The Art of Value Investing - DropPDF1.droppdf.com/files/tUSbn/the-art-of-value-investing-john-heins.pdf · Introduction Chapter 1: “All Sensible Investing Is Value Investing”

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

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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