain more or less fullyinvested.Ithinktimingthemarket is extremelydifficult to do profitably.Withindividualcompanies,Icanpinpointtherelativelyfewvariables Ineed togetright for a thesis to work.When you start looking atthe stock market'sdirection, there are somany variables that I can't

even identify them all, letalone predict or weighthemcorrectly.My time ismore productively spentelsewhere.

—EdWachenheim,GreenhavenAssociates

People we greatly respectthinkaboutthisdifferently,but if even in 2007 wecould buy a company likeWrigleyat80centson the

dollar,wethinkthat'sa lotmore attractive thanholding cash. We weregetting a substantial free-cash-flowcoupon,astrongbalance sheet with netcash, and bottom-lineearnings growing atdouble-digitrates.Thewaywe look at things, even at80centsonthedollar,we'dexpect a rate of return onsomething like that in the

mid-teens annually. Andthat was available in,across the board, thepriciest market I've everseen.—C.T.Fitzpatrick,Vulcan

ValuePartners

Ourcashbalance ispurelyaresidualofwhetherwe'refindingenoughtoinvestin.

—Jean-MarieEveillard,FirstEagleFunds

Our willingness to holdcash during fallow periodshasenabledus tomaintaina strict sell disciplineregardless of whether wehad anything promising toreplacewhatwesold.Thisview on cash, combinedwith a truly long-terminvestmentperspective,hasalsoenabledustoavoidthegun-to-the-head mentality

that pressures manyinvestors toown less-than-stellar investments. Theworlddoesn'tendwhenwepass on a borderlineinvestmentthatlaterworksout; thedangerwe seek toavoid is the temptation orpressuretomaketoomanyborderline investments thatlaterturnoutbadly.

—SethKlarman,TheBaupostGroup

We usually hold less than20 positions at a time, sono one would ever saywe'reaplacetoputallyourmoney,butwebehaveasifthat's what people havedone. So we think it'sreasonable to have somecash around foremergencies—as Buffettsays, why risk what youneed for that which you

don'tneed?We used to think havingcash was a byproduct ofnot having enough to do.But the older I get, themore I see it as a strategicasset. It allows us to takeadvantage of those greatopportunities that come upfrom time to time. We'rejust behaving like thecompanies we like toinvestin.

—BruceBerkowitz,FairholmeCapital

One big reason we like tohold cash is that myinherent nature is to feelsomething better to buy isalways going to comealong and I want to havethecashavailabletobuyit.People assume they canalways sell something tobuysomethingbetter,butI

don't like potentiallyselling intoa lousymarketwhen the liquidity isn'tthere.

—StevenRomick,FirstPacificAdvisors

Ben Graham always madethe point that even if youthoughtyouhadaportfolioofverycheapstocks,ifthemarket at the time wasfully priced, you should

haveat least 25percentofyourportfolioinsomethingotherthanequities,suchascash or bonds. To dootherwise would be todelude yourself that yourstocks, no matter howcheap they appeared toyou, would be magicallyimmune if the wholemarketwas to correct. I'vealwaysthoughtthatmadealotofsense.

—CharlesdeVaulx,InternationalValueAdvisers

If we can't findundervaluedstockswe'llletcash accumulate, as webelieve cash is a betteralternative than owning anovervalued security. I'dargue that having thepatience and discipline tosave your cash for whenthe fat pitches come along

is probably the mostvaluable trait an investorcanhave.—EricCinnamond,Intrepid

Capital

Periodsoflowreturnshaveoften historically beenaccompanied by highervolatility. That scaresinvestors away, butvolatility in a low-returnworld is a blessing for us,

because there's moreopportunitytobuylowandsell high. That's one mainreasonwehave15percentofourportfolioincash,sowe can pounce whenvolatility results inindividual stocks beingshotdownexcessively.

—CharlesdeVaulx,InternationalValueAdvisers

When I was first starting

out in the business, youcouldbemoreorlessfullyinvested all the time. Iftherewasadownturnintheindustrialsector,youcouldselltheutilitiesyouownedthatweredoingwelltobuythe beaten-downindustrials. In today'smarket,everythinggoesupanddownatthesametime,so you don't have stocksgoinguptosellinorderto

buy the bargains. The bestwaytotakeadvantageofabigmarketcorrection,then,istohavecash.Inanormaltime,we'll keep around10percent cash on hand forliquidity purposes. Giventhe state of the worldtoday, we're closer to 20percent.We'll miss some profitswhen valuations arerunning high and we're

raisingcash.That'sjustnotsomething we've everworriedabout.

—DennisDelafield,DelafieldFund

MIDASTOUCHHolding gold or otherprecious metals in one'sportfolio as a hedge againstmacroeconomic risks is a

common tactic among valueinvestors—one thatengenders, however, a gooddealofdebate.

***

Goldisalogicalalternativefor those worried aboutgovernments' ability tomanage their finances. Ifwestern political leadersadopt practices which

result in devaluedcurrencies, large budgetdeficitsandrisinginflation,gold to us represents aprettydecentstoreofvaluerelative to currencyalternatives.

—RobertKleinschmidt,TocquevilleAsset

Management

Afterthefinancialcrisiswedecidedweneeded todoa

little bit more macroinvesting, hedging forpotential strange outcomeswithin the system. Havingamaterialstakeingoldhasbeen one primary waywe'vedonethat.

—DavidEinhorn,GreenlightCapital

There is a survivalistaspecttohavingsuchabigstakeintangibleassets.As

long as governments showsuch low regard forpolicies that support thereal value of paperfinancial assets, investinginpreciousmetals isaboutthe only way to guaranteethe preservation of yourwealth.—EricSprott,SprottAsset

Management

Wedon't lookatgoldas a

commodity, but as a formof insurance against whatPeter Bernstein callsextremeoutcomes.Inmostcircumstances in whichworldwide equity marketswould go down—and notjustforaweekortwo—thepriceofgoldwouldgoup,providingapartialoffsettothe hits we'd take in ourequityportfolio.We don't have a blind

commitment to gold. Thetime may come when wethink the insurancepremium is too expensiveor we'll decide that theinsurance is no longerrequired.

—Jean-MarieEveillard,FirstEagleFunds

Gold kind of scares mebecause very often thepeople involved with it

seem tobe slightly insane.MyotherproblemisIdon'tknow how to value it.Unlike an equity thatsupposedly has cash flowattached to it, or unlike abond that has a coupon,gold isn't worth anythingintrinsically beyond whatsomebodyiswillingtopayforit.I have ended up buying it,however, because I

concluded it offeredopportunity under twoextreme outcomes. If theworld went into deflation,then gold would act as astore of value while thefinancial systemdisintegrated.On the otherside, we know people usegold as a store of valueduring inflationary times,particularly in a world inwhich you're seeing

competitive currencydevaluations.

—JamesMontier,GMO

Youcouldtakeallthegoldthat'severbeenmined,anditwouldfillacube67feetineachdirection.Forwhatthat'sworthatcurrentgoldprices,youcouldbuyall—not some, all—of thefarmland in the UnitedStates.Plus,youcouldbuy

10 Exxon Mobils, plushave$1trillionofwalking-around money. Or youcould have a big cube ofmetal. Which would youtake? Which is going toproducemorevalue?”—WarrenBuffett(asquoted

inFortune)

HEDGINGBETS

Beyond more common risk-mitigation methods such asdiversification, holding cash,andowninggold,thereareanever-increasing number ofstrategies—under thebroadlydefined rubric of hedging—that investors can use toguard against general orspecific risks in theirportfolios. We focus hereprimarilyononeof themorehotly debated of such

strategies, the willingness toshort individual stocks andindexes. While some marketobservers and practitionersconsider shorting to be thedevil's work, others can'timagine their portfolios—orthemarketingeneral,forthatmatter—functioning wellwithoutit.

ToShortorNotto

Short?Shorting stocks obviouslyisn't for everyone and bringswith it some uniquechallenges, not the least ofwhichisunlimitedriskoflosson any given position. Bothavid proponents andopponentsofthepracticetendto agree on one thing: it'sverydifficulttodowell.

***

Without having acommitment to the shortside, it's difficult to beoffensivewhenyoushouldbe. The highest-returnopportunities are availablewhen markets are in freefall, but if you're gettingshelled, youmay not havetheemotionalconvictiontobe aggressivelyopportunistic,andyoumay

not even be able to do it,because of redemptions.Being able to be offensivewhen everybody else isdefensive, in and of itself,canyieldexcessreturns.Asecondelementisthatastrue, committed shortsellers, we have to beimmensely skeptical, andskepticism is a terrificquality inavalue investor.A key reason for our

success is that we have ahighbattingaverageonthelong side. We're better atavoiding mistakes becausewe'reveryattunedtothosesituationswherevaluegetsdestroyed, orwhere it isn'treally there in the firstplace, say, because ofphonyaccounting.—RickySandler,Eminence

Capital

Our view is that shortselling may not in mostyearsbeworththetimeandeffort you spend on it, butyou do it precisely forthoseyearslike2008whenshorting not only offsetslosses on your longs, butalso produces capital thatallows you to averagedown on the long side. Alotofpeople in2007gaveuponshortsellingbecause

it hadn't been particularlyproductiveforafewyears.In retrospect, that shouldhavebeenanexcellentsignsomething bad was goingtohappen.Given all the stylisticdifferences of valueinvestors,it'seasytoforgetsometimes what valueinvesting is all about,which I would argue ismargin of safety. That

margin of safety doesn'tjust apply to yourindividualideas,butalsotohow your portfolio is puttogether. The goal shouldbe that in the middle of astormthatputsalltheless-seaworthy boats at thebottom of the ocean, yourboat,batteredasitmaybe,makes it back to shore.Short selling helps you dothat.

—ZekeAshton,CentaurCapital

Both our shorting andactivismhavedoneagoodjobforusintemperingthedownside. No one likesgoing through a crisis, butour shorts and someactivist longs that movedindependently of themarketin2008keptuswayahead of the market and

better able to respond toopportunities as they werecreated. On top of that, Ithink shorting isintellectually challengingandplaysavaluableroleinthemarkets.

—WilliamAckman,PershingSquareCapitalManagement

Ibelievetheirrationalityinthemarket generally tendsto bemore focused on the

long side. As a result, Ithink that overall there aremore incorrectly pricedshort opportunities thanlong opportunities. I [also]justconsidershortingtobemore intellectuallystimulating. Like a lot ofthingsinthemarketsandinlife, the more intellectualargument is usually thenegative one. There'ssomething very satisfying

aboutnailinganoverpricedsecurity.

—RobertJaffe,ForceCapitalManagement

WeshortbecauseIthinkitis themostprudentway tomanageaportfolio, fromarisk perspective, andbecauseIbelievethekeytosuccessful long-terminvestingistoavoidlosses.We also short because in

certain subsections of themarket it's easier thanbuying stocks. There arealways classes ofcompanies that are dying.If you really track themortality rates ofcompanies, you'd concludethat the market does nothave the upward biaseveryone thinks it does.The market is actually acarefullyprunedgarden.

—CarloCannell,CannellCapital

We think shorting makesus better analysts. CharlieMunger says you reallyunderstand a companywhenyoucanarticulatethenegative scenario betterthan the person on theothersideof thetrade.Wealso think that from abusiness standpoint, if

you've done all the workand conclude the negativescenario is most likely toplay out, itmakes a lot ofsensetobeabletoshort.—RicDillon,DiamondHill

InvestmentGroup

How would you judge aninvesting strategy with thefollowing fundamentaleconomic characteristics:(1) limited potential

returns, but unlimitedpotential losses; (2)skyrocketing competition;(3) tax inefficiency; (4)aggregate net losses overits history; (5) Theeliminationofasignificantsourceof income in recentyears; (6) risk of assetrepossession at creditors'whim? Having spent 15years of my career doingnothingbut short selling—

with periods of greatprosperity and otherperiods of fast, painfullosses—I can argue withsome authority that, as aninvestment strategy,shorting suffers from eachofthesecharacteristicsofabadbusiness.

—JosephFeshbach,JoeFeshbachPartners

We dabbled in shorting

early on, thinking weshould take advantage ofthe bad companies weuncovered as well as thegood. In reviewing ourshorts after our first year,wefound that ineachcasewe would have mademoney if we'd actuallyclosed out the positions,but we hadn't. We weregood at identifying theshort ideas, but were

terrible at trading them.Our batting average wasjust so much better withour longs that we decidedwe shouldn't devote thetimetotheshorts.

—JamesVanasek,VNCapital

One general mistake wemade in starting our firmwas thatwe told ourselvesthatwe should be hedging

against macro concernswhenthatwasn'treallyourexpertise. Short positionswere never going to be abig part of our portfolio,but they took up aninordinate amount of timeand added an inordinateamountofstress.

—JamesClarke,ClarkeBennittLLC

We do some shorting, but

very little. The problem isthat shorting requirestiming, which isn't mygreatest strength. I wouldguessthatforalltheshortswe'vedoneoverthepast25years we're at about a $0profitonthem.—RobertOlstein,Olstein

CapitalManagement

ValueDestroyers

Whetherone shorts stocksornot, the characteristics shortsellers look for in their bestideas are illustrative of whatlong-only investors shouldtypically take great pains toavoid.

***

Thefirstandmostlucrativecategory of short ideas arethe booms that go bust.

We've had our mostsuccesswith debt-financedasset bubbles—as opposedto just plain asset bubbles—where there are tickingtime bombs in terms ofdebt needing to be repaid,andwheretherearepeopleahead of the shareholdersin the bankruptcy orworkoutprocess.Thedebt-financed distinction isimportant. It kept us from

shorting the Internet in the1990s—that was avaluationbubblemorethananythingelse.Thenextcategoryinvolvestechnologicalobsolescence. Economiststalkquite rightlyabout thebenefits of “creativedestruction,” where newtechnologies andinnovations advancemankind and grow GDPs.

But such changes alsorender whole industriesobsolete. Disruptivetechnologies have twosidesandalwayshave.Yousaw it in the 1980s aspersonal computers wipedouttheword-processorandminicomputer markets.What's playing out now isthe transformation fromananalog to a digital world.While that's created great

fortunes like Google's, it'salso wiping out wholebusinesses. Traditionalmusic retailingwas one ofthe first to start going.Then came video rental.Value investorswill investintothesetypesofmarketsat their peril. Cash flowsevaporate faster than youeverdreamed.We also look foraccounting irregularities,

which can run the gamutfrom simple overstatementof earnings, often a grayarea, to outright fraud.We're trying to find caseswheretheeconomicrealityis significantly divorcedfrom the accountingpresentation of thebusiness. It's not GEmanaging earnings—everybody does that. Wewanttoseesomethingway

beyond that, wheremanagement is going outof its way to mislead. Itcould be the hiding lossesinoffshoresubsidiarieslikeEnron. It couldbe abusingmark-to-market accountingas Baldwin-United andmany others did. It couldbe Boston Chicken, a bigwinnerforusinthe1990s,lending money tofranchisees to cover losses

and not reserving for thereceivables. The biggestabuse in accounting today,often legally, is inacquisitionaccounting.The last big onewould beconsumer fads. This iswhen investors—typicallyretailinvestors—userecentexperience to extrapolateadinfinitum intothefuturewhat is clearly a one-timegrowth ramp of a product.

People are consistentlyway too optimistic andunderestimate just howcompetitive the U.S.economy is in these typesof things: Cabbage PatchKids in the 1980s,NordicTrack in the early1990s, George Foremangrillsintheearly2000s.—JamesChanos,Kynikos

Associates

[BlueRidgeCapital's]JohnGriffin, one of the fewinvestors who is reallygood at shorting, says youalwayswant time tobeonyour side with shorts.Taking that to heart, ourprimary focus on the shortside is on identifyingsecular problems that overthe cycle are workingagainst a given company.We try to steer clear of

short positions inbusinesses that haverelatively short businesscycles, shorts based onvaluation,or shortsbettingonabadearningsrelease.We often find short ideaswhen all everyone talksaboutishowgreatdemandis in an industry, whileignoring the supply side.We'veseenthatdynamicinsome of the component

markets for greentechnology, such as in thelight-emitting-diode (LED)space. With the vastexpansion of productioncapacity we can see goingon, good luck makingmoney in this businessovertime.—LeeAtzil,PennantCapital

We're looking forcompanieswithweakening

moats,oftencoupledwitharesulting deployment ofcapital into areas inwhichthey have no competitiveadvantage. Even better iswhenthey'redeployingnotjust excess capital, butleveraging the balancesheettodoso.—JamesCrichton,Scout

Capital

We don't short on

valuation, but rather insituationswherewebelievea company is violating thelaw, or has misleading orinaccurate accounting, orhas a potential regulatoryproblem.

—WilliamAckman,PershingSquareCapitalManagement

Whenwe'reshort,welookfor deteriorating industryconditions, company-

specific fundamentals atrisk, and liquidity issues.We will short a goodcompany, even a cheapcompany, if we thinkreality will fall short ofcurrent expectations. Thebest way I've learned toshort is by makingmistakes on the long side—in value traps, forexample—and then tryingto recognize when others

are making the samemistake.—LarryRobbins,Glenview

Capital

We primarily look formaterial disconnectsbetween our view ofeconomic earnings and theearnings that are reportedand people are using tovaluethestock.Itcouldbeaccounting related, so we

pay careful attention tothings like rising accountsreceivable relative to totalsales,cashfromoperationsthat is not keeping pacewith net income, anddecreasing returns oncapital.Wealsolookforlong-termstructural declines—kindoftheoppositeofwhatwelook for on the long side.Wall Street tends not to

fundamentallymark stocksdown until bad newsactually shows up in thenumbers. We'll ignore thesupposed value today andfocusonwhetherwe thinkthe“E”inaP/Eisgoingtobe materially less in threetofiveyears.—RickySandler,Eminence

Capital

We focus onwhatwe call

false hope, where statedcompanygoalsareunlikelyorunobtainable.We'vehadsuccess historically withsingle-product companies,often in the healthcarefield.Managementtendstobe promotional, thecompanies burn cashbecausethey'regrowingsofast, andWall Street tendsto love them becausethey're always raising

money.Whenexpectationsappear to be that growthwillneverstopandthatthesuccess with one productwill be replicated manytimes over, there's oftenplentyofroomforultimatedisappointment.

—RobertAlpert,AtlasCapital

We have a motto, “buycash flow, short cash

burn.” If a business isburning cash, they'redestroying value quarterafter quarter. Two thingsgenerally happen. Theyhave to recapitalize onunfavorable terms, whichis good for us as shortsellers. Or, they can't getfinancing, which, ofcourse,isnirvanaforusasshort sellers because thestocks then usually go to

zero.—ZekeAshton,Centaur

Capital

Whenthereisacycloneofwealth transfer into anarea, some of theparticipantsinthefledglingindustry will be realcompanieswhose productsand services will changethe world. But there willalso be dozens of other

companies that are bogusand run by unscrupulouspromoters. That's thesubset of themarket we'reattracted to on the shortside.—CarloCannell,Cannell

Capital

I have developedsomething called the Cscore,which is basically asix-variable method for

searching out ideal shortcandidates that arepotentially manipulatingearnings.Thevariablesarea growing differencebetween net income andcash flow fromoperations,increasing days salesoutstanding, growing dayssales inventory, growingother current assets torevenues, decliningdepreciation relative to

gross property, plant andequipment and, finally,total asset growth greaterthan10percent.There's a high probabilitythat companies that scorehighonthosesixmeasuresare actually manipulatingearnings.Byalsorequiringsome measure of highvaluation, sayaprice/salesratio greater than 2×, wecan imagine stock prices

for the remainingcompanies going southquitefast.—JamesMontier,Société

Générale

It'sveryhardtoshortgood-business-model,accelerating-growthcompanies just becauseyou believe they're wildlyovervalued. You don'toften hear of investors

making their fortune byshorting something likeGoogle or Amazon. Forvalue investors inparticular, it's better tostick on the short side tobroken business models,fads and frauds. There areusually enoughof those togoaround.

—GlennTongue,T2Partners

We won't short on

valuation—say, becauseGoogle is trading at 20×nextyear'scashflowwhenwe think it should onlytradeat15×.

—StevenTananbaum,GoldenTreeAsset

Management

We're not playing for amultiple reduction, or areversion to the mean forthe industry. My biggest

mistakes have generallybeenbecauseIstayedwithshorts just because theywere expensive. Themultiple game is adangerous one—valuationscan be crazy and staycrazy.Wetypicallywanttosee something already orsoon to be going verywrong. Our best shorts inthe past 10 years, in fact,have been more in low-

multiple companies,wherewe believed the earningswereillusionary.—JamesChanos,Kynikos

Associates

Onethingweliketodoonthe short side is towait tosee things start to breakdown before we getinvolved. Once somethingstarts to crack, there willstill likely be plenty of

disagreement—reflected inthe stock price—onwhetherornotthebusinessisreallybroken.—AlanFournier,Pennant

Capital

I guarantee that in everygreat blow-up there hasbeenat leastonebig-nameinvestor involved all thewaydown.Don'tstopyourwork on the downside

because you can't imagineso-and-so owner making amistake. It happens all thetime.—JamesChanos,Kynikos

Associates

PortfolioHedgingWhile many managers whoshort view the practice firstand foremost as a profitcenter, shorting individual

stocks and indexes also canplay an important role inoffsetting specific riskselsewhere in the portfolio.Someinvestorsarticulatewellthe strategy behind suchefforts, but too often theexplicationissocomplexthatmore questions are raisedthananswersgiven.

***

Togive an exampleof thetypeofhedgingwedo,weinvested last year inArkema, a specialtychemicalcompanythatwasspunoutofFrance'sTotal.It had all the classic spin-offdynamicsandwesawitasanexcellentopportunitytogetinatagoodpriceasa low-margin, neglectedcompanywasnowgoingtobe run by an independent

management that couldunlock the business value.At the same time, though,we didn't want to beexposed to a cyclicaldownturn in the chemicalsbusiness, so we shorted abasket of Europeanspecialty chemicalcompanies that had twicethemarginsofArkemaandwere trading at highervaluations.

—JeffreyTannenbaum,FirTreePartners

We keep our net exposureto the market in a tightband, usually from 0percent to 25 percent. Thebasicrationaleisthatwhilewe'reconfidentinourskillas stock pickers,we're notconfident at all in ourability to predict marketdirection. Another key

aspect of our portfoliostrategy is to limitexposure to exogenousvariables. If we're long achicken producer webelieve is highlyundervalued, for example,we'll pair thatwith a shortposition in a chickenproducer we believe isovervalued because wedon'twant exposure to theprice volatility of chicken,

soybean meal or corn,commodities thatdramatically impact theunit economics of thebusiness.Themorewecanhedge against exposuresthat concern us, the moreaggressive we can be inindividual long positionsbased on our view of thefundamentals.

—TuckerGolden,SolasCapital

Ourhedgingfallsintothreeprimary buckets, whichvaryinemphasisovertime.Typicallythebiggestoneisa global market hedge, inwhich we use things likeindex options, indexfutures or credit defaultswaps to insulate theportfolio, to a definedlevel, from big marketdislocations.

The second bucket isdirectly related towhatweown, inwhichwe'll hedgeagainstacommodityprice,a currency, or anotherindustry player in arelative-value trade. Inenergy, for example,we'reusuallytryingtoisolatetherelative value betweenstock prices andcommoditiesfuturesprices.In those cases, for

example,we'llshorttheoiland gas curve, to guardagainstthelongbetgettingwashed out if commodityprices fall. Anotherexample would be if weown Ford and believe notonly that it's absolutelycheap but also cheaprelative to GM or BMW,wemayshortoneof thoseto hedge against a generalauto-industrydecline.

The last bucket includesshorts in individual stockswhere we're trying tocreate alpha. It's beenincreasingly difficult to dothis for a lot of technicaland competitive reasons,which is why a lot ofpeoplehavegivenuponit.Wehaven'tgivenup,butasapercentageofthehedgingwe do it's currently thesmallest.

—JonJacobson,HighfieldsCapital

IsShortingInherentlyEvil?

We don't share the generalenmity sometimes directedtoward short sellers, as ifbetting against stocks wassomehow anti-American.Well-functioning marketsdepend on the transparent

flow of information, whichcanbegreatlyhinderedwhencriticsareattackednotforthequality of their analysis, butsimply for being skeptics.“Thevilificationofcritics,bethey short-sellers, journalists,or regulators, chills the freeflow of ideas and analysis—indeed, chills free speech—by making it so darnexpensive,”writesGreenlightCapital'sDavidEinhorninhis

book, Fooling Some of thePeople All of the Time,written about his experienceshortingAlliedCapitalstock.“If posting an analysis on awebsite or making a speechgets you an SECinvestigation,whybother?”As in any category of

investors, there may be badactors who should be heldaccountable for misdeedsproscribed by law or

regulation.Theremaybebadanalysisforwhichthemarkettends to be a strictdisciplinarian. Suchsafeguards should be fullysufficient to punishwrongdoers, while leavingthe free flow of informationintact.

***

I have no problem with

takinganegativeviewonacompany,butas it'sgotteneasier(throughtheInternetand TV) and moreeconomical (throughoptions markets) toconductbearraids,there'samuchgreaterriskthatshortsellers can manipulate themarkets and try to bringcompaniesdown.—MartinWhitman,Third

AvenueManagement

Fromourexperience,muchlong-oriented analysis issimplistic, highlyoptimistic, and sloppy.Short-sellers, by goingagainst the long-term tideof economic growth andthe short-term swells ofpublicopinionandmarginscalls, are forced to becrackerjack analysts. Theirwork product is usually

top-notch and needs to be.Short-sellers shouldn't bereviled or banned; mostshould be celebrated andencouraged. They are thepolicemen of the financialmarkets, identifying fraudsand cautioning againstbubbles. In effect, theyprotect the unsophisticatedfrom predatory schemesthat regulators andenforcementagenciesdon't

seemabletoprevent.—SethKlarman,TheBaupost

Group

One general benefit ofshorting is that it tempersvolatility in bothdirections. Risk is createdwhen markets getovervalued and shortsellers help keep that inline. I'd argue that onereason housing got so

overvalued is that untilvery late in the gameeveryonewas on the sameside of the trade, whichcreated significant risk inthe system. Short sellersalso temper volatility onthedownside– they'reoneoftheearliestbuyerswhenastockcrashes.I'd also argue that theshorts who do goodfundamental research play

an important watchdogrole. They have theresources to dig intosomething that a regulatormight miss. Had peoplelistened to Jim Chanosabout Enron, or us aboutMBIA, or David Einhornabout Lehman Brothers, alotofpeople'smoneycouldhavebeensaved.

—WilliamAckman,PershingSquareCapitalManagement

It annoys me whenmanagement blames shortsellers for a variety of illsand then tries to getCongress or the regulatorstoharassandvilifythem.Ilong for the day when amanagement team, whichhas a well-known shortseller publicly short itsstock, starts its quarterlyearnings call with a Q&A

session with the short-seller. “We are now goingto take all the questionswhich Jim Chanos,manager of KynikosAssociates, who is shortour stock, would like toask.Mr.Chanos,your lineis open. Please proceed.”Wouldn'tthatcleartheair?

—TimothyMullen,VNBTrust

Short selling is now a lot

more acceptable than itwas, but it's still difficult.People question ourmotivesandsaythingslike“What's your vestedinterest?Aren't you sayingthat just because youexpect the stock to godown?” Well, yeah . . .don't people who are longsaypositivethingsbecausethey think a stock's goingtogoup?

—JamesChanos,KynikosAssociates

CHAPTER11

MakingtheSale

Despite the obviousimportance of doing it well,selling often gets relatively

short shrift in the discussionof investment strategy.Investors who speak withgreat clarity and in greatdetail about their buyingstrategy often describe theirselling discipline in three orfour bullet points. Thelanguage used in explaininghow,why,andwhentheysella stockcanbe, forwantof abetterword,fuzzy.Thisattitude towardselling

isconsistentwithresearchbybehavioral-finance expertTerence Odean of theUniversity of California,Berkeley,whohasfoundthatinvestors tend to deriveconsiderably more pleasurefrom buying than they dofrom selling. “Buying isoptimistic, about what thestockcandofor theportfoliogoing forward,” he says.“Selling is generally more

pessimistic, about what thestockhasalreadydone to theportfolio,whichmay ormaynothavebeenpleasant.”This discomfort around

selling is also borne out inresearch of professionalinvestors' selling practices.AsMichaelErvolini,CEOofinvestment-research firmCabotResearch,putsit:Standard descriptions ofthe selling discipline

typically include: (1) Wesellwhenourthesisforthestockhasbeenrealized;(2)We sell when thefundamentals significantlychange; and (3) We sellopportunistically when weidentify better uses of ourcapital.These are fine reasons forselling a stock, but theydon't particularly suggeststrategicthinking.Thiswas

borne out in a survey ofprofessional investors thatmy firm, Cabot Research,conductedin2008withtheCFA Institute. The resultshighlighted that most selldecisions are based onjudgment,feel,andinstinct—less than 15 percent ofthe respondents said theyused a rigorous andcalibrated method foridentifyingsellcandidates.

Even the novice investorcan attest that selling carrieswith itmore than itsshareofemotional baggage. “Thisstock has been a dog, but Ican'tsellnowbecauseit'sgottobeabouttoturn.”“Thishasbeenabigwinner.Ilovethiscompany, I love thismanagement,howcanIsell?”“Wow, up 30 percent in sixmonths.Ibettergetoutwhilethegettingisgood!”

Novice and professionalinvestor alike are subject tothechallengesthatcomplicatethe selling process. But thebest investors tend to placeselling front and centeramong what they must dowell, and are adept inarticulating why they sell,their disciplines for decidingwhen they sell, and thelessons they've learned frompainfulexperience.

WHYTOSELLIn contemplating selling,investorsaredealingwiththegood,thebad,andtheuglyintheir portfolios. While thatcan make generalizationsdifficult,leadinginvestorsaretypically clear-headed andthoroughly unsentimentalaboutwhyanygivenpositionshould be headed for thechoppingblock.

***

We sell for four primaryreasons: when the pricereaches our appraisedvalue;when the portfolio'srisk/return profile can besignificantly improved byselling—for example, abusinessat80percentofitsworth for an equallyattractive one selling atonly 40 percent of its

value; when the futureearningspowerisimpairedby competitive or otherthreats to the business; orwhen we were wrong onmanagement and changingtheleadershipwouldbetoocostlyorproblematic.

—MasonHawkins,SoutheasternAsset

Management

WarrenBuffett talks about

a company's valuemovingthrough innovation,imitation and then idiocyphases. We're mostcomfortable in the earlystageswhenwethinkwe'rekind of writing theintellectualproperty.That'snot to say there's not a lotofmoneytobemadeintheimitation and even idiocyphases, but it's not ournative ground. If we're

saying the same thing asthe consensus andsomething is no longermisunderstood,chancesarewe'reselling.

—AdamWeiss,ScoutCapital

Ingeneral,weownastockbecause we have a thesisthat we don't believe iswidely recognized. Oncethat thesis is widelyrecognized, there's no

reason for us to own thestock.Wehopethestockisselling at a certain level atthat point, but sometimesit's higher than we expectand sometimes it's lower.But it's not the price thatmatters, it's whether thethesis is widely known. Ifit is, we should be sellingregardlessoftheprice.

—EdWachenheim,GreenhavenAssociates

Sometimes we sell whenwe've been right,sometimes we sell whenwe've been wrong, andsometimeswe sell becausethere are four more thingsthat became morecompelling. There's acommon expectation thatpeople who do primaryresearchinthedepthwedoto arrive at their own

fundamental view of whatvalue is over a three- tofive-year time horizonshould hold the stocks forthatlong.Thatcanhappen,but the reality is it oftendoesn'tworkoutthatway.When we look at ourportfolio and feelwe haveother,fresherideasmoreinthe early innings of themarket's misunderstandingthanthemiddleinnings,we

will consistentlymake thatswap.

—AdamWeiss,ScoutCapital

We replace portfolioholdings later in theirearnings cycle and at thehighendof theirvaluationrangewith those that havetheoppositecharacteristics.There's not one absolutenumber against which allideasarecompared.Thisis

the value-added offundamental research—using our judgment andexperience to gaugewherecompanies are in theirvaluation and earningscycles.

—KevinMcCreesh,SystematicFinancial

Management

We are fully aware whenvaluations are getting

stretched, which oftencoincides with a positiongetting outsized in theportfolio. In those cases,we will likely take moneyoff the table by managingthepositionsizedown.—ChuckAkre,AkreCapital

Management

We pay attention to whatI'd call technicalexhaustion points, where

the trading experienceindicates that marketenthusiasm is so overdonethat there's a highlikelihood of a reversal.Wealsokeepontopofourcompanies, industries, andtrends to gauge how wellthemarketisunderstandingthestory.Wewon'tputupbig returns holding stocksfor which the valuationrelative to the ongoing

potentialindicatesthestoryiswellunderstood.—JohnBurbank,Passport

Capital

We have for selling whatwecalltheIBDtest.Whenour companies startshowing up on Investor'sBusinessDaily'shottop-10lists, that's generally thetime for us to get out.When the momentum

investor's bible brands oneof our companies as a hotgrowth company, we'reusually ready to sell.Sometimes it's early, butwe've gotten in early aswell.—CaraDenver,D3Family

Funds

To be successful in anybusiness you have to havea certain competitiveness

and a certain paranoia. Inour business where theykeep score every day andyour problems are staringyouintheface,youneedtobe incredibly focused onthe problems in theportfolio and constantlyassess whether youranalysis is right and theconsensus is wrong.There'safinelinebetweenhaving done your

homework and havingconviction in it and justbeing stupidly stubborn.The best investors figureout how to walk that line,recognizing their mistakesand moving on when thesituation warrants. All ofthatisveryhard—ifitwereeasy, everyone would begoodatit.—JonJacobson,Highfields

Capital

We try not to have manyinvestingrules,butthereisonethathasserveduswell:If we decide we werewrongabout something, intermsofwhywedidit,weexit, period. We neverinvent new reasons tocontinue with a positionwhen the original reasonsarenolongeravailable.

—DavidEinhorn,Greenlight

Capital

One general principle Ilearnedfrom[famedhedgefund manager] MichaelSteinhardtyearsagoisthatif he had a position, andthere was any discrepancyat all factually orfundamentally from theoriginal thesis, he'd closeouttheposition.Youcouldgive him 20 good reasons

to stay the course and hewouldn't do it. At first Ithought he was just beingunreasonable anddogmatic, but I realized itwas just aboutprobabilities. He mighthave in his heart of heartsbelieved that those 20reasons were persuasiveand he should stay thecourse,butthatwasn'thowhethoughtaboutthings.He

was thinking “90 percentof the time whensomething like thishappens, I lose money, soI'm going to get out.” Hewouldn't ever say thismight be the 1-in-10 timeit'snotgoingtohappen.

—BryanJacoboski,AbingdonCapital

It's when we're trulynegatively surprised that

wetypicallyexitaposition.If we're surprised, thatusuallymeansmanagementis also and that there'ssomething morefundamentally wrong withthe business than wethought.—SteveGalbraith,Maverick

Capital

Wearerequiredasanalyststopresentfive,sixorseven

keyreasonstoownastock,and ifanyof thosestart toerode,that'sawarningsignwe regularly track thatoften leads us to sell. Forexample, we have tendedin thepast coupleofyearsto overestimate theintrinsic-value growth inmedia companies. As wescale those estimates back—taking away a primaryreason for our owning

them—we should beselling.—ClydeMcGregor,Harris

Associates

Wearepronetotheclassicvalue-investor mistake ofbeing stubborn aboutselling even when thethesisstartstobreakdown.I bought it cheap and nowit's even cheaper—I can'tsell now! That's

complicated by the factthat we're transparent withour investors about whatwe'redoing,andit'shardtoadmit that what you werearguing last quarter haschangedorwasjustflatoutwrong.We try to apply a couplebasic tests to avoid thatmistake. One is to besensitive that whensomething is taking up an

inordinate amount ofmental bandwidth, that'salmost always a bad sign.We spent way too muchtimetryingtograpplewithAIG in2008, forexample,as the bottom was fallingout.Probably the best questionwe ask ourselves whencontemplating selling is,“Ifwedidn'townit,wouldwebebuyingittoday.”We

bought Lockheed Martin[inearly2010]becauseweliked the hard-to-replicatefranchise, strong capitaldiscipline and positivecorrelation to risinggeopolitical tensions. Wealso thought that defense-spendingcutsmightbelessonerous than expected,especially if theRepublicansdidwellinthenext election. When

Republicansdiddowell inthe mid-term elections,defense stocks did littlebecause everyone wastalking about across-the-board belt-tightening.WhenNorthKorea shelledSouth Korea, Lockheedshares actually went downover the nextweek.Thosewere market signals thatwe listened to, and whenweaskedifwe'dbebuying

the shares today, theanswerwasno.Given thatwe also had many otherthings tobuy,we sold andmovedonquickly.

—DanielBubis,TetremCapital

Buying bargains is thesweet spot of valueinvestors, although howsmalladiscountonemightaccept can be subject to

debate. Selling is moredifficultbecauseitinvolvessecurities thatarecloser tofully priced. As withbuying, investors need adisciplineforselling.First,sell targets, once set,should be regularlyadjusted to reflect allcurrently availableinformation. Second,individual investors mustconsider taxconsequences.

Third, whether or not aninvestor is fully investedmay influence the urgencyof raising cash from astockholding as itapproaches full valuation.The availability of betterbargains might also makeone a more eager seller.Finally, value investorsshould completely exit asecurity by the time itreaches full value; owning

overvaluedsecuritiesistherealmofspeculators.

—SethKlarman,TheBaupostGroup

SELLINGBYTHENUMBERSIt's by no means a universalapproach, but the sellingprocess can be one of the

more rote disciplinesinvestors follow: “If X, thenwesell.”Xis,unsurprisingly,usuallybasedonvaluation.

***

Wegenerallysellataround90 percent of our estimateof business value and wetry to be quite disciplinedabout it. I've neverunderstood why value

investors who are verydisciplinedonthebuysidebecome momentuminvestors when they sell,saying they'll wait for themarket to tell them whenit'stherighttimetosell.It seems tome that if youthink your portfolio isbeing hurt by that lastmove from fair value toovervalued—that thatmove is greater than what

you'dgetbygoingfrom60percent of fair value to 90percent of fair value insomething else—thenshouldn't your strategy beto identify names thatyou've missed that haverun up to fair value andbuy them for the run toovervalued? Yeah, it'sfrustrating to sell namesand they go up more, butthe flip side is you've

reinvested that money insomething that you feel ismore undervalued andshould contribute to yourreturns beyondwhat you'llget from what you soldearly.

—BillNygren,HarrisAssociates

When the stock price getswithin our estimated rangefor intrinsic value, we're

sellers. To my mind,capturing a discount to aconservatively estimatedintrinsic value is a fareasier proposition thanbetting on the growth ofintrinsic value over time.Someone like WarrenBuffett, who has anincredible gift forimagining how acompany's business andmarketdevelopsovertime,

is going to bemuchbetterthan I am at seeing thepotentialforgrowth.Thereare exceptions, but Iusually leave thatpartofastock's upside to peoplelikehim.

—JimRoumell,RoumellAssetManagement

Psychological issues cancome intoplay,but sellingstrikes me as fairly

straightforward. We'll sellany time we conclude ourthesis is flawed or riskfactors have emerged thatmake us doubt theprobability of return. Inideas that areworkingout,ifwebelievethefairvalueof a stock that is a 5percent position andtrading at $80 is $100,westart staging out as theposition size gets larger

and the stock price getscloser to fair value. Sowemight start selling at $90andbeoutby$105.Wetrynot tomake it muchmorecomplicatedthanthat.We have a friend whokeeps sending us e-mailsaboutallthestockswesoldtoo soon. But you knowwhat? It's okay to give upthe risky profit. We kickourselveswhenweturnout

to be too conservative byselling at the midpoint ofour fair value range. Butwe can live with that.Wespecialize in getting thelow-risk profits. It's okaywith us if other peoplemake money on the high-riskprofits.

—ZekeAshton,CentaurCapital

We try to keep it fairly

rigid.When a holding hitssome combination of 8xEBITDA, 12x EBIT, or15x forward earnings,we'regoingtostartselling.Given the types ofcompanies we buy, thatmeansthesharesareinthetop end of their valuationrange and we can't expectenoughfurtherupside.

—AlexanderRoepers,AtlanticInvestment

Management

We have an absolutevaluationprocess,withbuyand sell prices for everystock in our portfolio.Wethinkintermsofcaprate,areal estate term,whichwecalculate by dividing ourestimate of a company'snormalized operatingearnings by its enterprisevalue.We're trying to buy

companies at a 15 percentearningsyieldandwe'llbesellingwhenthatyieldgetsto around 8 percent. At 8percent you're getting intothe rarefied zone wheregrowth and momentuminvestors are stillcomfortable, but wherethosewhocareaboutvalue—including potentialbuyers of the company—aren'tsointerested.

—WhitneyGeorge,Royce&Associates

When a stock hits 90percent of our valueestimate, we formallyreviewthefundamentalsofthe position and ourestimates. We also maybegin trimming,particularly if the positionis large or less liquid. At100 percent of estimated

value, we are activelytrimming the position. Ifwe still have a positionwhenitgetsto110percent,we must be out before itgets to 111 percent. Thisapproach gives usflexibility to let ourwinners run, but onlywithin the boundaries ofourvaluationdiscipline.That's not to say we'll letthe whole portfolio sit in

fully valued stocks. Wekeep careful overall trackof where our portfolioholdings trade relative toabsolute value. Thehistorical range is 65percent to 82 percent, andright now it's around 76percent. I'm not doing myjob as a portfoliomanagerif I'm not swapping outstocks trading closer toestimated valuewith those

trading at much biggerdiscounts.

—JamesShircliff,RiverRoadAssetManagement

I have a pretty strict rulethat if anything changesmy perspective on acompany so that myearnings estimates fall bymore than 15 percent, Isell. You couldlegitimately argue a stock

is even more attractive ifits price falls 25 percentandyourestimatesonlygodown 15 percent, but thatin many ways turns anoffensive thesis into adefensiveone,adynamicItrytoavoid.—JedNussdorf,Soapstone

Capital

Tracking insider selling issometimes not so helpful,

butifyoudoseeaninsideraggressively selling whenthe stock is falling, run.There's only one reasonsomebody does that, andit's not because they'rebullish on the stock'sprospects. I couldn't careless if you're paying for anew swimming pool oryour kids' tuition—you'reselling and think yourstockisovervalued,sowhy

shouldIownit?—AaronEdelheit,Sabre

ValueManagement

Our selling disciplinereflects our desire to exitinvestments when theyreach fair value, althoughwedopayalotofattentionto taxes, which areinexplicablyoverlookedbya lot of long/short funds.The common wisdom

seems to be that youshouldn't let taxes cloudyour investment judgment,but that's unrealistic to usgiven the differencebetween short- and long-term tax rates. We do notliketosellstocksthathaveworked before owningthemforafullyear,unlesswe feel a stock's priceexceeds fair value to theextent that the tax benefit

ofwaitingtosellnolongercompensatesfortheriskofa return to fair value, orworse.

—TuckerGolden,SolasCapital

I arrived at a rigidquantitative disciplinebecause otherwise Iwouldhavenoideahowtosell.Itstruck me that if you letyouremotionsdictatewhen

to sell, you risk falling inlove with companies thathave been doing well andyouridethemtoolong,andthen something goeswrong. I guess I have theclassicvaluementality. It'sinstinctual for me to wanttosellasthingsgoupandIstart getting nervous. Forme, having somethingsystematicthatsaysìthisischeapî or ìthis is fairly

valuedî is really, reallyimportant.

—RichardPzena,PzenaInvestmentManagement

GETTINGTHETIMINGRIGHTAsk investors to reflect ontheir mistakes and theyfrequentlycitepoor timing—

both too early and too late—when it comes to selling.Howtheycometotermswiththis timing challenge, andwhat they do to overcome it,can be highly instructive inunderstanding their overallinvestmentapproach.

***

Given our value bias, wetend to buy early and sell

early. Often in our bestinvestments theshareholder base changes,from value investors toGARP investors, and wemiss out as that fulltransition takes place andthe true believerscompletely take over. I'vecome to accept that andconsider it kind ofinevitable with a valuediscipline.

—JonJacobson,HighfieldsCapital

As sensible as a buy-and-hold strategy is in a bullmarket,itcanbedangerousin a volatile, downward-trending one. It's a faircriticism that wehistorically may have heldtoo closely to ouraspirationalvaluation,evenafter what we considered

our proprietary insight hadbecome conventionallyheld. We're less worriednow about the perfect exitand are content with theperfectlygoodone.

—DavidNierenberg,D3FamilyFunds

I more often than not selltoosoon.Toavoidthat,I'mtrying to better distinguishbetweencasesinwhichthe

rise in the share price isstillprimarilyafunctionofimproving businessfundamentals and thosewhere multiple expansionhas become mostimportant. A rapidlyincreasing multiple oftenmeanstoomanypeoplearestarting to agree with me,whichmakesmenervous.

—AaronEdelheit,SabreValueManagement

We've many times soldway too soon. To try toavoid this, we've forcedourselvestolookoverlongperiods at where marginand sentiment peaks havebeen in individual stocks,to really vet how highsomething mightreasonablygo.

—PhilipTasho,TAMROCapital

In cases in which wehaven't made a mistake orsomething better hasn'tcomealong,we'veevolvedour selling strategysomewhat. We used tohaveafairlyrigidrulethatassoonassomethingwentabove the market multiplewe'd sell, but we thoughtwe too often were leavingmoney on the table so wenowusetrailingstops.That

meansifsomethinghitsthemarketmultipleonthedayit'stradingat$61,we'llsetastoptosell,say,at$59.Ifthe stock goes up to $63,we'llsetthetrailingstopat$61, and so on. Hopefullythisallowsustobettertakeadvantage of people'swillingness to overpay forourshares.

—JohnDorfman,ThunderstormCapital

In one stock we sold waytoo early. Dealing withmanagement was sofrustrating that itdiscombobulatedusandweconcluded the situationcouldn't be fixed. In fact,we should have steppedback and recognized thatthe attractiveness of thebusiness would outlastmanagement.Withinayear

oftheoldCEOleaving,thestock went from the lowteens to $40. We had theconversation at $7 aboutwhether to take a muchbigger position and poundthe table more withmanagement,wejustdidn'tdoit.—DonNoone,VNCapital

When management reallymakesusangry,weputthe

fileinadrawerforawhileand just don't do anything.We try not to sell justbecausewe'reangry.Ifyousellwhenyou'reangry,youcan imagine everybodyelse who sells that wayreaches the point ofexasperation at exactly thesame time. That's the kindofthingthatcreatesatleasta tradingbottom.Better tositonitforsometime,and

even if you still hatewhatthe company's doing,you're probably going toget a better chance to getout.

—DavidEinhorn,GreenlightCapital

We make a cleardistinction when sellingbetween compounders andcigar-butt stocks.Once thecigarbuttscomeback,you

know to get out becausethey're just going to godown again. With[something like] Johnson& Johnson, though, youmakeajudgmentcallwhenithitsintrinsicvalue,basedon your confidence in itsabilitytocompoundreturnsand what your alternativesare.

—ChristopherBrowne,Tweedy,BrowneCo.

We will sell when eventsmaterially threaten returnoncapital,thediscountrateimplicit in the stock getstoo low because thevaluationhasgoneup,orifI just have a much betteridea. But if a company isdoingwellandcontinuestoearnanattractivereturnoncapital, I'm in no hurry tosell.

—MurrayStahl,HorizonAssetManagement

If we're investing incompetitively advantagedbusinessesrunbyexcellentmanagement, we won't gotoowrongeven ifweholdcompanies trading aboveour estimate of intrinsicvalue from time to time.We've owned MorningstarsinceitsIPOandIcansee

itonedaybecominga$10billion business. Thefounder and CEO ownsmore than half thecompany and for 25 yearshas run it at every level tomaximize long-termreturns. Unless somethingfundamentally changes inthat situation, why wouldwesell?

—BrianBares,BaresCapital

Selling for me is rarelyabout pure valuation. Thereally good ones are toohard to find—you don'twant to part with themlightly. Life experiencetells me that if you sellsomething at $50 and tellyourself you'll get back inif it goes back down to$35, it will go down to$35.01 and the next timeyou have a serious look it

willbeat$300.Thathurts.—ChuckAkre,AkreCapital

Management

When somethingapproaches our pricetarget, we will reassess itcarefully and the decisiontoselloftenhasalottodowith the alternatives wehave. We think it's overlybold of us to try to timegoinginandoutofcash,so

we're apt to let somethingwe know well run if wedon'thavesomethingbetterto buy. Overall, I'd say inmy career I've sold tooearly many more timesthanI'vesoldtoolate.—CandaceWeir,Paradigm

Capital

Based on our research,investorswho sellwinnersand hold losers because

they expect the losers tooutperform the winners inthe future are, on average,mistaken.

—TerenceOdean,UniversityofCalifornia,Berkeley

Oncewetakeownershipofan idea—whether it'srelated topoliticsorsportsor investing—a lot ofchanges take place. Weprobably fall in love with

the idea more than weshould. We value it formore than it's worth. Andquite often, we havetrouble letting go of itbecausewe can't stand theidea of its loss. What areyouleftwiththen?Arigidand unyielding ideologythat can be quitedetrimental to clearthought.

—DanAriely,Duke

University

Some of our biggestmistakes have been incompanies on which weinitially made a lot ofmoney, but then got soenamoredwiththebusinessthatwedidn'trealizewhenit stopped being relativelyspecial. Not only did wenot sell when we shouldhave,weboughtmoreasit

startedtodecline.Youstartto believe advantagedcompaniesshouldstay thatway forever, but thedynamics ofmarkets oftenworkagainstthatandweasinvestors miss that at ourperil.What's important is to tryto constantly reassessinvestments as if you'relookingatthemforthefirsttime. That's not always

easy, but we find it helpskeep us from falling intothe trap of assuming keyassumptions are intactwhentheyreallyaren't.—PaulTanico,CastleRock

Management

Given the importance weoftenputonmanagement'sability to fix problems, it'sinevitablethatfromtimetotime we'll fall in love too

easily and make excusesfor those in charge whenthe company continues todo poorly. In these cases,my patienceworks againstme and we tend to ride astock down until I getdisgustedandsellit.—PrestonAthey,T.Rowe

Price

SALEPROCESSGiven the many potentialpitfalls that attend the sellingprocess,savvyinvestorsoftenimplementguidelinesorrulesmeant to limit those pitfalls'frequency and severity.Forewarnedisforearmed.

***

As our positions have

gottenlarger,weoftenfindourselves in situationswhere we can't trade outpositions quickly. Therehave been caseswhereweown, say, one millionshares and we think wewant to sell, but we canonly sell 25,000 sharesrightaway.Youcouldsay,“Why bother, it's only25,000 shares?” But ourfeeling is that's silly—it

might only help solve 2.5percentoftheproblem,butthe problem is now 2.5percentsmallerthanitwas.We also find that as youbegin to exit a position,sometimes the stomachtellsyouwhetheryouwantto keep going, accelerate,or whether it isn't reallynecessary.

—DavidEinhorn,GreenlightCapital

When we worked forBoone Pickens, he taughtus that themostsuccessfulwildcat oilmen were notthe ones who hit the mostgushers, but the ones whoknew when to plug a dryhole. I think we'redisciplined about ignoringsunk costs. We mark ourinvestments to marketevery day and say, “Okay,

we bought this at $25 andit's now at $12,what doesthe upside look like withthis new investment at$12?” If it meets ourtargets,we'llstillownit.Ifit doesn't, we'll get out.People are afraid to admittoclientsthatsomethingisa bust, but we're prettygood at just taking ourlumpsandmovingon.

—RalphWhitworth,

RelationalInvestors

Wegooutofourwaywithourpositionsnottolookatthe original pricewe paid.Allofour summarysheetshave intrinsic value andclosing price—if youwanted to know the pricepaidyou'dhave togo lookit up. Anchoring on yourcost—I know fromexperience—can often

cause you to want to takesome money off the tableandyouendupselling tooearly.On theother side, ifyou're underwater thetendency is to want to getsomeofitbackfirstbeforeselling. But if it's amistake, obviously, it'sbettertodealwithitearlierratherthanlater.

—BryanJacoboski,AbingdonCapital

Themarket encourages allkinds of anchoring. Theprice at which you boughta stock is very vivid inyour mind, but in realityyou'dbemuchbetteroff ifimmediately after thepurchase you forgot theprice you paid. We alsoascribe importance to 52-week highs and lows, butwhythat?Itwouldmakeas

much sense to look at thehighs and lows over 70weeks,or40weeks.

—DanAriely,DukeUniversity

One lesson learned afterenduring a few too manyround trips is to takemoreofaninternalrateofreturn(IRR)focusonwhentosell—what is the returnpotential from today, not

“I'm holding this until itreaches my target price of$X.”We'll still ride thingsupanddown,but it's beenless frequent since westarting thinking more interms of today's IRR.Whenwenolongerbelievesomethingcanmakeus50percent over the next twoyears,we start pickingourspotstosell.—RobertLietzow,Lakeway

Capital

Weconstantlyevaluate thekey investment-caseelements for each of ourholdings and prepare anexceptionreporteachweekthat flags any number ofissues.Theseincludewhenthere are material changesin the remaining upside toour target price, whenearnings estimates are

revised downward, whenquestionshavearisenaboutany existing catalysts,when new risks appear, orwhen the stock has beensignificantlyunderperforming. Weusually have a limitednumber of reasons forowningastock,soifanyofthose reasons change, wewant to recognize thatearlyandmoveon.

—JerrySenser,InstitutionalCapitalLLC

One thing about ourprocessthatIbelievehelpsuswhenitcomestosellingis that we lay out specificmilestones in writing thatwe're counting on tosupport our thesis.We tryto be as specific aspossible: inventory turnsareexpectedtoimproveby

this much by the end of2010, or gross marginsshould increase from 82percent to 87 percentwithin twoyears.Trackingreality against thesemilestoneskeepsyou frombeing in denial whensomething isn't going theright way, and makescuttingitlooseeasier.—MarikoGordon,Daruma

CapitalManagement

There can be emotionalaspects to all theseinvestments, so there's arealbenefittohavingmorethan one person makingbig decisions. Our rule isthat our investmentcommittee has to beunanimous in order to buysomething, but if any oneof the threeofuswants tosell, we sell it. That way

there's never anything intheportfolio thatwe'renotunanimouson.

—RalphWhitworth,RelationalInvestors

We have three people inchargeof theportfolioandwe require unanimity on astock in order to buy. Butit's majority rules onselling.The fact is that it'svery hard to sell one of

yourideas,especiallywhenit'sworking beautifully. Inthose cases, it's often beenhelpful to have the twomore rational partners beable to overrule the mostenthusiasticone.

—ChristopherGrisanti,Grisanti,Brown&Partners

We have formed, for lackof a better word, acommittee, to which any

analyst or portfoliomanager can call formoreimmediate action on aholding than is currentlybeing taken. If thecommitteebymajorityvotedecides a stock should besold,thatdecision,ifI'mintheminority, overridesmeas chairman and chiefinvestmentofficer.Iagreedto that because no oneposition should ever be

overly disruptive, andbecause sometimes youneedamechanismtocheckyouwhenyou'redigginginyour heels. At some pointin our careers, because ofbull markets, we can starttothinkwe'regeniuses.I'mold enough now that I'mwelloverthat.

—JamesShircliff,RiverRoadAssetManagement

PARTFour

OfSoundMind

CHAPTER12

OfSoundMind

Value investors have beeneagerstudentsof—andactivecontributors to—theincreasingly popular field ofbehavioral finance, which

draws from both psychologyandeconomicsinanefforttounderstand the economicdecisions human beingsmake.Thesearenotthefullyrational decisions thatefficient-markets enthusiastsassume, but the messieractual decisions peoplemakethatimpactmarketpricesandare driven by a variety ofsocial, cognitive, andemotional factors.Behavioral

finance looks to understandand explain investors' naturaland evolutionarily supportedtendencies toward—to namea few—overconfidence,sticking with the herd,panicking in the face oftrouble,disliking lossesmorethantheylikegains,fallinginlove with what they own,overweighting more recentinformation, and craving thebigscore.

Of course it's one thing tounderstandhowhumannaturecan conspire against rationalinvestment decision-making,and quite another to keep itfrom happening to you. AsWarren Buffett puts it:“Investing is not a gamewhere the 160-IQ guy beatsthe guy with the 130 IQ.Rationality is essential whenothers are making decisionsbased on short-term greed or

fear.Thatiswhenthemoneyismade.”Infact,manyofthestrategies, processes, anddisciplines articulatedthroughout this book aremeant tohelperadicate thoseirrational and painful “Whatwas I thinking?” types ofmistakes.Beyond more concrete

elements of strategy andtactics, the best investorsoften also emphasize the

importance of mindset totheir ultimate success. Whatarecommonelementsoftheirmindset?They'recompetitive.They're contrarian. Theybalance self-confidence withhumility. They're inherentlycurious. They're constantlylearning. While such traitsmay be more innate thanlearnedandmoredifficultfortheoutsideobservertoassess,they'reextremelyimportantin

distinguishing the investorswho havewhat it takes fromthosewhodon't.

COMPETITIVESPIRIT

Over a total of 38 years as aDivision I college basketballcoach, the lateNormStewartamassed 728 wins, most ofthose at his alma mater, the

University of Missouri.Knownasa tireless recruiter,the first question he wouldoften pose to aspiring highschool players was a simpleone, “Do you love to play?”All of course said yes, buthowtheyansweredwasoftentelling.Stewart explained that he

askedoutofaconvictionthatthosewhodidn'ttrulylovetoplay would never have the

dedication and drivenecessary to compete at thehighest levels, regardless ofhow talented theywere.Thisuniversal insight certainlyholds true for investors. Iftheir love of the game isn'tevident, it calls into questiontheirabilitytoplayitwell.

***

What other business is as

intellectuallystimulatingasthis? Other than maybeintelligence gathering fornational security, I don'tknow of one. If you likewinning, there's ascorecard.Ifyoulikegametheory and trying tologically deduce what'slikely to happen, this is agreat application for thatand it's very gratifying tobeprovencorrect.

—KyleBass,HaymanAdvisors

I'd use the analogy of aprofessional baseballplayer. If you think aboutwhat would motivatesomeone to put so muchtimeandenergyintodoingsomething as repetitive asplayingbaseball,youcouldprobably boil it down tothree things. It could be

theyjustliketheprocessofplaying the game, becausethey'regoodatitandgetalot of personal validationout of it. It could bebecause they're verycompetitiveandwanttobeon the winning team andwant to succeed in anobjectively measured way.Or it could be they're justin it for the money, tobecome accomplished in

the field, and be wellcompensated for theirtalent.Forme,Ienjoytheprocessof trying to figure outwhat's going on in theworld and think investingis about as good as it getsin business in terms ofintellectual stimulation.Second, I'm verycompetitive, but in thepositive sense of trying to

improve and alwaysmeasuring how well I'mdoingthat.Thethirdpart—making money—is notrequired, but convenientlyandpleasantlyisaresultofbeinggoodatthefirsttwo.

JohnBurbank,PassportCapital

I love the challenge ofinvesting—for acompetitive person there's

nothing better than whenyou absolutely nailsomething thatnooneelsewasgetting.It'salsoagreatbusiness for people whoare intellectually curious.I've followed the batteryindustryfor20years,butIlearned several new thingsfrom my conversationearlier today with thepresident of Exide. It's anewgameeveryday—why

wouldIdoanythingelse?—CandaceWeir,Paradigm

Capital

WhenIstartedthebusinessIwasmotivatedbybeingareal competitor. I love towin, and the idea of beingin an industry where youkeep score and knowwhereyoustandeverydaywashighlyappealingtome—and, in the end, seemed

inherentlyfair.—JohnRogers,Ariel

Investments

Somany things impact themarkets, from history, topolitics, topopularculture,and those elements changeday-to-day. The challengeofworkingthroughallthatis consistently exciting–and you can see yourresultsonareal-timebasis.

—TomPerkins,PerkinsInvestmentManagement

I love learning aboutbusinesses and theintellectual challenge ofinvesting. I'm alsointenselycompetitiveaboutgenerating great returns. Ilove that you get ascorecardat theendof theday and I love to win.Winning to me is looking

back after 30 years andsaying,“Wow,lookat thattrack record—these guysdid it well and they did itright.”That's not to say I'mparticularly fond of thosedayswhenyoufeellikeanidiot and your numbersmake you look like anidiot.But as a competitiveperson, I wouldn't have itanyotherway.

—RickySandler,EminenceCapital

Figuring things out andsolving the puzzles is stillthe most exciting part. It'svery fun to think weunderstand something thatit appears most peopleviewdifferently.Thenyougettofindoutwho'sright.

—DavidEinhorn,GreenlightCapital

There's a big differencebetween loving towinandhatingtolose,whichhasalot to do with one'sapproach to risk. Someonewholovestowiniswillingto take a lot of risksbecause the euphoria ofwinningoutweighsthebadoutcomes. If you hate tolose, though, any badoutcome is not acceptable.

To be a great investor, Ithink you really have tohatetolose.—JonJacobson,Highfields

Capital

Investingisafungameandyouwanttofindthepeoplewho are just smitten withit. I wouldn't say for thebestonesthatit'saboutthemoney—itmayfalloff theback of the truck, but it's

notatallwhytheyplaythegame.—JoelGreenblatt,Gotham

Capital

People who are in a goodmood aremore inclined totry learning new skills, tosee things in a broadercontext,tothinkofcreativesolutions to problems, towork well with otherpeople, and to persist

insteadofgivingup.Ifyouwere writing a recipe forhowtomakemoremoney,those are among the firstingredients you wouldinclude.JasonZweig,Author,Your

MoneyandYourBrain

I've always consideredmyself privileged to livethe life I do, making aliving doing something I

enjoyverymuch.—FranciscoGarcia

Parames,BestinverAssetManagement

[My level ofcompetitiveness] wasimportant, yes. I alwayssaid that when TigerManagement was going,that our employees wouldhave taken a 15 to 20percent pay cut if that

would have somehowguaranteedustobenumberone. That definitelymellowsoutovertime,butI still like winning, whichisonereasonI'vedonethissamethingforalongtime.You can get too muchcompetitiveness, though,andthenyou'recompetitivewithyoursubordinatesandyour superiors and you'rekindofahorse'sass.

—JulianRobertson,TigerManagement

I did worry when I shutdownmymainhedgefundin 2000 that I didn't wantmy tombstone to say, “Hediedgettingaquoteontheyen”—as if I had nothingbetter to do in the middleofthenightthanthat.—JulianRobertson,Tiger

Management

INDEPENDENTTHOUGHT

One of our favorite quoteswith clear application toinvesting is fromSpanish/Americanphilosopher GeorgeSantayana, who wrote,“Skepticismisthechastityofthe intellect, and it is

shameful to surrender it toosoon or to the first comer.”Thebestinvestorsarewithoutquestionaskepticallot,quickto question the status quo orconventional wisdom, andslow to build the convictionnecessarytogoagainsteither.

***

If you subscribe to thethesis—as I do—that the

greatest amount of moneyismade from having greatconfidence in contrarianpositions,Ithinkyou'dfindthe people who arecomfortable taking thesepositionsdon'ttendtofitinwiththemainstream.Going against the grain isclearly not for everyone—and it doesn't tend to helpyour social life—but tomake the really large

money in investing, youhave to have the guts tomake the bets thateveryone else is afraid tomake.—CarloCannell,Cannell

Capital

Figuring out what youshould do as an investorisn't thatdifficult.YoucanreadallWarrenBuffetthaswritten or said over the

years, for example, andbasicallyemulate that.Thehard part is to have thediscipline and the patiencetoexecute.The bottom line is that tobe a good investor youneed toonlybuywhen it'semotionally the hardest,only sell when it'semotionally the hardest,anddoprettymuchnothingwhile waiting for market

extremes to offeropportunities to do either.That's all incredibly hard.You often don't knowyou've been right untilmonthsorevenyearslater.Most people need moreimmediate gratificationthan value investingtypicallyoffersup.—SteveLeonard,Pacifica

Capital

One of the keys to thisbusiness is havingconviction based on yourwork that you're right andthe rest of the world iswrong. If you don't havethat confidence, you'llnever buy anythingbecause there's alwayssomething that can gowrong. Everyone thoughttheideaofbuyingstockinGeneralGrowth Properties

right before it wentbankrupt in the middle ofthe financial crisiswas thestupidest idea they've everheard of, and plenty ofpeople said so. The stockwas at 35 cents a share,down from $63, and webought 25% of thecompany. You can't getmuchmorecontrarian thanthat.

—WilliamAckman,Pershing

SquareCapitalManagement

Acknowledge thecomplexity of the worldand resist the impressionthat you easily understandit. People are too quick toaccept conventionalwisdom, because it soundsbasically true and it tendsto be reinforced by boththeir peers and opinionleaders, many of whom

have never looked atwhether the facts supportthe receivedwisdom. It's abasicfactoflifethatmanythings “everybody knows”turnouttobewrong.How can an investor usethat? The uncertaintyinvolved in predictingcomplex events wouldargue for some level ofdiversification and agreater focus on hedging.

At the same time, the factthat people tend towardoverconfidence and followconventional wisdomshouldprovideopportunityfor those taking contrarianpositions against that. Thetrick, of course, is to haveconcrete justification forwhythecrowdiswrong.

—RobertShiller,YaleUniversity

As value investors, we'requiteusedtobeingshortonsocial acceptance atdifferent periods of time.It's always important tokeep inmind thatourownbalance and equanimityshould not be based onexternalperceptions.—MatthewMcLennan,First

EagleFunds

You learn quickly in this

business that you're notgoing to looksmartall thetime, which inevitablybrings criticism. Wealwaysremindourselvesofthat great Jean-MarieEveillard quote, “I'd ratherlose clients than loseclients'money.”

—DavidSamra,ArtisanPartners

As it turns out, one of the

key lessons of investing isthat the best successes areborn during times whenyou're not awinner. Iwasdown2percent in1999 [ayear the S&P 500 rose 21percent] and it wasprobably my best year.Nothing worked that year,butresistingthetemptationto chase ideas I didn'tbelieve in left mepositioned for someofmy

bestyearsthereafter.It'salongrace,notasprint—if you rely on themarket's validation all thetime, not only are yougoing to be verydisappointed, you're alsogoing to make a lot ofmistakes.—ThomasRusso,Gardner

Russo&Gardner

I think our being based in

Columbus, Ohio makes iteasier for us to beindependent thinkers,which is so important tosuccessfulinvesting.Whenwe leave the office, we'renot very likely to beinfluenced by what otherinvestors are talking aboutbecause there aren't manyout there. I honestlybelieve that's an advantage—there'snoherdmentality

becausethere'snoherd.—RicDillon,DiamondHill

Investments

One reason our resultshavebeenrelativelystrongis because our mistakeshave been in smallerpositionsandoursuccessesin largerones. I attributealot of that to ourpartnership: I tend to be aglass-half-full person,

while Ed [co-managerEdward Studzinski]behaves more as if theglass isbrokenandempty.Hehelps restrainmymoreaggressiveinstinctsandhisnaturalskepticismhasbeenincrediblyvaluable.—ClydeMcGregor,Harris

Associates

Wetendtobeconservativeanddeliberate,whichoften

keeps us from buying asmuch as we should asquickly as we should.Having said that, I thinkbeing skeptical and waryaboutallthethingsthatcangowrongisagoodwaytoavoid making a lot ofmistakes. Anyway, it's mynature to be that way andevenifIcouldchangeit, Iwouldn'treallywantto.

—WayneCooperman,Cobalt

Capital

An early mentor of mine,T. Edmund Beck, startedout during the Depressionandused toalwayssaywewere in the rejectionbusiness—that we're paidtobecynicalandthatabigpartofsuccessininvestingisknowinghow to sayno.He never dwelled onmissed opportunities

because something else—even the same thing lateron—would always comealong.I'mabigbelieverinthatapproach.

—SpencerDavidson,GeneralAmericanInvestors

PERPETUALSTUDENT

Unlike basketball, investingis a game at which youshould become moreproficient with the longpassage of time. This canonly happen, however, withthe mindset of a perpetualstudent, as conversant inhistorical precedent as youareinfuturepossibility.

***

The nice thing aboutinvesting is that ifyoucanprotect your physical andmental health you shouldonly get better at it overtime. Experience improvesyour ability to recognizepatterns and to exercisejudgment in difficultsituations, of which therehave certainly been noshortageinrecentyears.

—DavidNierenberg,D3

FamilyFunds

I enjoy being a perpetualstudent, and working withgood people. I'll probablybe here until I go noncomposmentis.I'lllosemymarbles, then they have arighttogetridofme.—MartinWhitman,Third

AvenueManagement

I generally find the best

investorsareveryopenandhave almost a child-likecuriosity about howeverything works. Theydon'tcometothetablewithpreconceived notions.Americans, in fact, aremore likely to have thiskind of attitude thanEuropeans or Asians. It'smuch harder to learn newthingswhenyou thinkyoualreadyknoweverything.

—OliverKratz,DeutscheAssetManagement

Soonaftergraduatingfromcollege I went throughsometestingattheJohnsonO'Conner Institute andfound I have twoprominent aptitudes,inductive reasoning andwhat they call ideaphoria.These don't often gotogether—one involves a

logical progression fromspecific observations toarriving at broadergeneralizations, while theother isanunusuallyhigh-frequency flow of ideas,many of which areunfocused and non-linear.You don't want muchideaphoria if you're anaccountant, but those twoaptitudes combined seemto be conducive to

investing.—CarloCannell,Cannell

Capital

Fortunemagazine recentlyhad an interesting articleabout how successfulpeopleworkandoneofthepeopletheyspokewithwasWyntonMarsalis,thegreatjazztrumpeter.Hesaidthatif you want to be able tofind agroove,youhave to

practice, practice, practice.You've got to know thescales and you've got toknow the basics if youwanttoimprovise.—MitchellJulis,Canyon

Capital

Things trade at differentvalues from their trueworth because humanbeings look at them incertain ways in certain

circumstances.Thosewaysand circumstances canchange, so the tools youuse and your thoughtprocesses have to evolve.The exact same thingdoesn't always work overand over again—themarket'stoosmartforthat.—LisaRapuano,Matador

CapitalManagement

One of the things about

which we're institutionallymost proud is havingoutperformed theS&P500in every rolling 10-yearperiod since 1969. Thatmeans we've had to beopentochangeandnotjustdo exactly what hadworkedfortheprevious10years, because the bestfundsinany10-yearperiodare always the fundsoptimized to that period—

in healthcare, say, orcommodities ortechnology. The biggestriskweworry about is notadapting to the times andparticipating in change.That'swhatkeepsusonourtoes.—ChristopherDavis,Davis

Advisors

I'magolfer,andoneofthethingsIloveaboutitisthat

you can play the samecourse 20 days in a rowand every day will bedifferent. It just rained, orit's hot, or the wind isblowing from a differentdirection. You have toadjustall the timefora lotof changing factors,whichis also true of investing.People who really love toinvestwouldn'thaveitanyotherway.

—RobertLeitzow,LakewayCapital

I'vehadthegoodfortuneofbeing around smartinvestors my whole life,including my father.Because of that, I'm surethingsmaybe clicked a bitmore quickly when Istartedgettinginterestedininvesting. But I'd have tosay learning from what

works and what doesn't ishow you really become abetter investor. In the end,the market is the bestteacher.

—WayneCooperman,CobaltCapital

You have to have youreyes open all the time anddevoteyourself, asCharlieMunger says, to lifetimelearning. As I like to say,

in life as well as inbusinessI'mluckyifIhavelearned something neweveryday—andI'mdoublylucky if it didn't cost toomuchtodoso.—ChuckAkre,AkreCapital

Management

Will Rogers once said,“Good judgment comesfrom experience, and a lotof that comes from bad

judgment.” I add to mybase of experience everyday.

—DonaldYacktman,YacktmanAssetManagement

One great thing aboutinvestingisthat,unlikethepitcher who starts to losehis fastball in hismid-30s,my fastball as an investorshould keep getting better.I'moneof thoseguyswho

says “Thank God it'sMonday,” because this isasmuchmyhobbyas it ishowImakealiving.Ifyoudon't feel that way, youshould probably be doingsomethingelse.

—AndrewPilara,RSInvestments

TOERRIS

HUMANCritical to the learningprocess is a rigorousassessment of how and whypastmistakesweremade.Noportfolio manager wouldadmit that he or she makeslittle effort to learn frommistakes, but we have oftenfound in this regard thatwords often don't matchdeeds. Money managers

expect executives of thecompanieswhosestocks theyown to be open and honestaboutmistakes,tobequicktocorrect them, and to bediligentintryingtomakesurethey don't happen again.Investors should expectnothing less from those towhom they have entrustedtheirmoney.

***

We have a deliberateprocess to at least once ayear sit down and look atthemistakeswe'vemade.Ifyou do it too often youprobably don't achievemuch at all becauseyou'reconstantly looking overthingsbeforethemistakeisactuallyclear.We try to focus more onprocess errors we cancontrol than just on what

went wrong in terms ofoutcomes. It's alsoimportanttomakesureyoulearntherightlessons—it'svery easy to learn aspecific lesson that isn'tvery helpful because youwon't find yourself inexactly that specificsituation again. You wantto learn the most generallesson you can from themistakesyoumake.

—JamesMontier,GMO

I'm playing golf in afoursome that includessomeone who's a terriblegolfer. He's teeing off andtakes a big swing andmisses, digging up a divotoff to the side of the ballandtee.Heregroups,takesadeepbreathandthendoestheexactsamethingagain,digging an even bigger

divotinthesameplace.Helooks at his caddy, whowalks over and takes theballandteeandputsitintothe divot hole and says,“Trythis.”I thought that washilarious, but it gets to theimportance of workinghardnottorepeatmistakes.We set up our process sothat we're formallyaddressing as many of the

answers as possible to thequestion, “If it turns outtwoyears fromnowwe'vemade a mistake, whywould that be?” Itobviouslydoesn'teliminateall mistakes, but for aconcentratedmanager,ifasaresultyoumakeonlytwomaterial mistakes per yearrather than four, that canmake a huge difference inyourperformance.

—JeffreyBronchick,CoveStreetCapital

Wedopost-mortemsonallof our positions—as wellas regularposition reviewsof what we own—toconstantly assess what wegot right and what wedidn't. That mattersbecause we want to learnfrom mistakes even if theinvestmentoutcometurned

out fine because we werelucky. Luck is not asustainable way to makemoney as an investor.Avoiding mistakes thatyou'vemadebeforeis.One primary virtue ofexperience is that you'reconstantly learning theways in which things cango wrong. If youinternalize that into yourprocess, you're identifying

moreofwhatcangowrongand assessing how thatchanges your investmentcase. Minimizing thenumber of times you getblindsidedisaveryworthygoal.

—ShawnKravetz,EsplanadeCapital

Some investors don't wantto dwell on theirmistakes,but we closely track over

rolling five-year periodshow all of our buy/selldecisions are working out.In the same way we don'tbeat ourselves up formissing something thattruly couldn't have beenseen in advance, we don'twanttotakecomfortwhenan investment works outbut our analysis waswrong.—RicDillon,DiamondHill

Investments

Mistakes of judgment arethe toughest to learn from,because each one isdifferent. They tend to bein companies in whichthere has been gradualdegradation—hard to pickupfromtheoutside—eitherin the competitivelandscapeor thecultureofthecompany.Becauseeach

caseisdifferent,it'shardtodraw general lessons andyoudon'twant tolearnthewrong one. There were alot of ways to look at themistake of buying AT&Twhen Michael Armstrongtook over—successfulexecutive from outside theindustry—that would havepreventedyoufrombuyingIBM when Lou Gerstnercamein.

—ChristopherDavis,DavisAdvisors

I did a simulation of howoftenatopmoneymanagerearning20percentperyearwith a 15 percent standarddeviation would losemoney over short timeperiods. A 20 percentreturn would be aboutdouble the market's long-term average return and a

15 percent standarddeviation would be lowerthan historic marketvolatility. So this issomeonewho's doing verywell.Buton anygivenday, thishypothetical managerwould lose money almosthalf the time. He'd losemoneyin35percentofthemonths and in an averageof one quarter per year.

Once every 10 years he'dhavealosingyear.I think it's healthy forinvestors to remember thateven great long-termrecordsarefullofplentyofdownmonthsandquarters.Remembering that is hardto do sometimes as timehorizons in the industryhavegottensoshort.

—BryanJacoboski,AbingdonCapital

My time playing golftaught me some usefullessons as an investor. Forone,youmakemistakesallthe time and you try tolearn from them, but it'salwaysaboutthenextshot.It's about properlypreparing and thenexecuting to the best ofyour ability. That's anexcellent mindset for an

investortohave.—PatEnglish,Fiduciary

Management,Inc.

I've been doing this formore than 25 years andhave learned never to takemistakes lightly. What'smost important for us,though, is to stay focusedon the discipline of onlyinvesting in companieswith the characteristics of

leaders, laggards, andinnovators that we've seenworkasinvestmentsoveralong period of time. Thatdiscipline keeps usgrounded, and helps uskeep mistakes inperspective. Otherwise,you can drive yourselfcrazy.

—PhilipTasho,TAMROCapital

Don't be paralyzed by thefear of making a mistake.Understand that the bestopportunities usually carrymore perceived risks, anddistinguish carefullybetween the risks thatmattermost and those youcan livewith.As longas Iknow the risks I'm takingand the stock prices arecompensating me to takethose risks, I can livewith

that.—BrianGaines,Springhouse

Capital

You want to makemistakesonceinawhile.Ifyounevermakeamistake,you're being tooconservative and missingprofit opportunities youshouldn't.

—EdWachenheim,GreenhavenAssociates

BEEVERSOHUMBLE

There's no questionconfidenceinone'sabilitiesiscritical to successfulinvesting. To commit one'sown and others' hard-earnedcapital requires conviction,and conviction requiresconfidence. But as with fine

scotchorpepperonipizza,toomuch of a good thing cancause problems. It can attimes be difficult to see, butquite often even the mostaccomplished moneymanagers exhibit a level ofhumilityabouttheircraftthat,far from a sign ofweakness,isoftenaprerequisitetolong-termsuccess.

***

Onecanseetheinvestmentuniverse as full ofcertainties, or one can seeit as replete withprobabilities. Those whoreflect and hesitate makefar less in a bull market,but those who neverquestion themselves getobliterated when the bearmarketcomes.Ininvesting,certainty can be a seriousproblem, because it causes

one not to reassess flawedconclusions. Nobody canknowall thefacts.Instead,onemust relyonshredsofevidence, kernels of truth,and what one suspects tobetruebutcannotprove.

—SethKlarman,TheBaupostGroup

You obviously need todevelop strong opinionsand to have the conviction

to stick with them whenyou believe you're right,even when everybody elsemay think you're an idiot.ButwhereI'veseenegogetinthewayisbynotalwaysbeingopentoquestionandto input that could changeyour mind. If you can'tever admit you're wrong,you'remore likely to hangon to your losers and sellyourwinners,which isnot

arecipeforsuccess.—KyleBass,Hayman

Advisors

It is much harderpsychologically to beunsure than to be sure;certaintybuildsconfidence,and confidence reinforcescertainty.Yetbeingoverlycertain in an uncertain,protean, and ultimatelyunknowable world is

hazardousforinvestors.Tobe sure,uncertaintybreedsdoubt, which can beparalyzing.Butuncertaintyalsomotivatesdiligence,asone pursues theunattainable goal ofeliminating all doubt.Unlike premature or falsecertainty, which inducesflawed analysis and failedjudgments, a healthyuncertaintydrivesthequest

forjustifiableconviction.—SethKlarman,TheBaupost

Group

When I worked for NewYork City, I met an old-time surveyor in mydepartment who had gonebroke betting on horses.The first timehehadgonetotheracetrackhedecidedto bet on a horse namedSurveyor, and the worst

possible thing happened—the horse won. This guyfigured it was easymoneyandover thenext20yearshe proceeded to lose justabouteverythinghehad.People forget it all thetime, but it's important asinvestors to differentiatebetween luck and skill.Overshortperiodsoftime,youcandothewrongthingand make a lot of money

and do the right thing andlooklikeanidiot.Wetrytostick to what we do welland not get too caught upin what's working at anygivenmoment. In the longrun, that sort of disciplinewill keep you fromblowing up. It's a lesson alotofsmarterguysthanushaveobviouslyforgotten.—PhilGoldstein,Bulldog

Investors

Whatever the environmentwe try to remain humble,which means maintainingour discipline of buyingonly great companies withstrongbalancesheetswhenthey're priced with a widemarginof safety. It'swhenyou'renothumblethatyouend up doing things thatwillmakeyouhumble.—FrançoisRochon,Giverny

Capital

Over a long career youlearnacertainhumilityandare quicker to attributesuccess to luck rather thanyourownbrilliance.Ithinkthat makes you a betterinvestor, because you'reless apt to make the bigmistake and you'reprobably quicker tocapitalize on good fortune

whenitshinesuponyou.—SpencerDavidson,General

AmericanInvestors

Weknowourinvestorsaregoing toworry about theirportfolios over short timeperiods, but we explain tothemthatwewon't.Wetryto look at short-termmarket gyrations asnothing more thanopportunities to smartly

enter or exit a position,subject to valuation andfundamentals. While Ihopethatkeepsusrational,I wouldn't say I'm alwayscalm. My style at heart isout of the pages of AndyGrove's book, Only theParanoid Survive. Whenour stocks are goingdownI'm driving everyone nutsto see what we might bemissing. When our stocks

are going up I'm not anymore comfortable. I'mworried whether they'regoing up for the rightreasons and how it mightall come crashing down. Isay we invest paranoidsomewhattongue-in-cheek,because we couldn't takethesizablepositionswedoifweweretrulyparanoid.Ijust worry about it everystepoftheway.

—StevenRomick,FirstPacificAdvisors

I've seen too manybusinesses—investmentfirms and others—run intothe ground by impressivepeople who start to thinkthey're smarter thaneveryoneelse.That'swhenbig mistakes get made.There are enough ways toscrew up in this business

without bringing it onyourselfbecauseofego.—BarryRosenstein,JANA

Partners

Attempting to achieve asuperior long-term recordbystringing togethera runof top-decile years isunlikely to succeed.Rather, striving to do alittle better than averageevery year, and through

discipline to have highlysuperior relative results inbadtimes,is:(1)lesslikelyto produce extremevolatility; (2) less likely toproducehuge losseswhichcan't be recouped, and (3)most importantly, morelikelytowork.—HowardMarks,Oaktree

Capital

This is the world's best

businesswhenyou'redoingwell and somewhat less sowhen everybody's yellingat you because you'retrailing the market. It'simportantnottogetcarriedaway with yourself whentimes are good, and to beabletoadmityourmistakesandmove onwhen they'renot so good. If you areintellectually honest—andnotafraidtobevisiblyand

sometimes painfullyjudged by your peers—investing is not work, it'sfun.—JeffreyBronchick,Reed,

Conner&Birdwell

TheFinalWord

Value investors have a longtradition of sharing whatthey've learned, which wehope to have honored byassembling the insightsmanyof the best money managersin the business have sharedwith us over the years. Wehavegone togreat lengths to

make sure that their words,notours,havetakenthemostprominence. Our greatestwish is thatyou'll find in thewisdom they've impartedinsights thatwillmakeyouabetter investor tomorrow, ayearfromnow,andtenyearsfrom now. To that end, it'sonlyfittingthatweclosewiththequoteweusedto leadoffour Editors' Letter in theinaugural issue of Value

InvestorInsight,fromWarrenBuffett's long-time partner—andabrilliant investor inhisownright—CharlieMunger:IfWarrenBuffetthadneverlearnedanythingnewaftergraduating fromColumbiaBusinessSchool,BerkshireHathawaywouldbeapaleshadow of its present self.Warrenwould have gottenrich—whathelearnedfromBen Graham at Columbia

was enough to makeanybody rich. But hewouldn't have the kind ofenterprise Berkshire is ifhe hadn't kept learning. Idon't know anyone who[became a great investor]with great rapidity. Thegameistokeeplearning...ifyoudon'tkeeplearning,other people will pass youby.Here's wishing you a

lifetime of investing pleasureandprosperity...atthefrontofthepack.

AbouttheAuthors

JohnHeins is the cofounderand President of ValueInvestor Media, Inc., andEditor-in-Chief of ValueInvestor Insight andSuperInvestor Insight. He isresponsible for day-to-day

operations of Value InvestorMedia, a media companyfounded in 2004 to provideinvesting ideasand insight tosophisticatedprofessionalandindividualinvestors.Previously, Mr. Heins wasPresident and ChiefExecutive Officer of Gruner+ Jahr USA Publishing,Bertelsmann AG's U.S.magazine subsidiary, SeniorVice President and General

ManagerofAmericaOnline'sPersonal Finance business,andareporterandstaffwriterfor Forbes magazine. Hegraduated magna cum laudefrom the University ofPennsylvania's WhartonSchool with a bachelor'sdegreeinEconomicsandalsoholdsanMBAfromStanfordUniversity's Graduate SchoolofBusiness.Whitney Tilson is the

cofounder of hedge fundsKaseCapital,T2PartnersandTilson Capital Partners, theTilson Mutual Funds, ValueInvestorMedia, Inc., and theValueInvestingCongress.Mr. Tilson coauthored thebook, More MortgageMeltdown: 6 Ways to Profitin These Bad Times, haswritten for Forbes, theFinancial Times,Kiplinger's,the Motley Fool, and

TheStreet.com, and was oneof the authors of PoorCharlie's Almanack, thedefinitive book on BerkshireHathaway Vice ChairmanCharlie Munger. He is aCNBC Contributor, wasfeaturedina200860Minutessegment about the housingcrisisthatwonanEmmy,wasoneoffiveinvestorsincludedin SmartMoney's 2006“Power 30,” and was named

by Institutional Investor in2007 as one of “20 RisingStars.”Mr. Tilson was a foundingmember of Teach forAmericaandtheInitiativeforaCompetitiveInnerCity,andwas a consultant at TheBostonConsultingGroup.Hereceived anMBAwith HighDistinction from theHarvardBusiness School andgraduated magna cum laude

fromHarvardCollegewith abachelor's degree inGovernment.

Index

AAbingdonCapitalAbramson,RandallAckman,WilliamActivismsituationsripeforstrategy,asa

Adams,Ellen

AdvisoryResearch,Inc.AgainsttheGodsAinslie,LeeAkre,ChuckAkreCapitalManagementAlFrankAssetManagementAlatusCapitalAlpert,RobertAlsin,ArneAlsinCapitalManagementAmarilloSlimAnalysis,Investment

cashflow,primacyofgeneralmodeling,financialriskvs.rewardvaluation

AquamarineFundArielInvestmentsAriely,DanArtisanPartnersAshton,ZekeAthey,PrestonAtlantic Investment

ManagementAtlasCapitalAtzil,LeeAvenirCorp.

BBares,BrianBaresCapitalBarish,BrianBass,KyleBaupostGroupBehavioralFinance

competitive spirit, of topinvestorsgeneralindependentthinkinglearning,importanceofhumility,importanceof

Berkowitz,BruceBerkshireHathawayBerler,MatthewBestinverAssetManagementBerstein,PeterBeyer,Timothy

Bingaman,ChrisBronchick,JeffreyBrownBrothersHarrimanBrown,ThomasBrowne,ChristopherBrowne,WillBubis,DanielBuckingham,JohnBuffett,WarrenBulldogInvestorsBurbank,JohnBuyingDiscipline

Byrne,Susan

CCabotResearchCambiarInvestorsCannell,CarloCannellCapitalCanyonCapitalCapitalization, Market. SeeCircleofCompetenceCardinalCapitalCash, use of. See Risk

ManagementCashFlow.SeeAnalysisCastleRockManagementCates,StaleyCatalysts.SeeResearchCausewayCapitalCentaurCapitalChanos,JamesCibelli,MarioCinnamond,EricCircleofCompetencegeneral

geographicalpreferenceindustrypreferencemarketcapitalization

Claar,GaryClarke,JamesClarkeBennittLLCCobaltCapitalColeman,CanonCollins,JimCooperman,LeonCooperman,WayneConcentration, Portfolio. See

PortfolioManagementCoveStreetCapitalCrichton,JamesCrist,StevenCurry,BoykinCyclicality, investingramifications

DDailyRacingFormDarumaCapitalManagementDavidson,Spencer

Davis,ChristopherDavisAdvisorsDefianceCapitaldeLardemelle,CharlesdeVaulx,CharlesDelafield,DennisDelafieldFundDenver,CaraDeutscheAssetManagementDeshpande,AbhayDiamondHillInvestmentsDiedrich,Joerg

Dillon,RicDiversification,Portfolio.SeePortfolioManagementDorfman,John72Downside protection. SeeResearchandSeeAnalysisD3FamilyFunds

EEagleCapitalEdelheit,AaronEfficiency,Market

Eigen,DavidEinhorn,DavidEinhorn,StevenEl-Erian,MohamedEminenceCapitalEnde,EricEnglish,PatErvolini,MichaelEsplanadeCapitalEveillard,Jean-Marie

F

FairfaxFinancialFairholmeCapitalFeinberg,KennethFeld,PeterFeltzin,BrianFeshbach,JosephFiduciaryManagement,Inc.Financial Analysis. SeeResearchandSeeAnalysisFirTreePartnersFirstEagleFundsFirstPacificAdvisors

FirstWilshireSecuritiesFisher,PhilFitzpatrick,C.T.Fooling Some of the PeopleAlloftheTimeForceCapitalManagementFournier,AlanFox,EugeneFPAFunds.See First PacificAdvisorsFrels,WilliamFries,William

GGabelli,MarioGaines,BrianGalbraith,SteveGAMCOInvestorsGarciaParames,FranciscoGardner,Russo&GardnerGayner,ThomasGeneralAmericanInvestorsGeographical Preference. SeeCircleofCompetenceGeorge,Whitney

Ghazi,KianGivernyCapitalGlenviewCapitalGMOGoddard,StephenGold, use of. See RiskManagementGolden,TuckerGoldenTree AssetManagementGoldstein,PhillipGordon,Mariko

GothamCapitalGraham,BenjaminGrantham,JeremyGreenblatt,JoelGreenhavenAssociatesGreenlightCapitalGrisanti,ChristopherGrisantiBrown&Partners

HHarrisAssociatesHartch,Timothy

Hawkins,MasonHawkshawCapitalHaymanAdvisorsHeartlandAdvisorsHedging. See RiskManagementHerro,DavidHighfieldsCapitalHood,ScottHorizonAssetManagementHorizon,TimeHorn,Bernard

HowtheMightyFallHummingbirdValueFund

IIdeaGenerationgeneralscreening,computersourcesspecialsituationsthematicturnaroundsuncertainty,insearchof

Industry Preference. SeeCircleofCompetenceInefficiencies,MarketInstitutionalCapitalLLCIntelligentInvestor,TheInternational Investing. SeeCircleofCompetenceInternationalValueAdvisersIntrepidCapitalInvescoIsaly,SamIvoryCapital

JJacoboski,BryanJacobson,JonJaffe,RobertJANAPartnersJensen,CurtisJoeFeshbachPartnersJones,AndrewJulis,Mitchell

K

Kaplan,JayKarsch,MichaelKarschCapitalKautz,JeffKeefe,PeterKetterer,SarahKhaner,LloydKhanerCapitalKieffer,JamesKirkpatrick,RobertKlarman,SethKleinschmidt,Robert

Kovitz,MitchellKovitzInvestmentGroupKratz,OliverKravetz,ShawnKrawez.BrianKynikosAssociates

LLahr,CharlesLakeviewInvestmentGroupLakewayCapitalLangerman,Peter

LeggMasonFundsLeonard,SteveLevy,AriLietzow,RobertLondonCompany,TheLynch,Peter

MMackall,CharlesMacnguyen,CurtisMacro vs. Micro. SeeResearch

Mairs&Power,Inc.Management,Assessment of.SeeResearchMaran,Edward.247MarathonPartnersMargin of Safety. See RiskManagementMark,MorrisMarkAssetManagementMarkelCorp.Market Capitalization. SeeCircleofCompetence

MarketEfficiencyMarketInefficienciesMarks,HowardMatadorCapitalManagementMauboussin,MichaelMaverickCapitalMcConnell,MichaelMcCreesh,KevinMcGregor,ClydeMcLennan,MatthewMcNeill,PatrickMetropolitanCapital

Miller,BillMistakes, learning from. SeeBehavioralFinanceMittleman,ChrisMittlemanBrothers,LLCModeling, Financial. SeeAnalysisMontier,JamesMorrow,SteveMullen,TimothyMunger,CharlieMurray,Win

Mushock,RonaldMutualSeriesFunds

NNasgovitz,WilliamNewSouthCapitalNierenberg,DavidNoone,DonNorthStarPartnersNorton,CharlesNussdorf,JedNygren,Bill19

OOaktreeCapitalO'Boyle,KevinOdean,TerenceOlstein,RobertOlsteinCapitalManagementOmegaAdvisorsOrbiMedAdvisorsO'Keefe,DanO'Shaughnessy,JamesO'Shaughnessy AssetManagement

Osterweis,JohnOsterweis CapitalManagement

PPabrai,MohnishPabraiFundsPacificaCapitalParadigmCapitalParenteau,FrancoisPassportCapitalPennantCapital

Perkins,TomPerkins InvestmentManagementPershing Square CapitalManagementPilara,AndrewPIMCOPolarisCapitalPoorCharlie'sAlmanackPortfolioManagementconcentration vs.diversification

correlations,monitoringofpositionsizingtradingturnover

PositionSizing.SeePortfolioManagementPostRoadCapitalPredictablyIrrationalPresidioFundPreston,ThomasAustinPrice,T.RowePrivateMarketValue

Process,importanceofPzena,RichardPzena InvestmentManagement

RRapuano,LisaReed,Conner&BirdwellRelationalInvestorsResearch,Investmentbusinessfirstcatalysts,importanceof

downsideprotectionfinancialstatementanalysismacrovs.micromanagement, assessmentoforganizationprocessquality,howdefinedsecond-levelthinking

RiskManagementmarginofsafetycash,useof

gold,useofshortsellinghedging

River Road AssetManagementRobbins,LarryRobertson,JulianRobotti,RobertRobotti&Co.Rochon,FrancoisRoepers,AlexanderRogers,John

Romick,StevenRooney,JamesRosenstein,BarryRoumell,JimRoumellAssetManagementRoyce,CharlesRoyce&AssociatesRSInvestmentsRusso,Thomas

SSabreValueManagement

Samra,DavidSandler,RickySantayana,GeorgeSatterwhite,ScottScharfInvestmentsSchram,AlanSchwarz,JeffreyScoutCapitalScreening. See IdeaGenerationSecondCurveCapitalSellecchia,Vincent

Sellers,MarkSellersCapitalSellingDisciplineSenser,JerrySertl,GeorgeShamrockCapitalAdvisorsShapiro,JonathanShareholder Activism. SeeActivismSheffieldAssetManagementShiller,RobertShircliff,James

Shive,RalphShort Selling. See RiskManagementShubinStein,KenSinger,BradSizing of Positions. SeePortfolioManagementSmith,JeffreySoapstoneCapitalSociétéGénéraleSolasCapitalSonkin,Paul

Southeastern AssetManagementSpears,JohnSpecial Situations. See IdeaGenerationSpencerCapitalSpier,GuySpringhouseCapitalSprott,EricSprottAssetManagementStahl,MurrayStarboardValue

Steinhardt,MichaelSterlingCapitalManagementStewart,NormStienke,RagenStudzinski,EdwardSwaim,MatthewSystematic FinancialManagement

TTaleb,NassimTAMROCapital

Tananbaum,StevenTanico,PaulTannenbaum,JeffreyTasho,PhilipTempleton,JohnTetremCapitalThirdAvenueManagementThornburg InvestmentManagementThunderstormCapitalTigerManagementTimeArbitrage

TimeHorizonTocqueville AssetManagementTongue,GlennTrading. See PortfolioManagementTrapezeAssetManagementT2PartnersTurnarounds. See IdeaGenerationTurnover. See PortfolioManagement

Tweedy,BrowneCo.

UUbben,Jeffrey

VValueActCapitalValuation.SeeAnalysisValueInvestingbusiness growth,importanceofbusiness quality,

importanceofcharacteristicsofmindset

Vanasek,JamesVariantPerceptionVeZolles,PaulViceFundVNCapitalVNBTrustVogel,RichardVulcanValuePartners

WWachenheim,EdWadhwaney,AmitWasatchAdvisorsWatsa,PremWEDGECapitalWeir,AmeliaWeir,CandaceWeiss,AdamWeitz,WallyWeitzFunds

WeizmannInstituteWelch,ChrisWellCapPartnersWestwoodManagementWhitman,MartinWhitworth,RalphWilliamsonRobertWilliamson McAreeInvestmentPartnersWiner,MichaelWintergreenFundWinters,David

Wolf,JasonWolf,JoeWyckoff,Robert

XYYacktman,DonaldYacktman,StephenYacktmanAssetManagementYourMoneyandYourBrain

Z

Zessar,BruceZweig,Jason