An Interview With Bruce Greenwald, Value Investing Guru

Hailed by The New York Times as a "guru to Wall Street's gurus," value investing expert Bruce Greenwald takes some time to offer his insight and advice to The Motley Fool. A professor at Columbia University's Graduate School of Business, Greenwald has also authored multiple books, including Value Investing: from Graham to Buffett and Beyond.

In this interview Greenwald offers his thoughts on growth stocks and when to sell, the value of the financial sector today, whether reputational risk matters in the long term, predicting the macro environment, the need for a catalyst, and three ways to hedge -- including gold and how to use it.

Full transcript below.

Matt Koppenheffer: Thanks for joining us, Professor Greenwald. This is a great opportunity.

We were actually in town for the Value Investing Congress, and it seems like one of the themes that was running through the Congress is that there had been value available all over the U.S. market, and now that's sort of disappearing. Have you seen anything similar?

Bruce Greenwald: I think that is pretty much a universal theme. How long it's been a theme, and how novel it is, depends on how you read the level of profits in the economy.

If you are Jeremy Grantham and you believe in regression to the mean, profits are currently about 14-14.5% of national income. Historical norms are 9%, so that would mean we're talking about profits being inflated by a third.

If we've got pretty much normal multiples, which are 15-16 times forward earnings based on current projections, and those projections are 40% overestimated, you're talking about 20-plus multiples to sustainable earnings. If that's the case, then we're in for a world of hurt and there really is no opportunity.

But having said that, I think -- and you've got to remember, I think Jeremy has been wrong about the reversion to the mean for about eight years now -- and I think that there are structural reasons to believe that profits at or near this level may be more sustainable than he's giving them credit for.

The reason for that is that, as we move to a service economy, what you've got is a lot more markets where goods are locally produced and locally consumed. Those are, by their nature, small markets. Small markets are dominatable.

It's very hard to dominate the global automobile market. It's a big, global market. Anybody who can get 3-4% share can be viable in a global market. There's no way you're going to keep people out at that level.

If you're talking about local grocery stores -- where you've got economies of scale and distribution, you've got a lot of high turnover and low-cost workers, so you've got big economies of scale and management, and an advertising that's at fixed cost -- you're not going to be viable in most of those local markets unless you get a 20-25% share.

That means much more of the economy is in markets with significant barriers to entry, and that means significantly higher profits that are protected by those barriers to entry.

I'll give you just a particular example of it...

If you look at the comparison of Apple to IBM, they were both, a year ago, at historically high profit levels. Apple's profits, as a fraction of operating earnings, were 40%. It's a big, global goods market.

They spend only about 2 to maybe 2.5% of their income on R&D. Advertising is even less than that; it's only $1 billion. There are not a lot of fixed costs here. They're all variable costs, and what that means is people can come in at the margin, without being able to capture a huge part of this market, and undermine Apple.

If you look at the history of that market, first with Motorola and the Razr, and then with Nokia and their phones, there has never been a sustainably dominant competitor. If you look at the Razr at its peak, it's at a 15% margin.

When Apple is at 40%, that's an inflated margin that's clearly going away. What you've seen in the last two quarters is that that's come down to 28%. There's been a huge drop in those margins.

In contrast, if you look at IBM, IBM is also at historically high margins. If you look seven years ago, it's at 14% operating income to earnings. You look today, it's at 20.5%.

On the other hand, IBM dominates a lot of little vertical markets in a lot of localities because it's the support that they give, it's the selling expertise that they have, that enables them to be the company that they are. To compete with them on that level you have to have that local presence, both in the specific product market, and in the geographic area.

If you look at IBM, they have suffered too. Their sales are down a lot, but their margins have shown a lot more stability.

To the extent that the market is moving away from the Apple direction, away from manufacture -- because productivity in manufacturing is 5-7% a year, and demand growth is 3-4% a year, so just like agriculture that's going away -- into these very much more differentiated service markets, these much more fragmented service markets, it looks like the profits may be more sustainable than people are giving them credit for.

That means that things are probably not as crazy overvalued as some people think, especially if you concentrate on locally dominant service franchises.

Koppenheffer: You may have some of these examples like Apple, where the margins are at risk, but then a lot more examples that are balancing that out.

Greenwald: Right, that are not that expensive. A classic company of that is Nestle has come down because they've started to do stupid things that they're historically prone to do in capital allocation, which means that they make their money in the markets they dominate.

I could give you an example of a similar company. Coca-Cola, historically, has made more than 110% of its operating profits in the 8-10 biggest markets in which it operates, which means it loses money in the markets where it's not dense and doesn't have scale and distribution.

Same thing is true of Nestle. Where they try and go all over the world, and they have sub-scale distribution networks, they lose money -- and they've just started doing that again.

Where they were sensible and they consolidate and license their products in the markets where they don't have dominant scale and distribution, and concentrate on markets where they do have dominant scale and distribution -- like pet food in the United States -- they do very well.

But they're trading at a 3.3-3.4% dividend. Their growth, because they are in high-growth areas -- if you read their financials, it looks like the growth is slower because historically it's been in Swiss francs and the Swiss franc has been appreciated -- strongly relative to the currencies in which they sell, but their growth is probably, especially in earnings because they have operating leverage, maybe 6%, which is a little above the 4.5% nominal world GDP growth, or even 4% nominal world GDP growth.

You had a 6% earnings growth, a 3.3% dividend, and probably some buybacks on top of it because they really don't need all that much capital, so you're looking at a 10% return on a stock. That is extraordinarily safe.

You look at what happened to them after 2003, where their input prices when through the roof, and there was no general inflation, and their margins go up steadily. You look at them in the crisis and they're barely affected by it in '08-'09.

It's sort of recession-proof and inflation-proof, and it's a 10% return. Maybe as low as 8, but in a world -- even where 30-year Treasuries, which have all the inflation risk, are 3% -- that is not an expensive stock, and there a fair number of opportunities.

Not as many, obviously, as there were 18 months ago.

Koppenheffer: When the market goes up as much as it has, you naturally have that.

Greenwald: Right. Right, you're naturally not happy.

Koppenheffer: Jumping off of something that you just said that I thought was kind of interesting, you said they're valued at a 3.3-4% dividend.

I've always thought about dividends as a valuation metric, but you don't hear that a lot, where people are using dividends as a metric of valuation. But post-financial crisis, it seems like more investors are revisiting dividends.

I was wondering if you would talk a little bit about using a dividend as a valuation metric, but then also some of the risks of looking for dividends, and particularly going after higher dividends.

Greenwald: OK, I got it. That's a really good question. Actually, let me describe what we're doing here.

When growth has value, what you're trying to do is take a cash flow number and multiply it by the appropriate multiple for a growing stream. Costs of capital these days are probably 8%. Growth rates for anybody with a franchise... and growth has no value if you don't have barriers to entry, because your return on capital is driven by the cost of capital, so you invest $100 million in growth, you earn 8%, you have to pay 8% to the people who provided it.

In the stocks where growth matters, you've got, say, an 8% cost of capital and, because you've got operating leverage, probably a 5% growth in earnings. That's 1/3%, which is 33 times, which is a crazy multiple.

If you're off by just 1%, you could have 100 times. If, for example, the cost of capital was 7 and the growth was not 5, it was 6, which is 1/1%, or if the cost of capital was 9 and the growth rate is 5, you're 25 times, and even lower.

You make small mistakes in those numbers, you get massive mistakes in valuation, so when you've got a growing stream, it's almost impossible to put a value on it. If the growth doesn't matter, you can get an earnings-powered value. It ought to be supported by assets because there are no barriers to entry, and you'll get a very good valuation.

You can get a valuation metric in terms of price/earnings ratios, price to tangible book, ultimately price to replacement cost, and price to sustainable earnings.

In the non-growth stocks, which are the non-franchised stocks, it's always been the case that traditional valuation metrics apply, and they continue to apply. In the growth stocks, on the other hand, I think we now have learned, to our cost -- and by the way, not just in this crisis but in the sell-off for the tech bust in '99-2000 -- that you cannot put a sensible value on things.

If you can't put a sensible value on things, the question is how do you decide if they're worth buying? The answer is, you can put a sensible return on things.

In those cases, notice what I did. I said, "OK, here's the cash return." It's the dividends plus the buybacks, probably -- expected level of buybacks, which is like 4.4% -- the growth is what it is, and the growth in earnings may be slightly higher than the growth in sales, but the growth in sales is forecastable.

It's going to be either slightly above or slightly below the level of GDP growth, depending on how successfully they allocate capital to grab market share or whether they're in a category that's growing faster, like pet food, than GDP or much slower, like newspapers or automobiles, than GDP.

You can assess those numbers and notice that now it's not 1/R-G. It's just linearly related to the return. What I did for you is I basically calculated a total return for Nestle, and that has always been the sensible way to look at growth stocks.

You notice you can compare that directly to returns on Treasuries, to returns on junk debt, to returns on regular debt, because they're all in returns space so you've got a much better idea of what you're buying.

That's the good news about what we've learned. I think it's not just been from the crisis. I think, as I say, it goes back to the tech bust where people put unrealistic and crazy valuations on things.

Koppenheffer: So there's bad news. You're saying there's bad news.

Greenwald: On the other hand... No. The bad news is that...

It's what, really, people like Warren Buffett, who have pioneered the process of investing in these franchise businesses -- and it's only the franchise businesses where growth has value, because that's where you earn above the cost of capital.

I mean, if a market grows with no barriers to entry, you just get a lot of entry. It drives prices down and it eliminates the profitability, so you have to have the barriers to entry.

What they always said is, you can make a sensible buy decision. It is incredibly difficult to make a sensible sell decision. That's because you have to pick a price at which to sell. I get a price from the market today and I can calculate, just as I did for Nestle and other things, a return at that price.

But when I decide to sell Nestle, I've got to pick a price to sell it at. That, of course, gets into all the problems of at what point it's overvalued or not. There, I think what you have to do is not hold on too long. That's the temptation.

That's what kills Buffett when he won't sell Coca-Cola at $80 a share. It's what kills him when he holds onto the Washington Post for too long.

It's a very difficult decision to make, but I think the evidence is that you've got to be pretty conservative about it so that if the dividend return for Nestle, for example, plus the buyback return, goes down to 3.5, even though the overall return may be reasonable relative to returns on fixed income, you're still going to have to sell at that point.

But I think what we've learned in, as I say, as much the tech bust as the current crisis, is you cannot effectively put numerical values on stocks, or have price-related multiples on stocks, that are growth stocks.

If you'll let me, I'll do just one more example that shows you.

Koppenheffer: Sure. Yeah.

Greenwald: People got really excited about newspapers when they got down to like 8 times earnings. Eight times earnings is an earnings return of about 12.5%. They were distributing 80% of that, so it was a 10% cash return, either buybacks or dividends.

In spite of what investments they were doing, those businesses were shrinking at at least 5% a year in terms of their earnings power, and they had no good alternative investments. They tried and failed, and the basic businesses were shrinking. You had all the loss in operating leverage, because you had this big fixed cost infrastructure to fill and sell newspapers and a shrinking revenue base against it.

Koppenheffer: Not an ideal situation.

Greenwald: Yeah, not an ideal situation. But let's say it was 7% a year, which means it takes 14 years for it to fall in half. You start with 10 and subtract 7, that's a 3% return, which is a substandard return in a very high-risk investment.

When people are excited by the multiple, which has never been as low as 8, if they do the return calculation, they'll understand that the multiple is almost completely uninformative, that you have to look at the implied returns. That's what I think people have learned to in these franchise stocks.

Koppenheffer: OK. Once you have that implied return type of number, obviously you can compare that to other alternatives.

Greenwald: Right, exactly.

Koppenheffer: A lot of people look at that risk-free rate from Treasury bonds or the like. You get into the difficult situation in an environment like this, where you have such low fixed income payouts, and you compare to that.

We were listening to Donald Yacktman speak yesterday and he was talking about comparing to low Treasury rates, and you can justify stuff looking a lot more attractive against that. But then I think about, I'm pretty sure it was Mohnish Pabrai who talks about targeting a specific -- I think he wants to double his money every three years or so, and that's like a 25-26%.

Greenwald: Lots of luck. As a target.

Koppenheffer: It's a high mark, yeah. I guess what I'm curious about is benchmarking against Treasuries, particularly when they're low. Maybe you shoot and score and you get a 5% return. That's a low return, but if you are targeting a really high rate -- even if it's not that high -- then if you hit and miss by a little bit, maybe you're getting 15%.

Is there any advantage to targeting a specific ...

Greenwald: Look, I think that if you do the kind of calculation I just did, there are no stocks that are offering safe 20-25% returns, so what he's implicitly counting on is some sort of improvement in multiple, and lots of luck forecasting that.

 OK, but let's go back to the Nestle versus Treasury calculation. You're getting 3% in 10-year Treasuries, 4% in 30-year Treasuries. You've got all the risk of inflation.

Now at the moment, and for a while, inflation has been incredibly stable between 1-2%. Except for a while it was a little bit -- because of the natural resource inflation -- it was a little bit above 2, but it's basically fluctuating around 1.7.

On the other hand, you have an absolutely unprecedented monetary environment. But you've had long-term deflationary pressure in the international economy as a whole, whether it's from Europe or the United States or Japan, or all these other now-emerging market countries.

Who the hell knows what's going to go on? But there's got to be at least a one-third chance that we're going to turn into a much higher inflation environment. You have to be aware of that risk. You're getting a 3-4% return in a very high risk context.

Now look at the Nestle return of 9-10%. In the long run, is inflation going to affect Nestle? No. We've seen it. We've seen the worst kind of inflation we could have, where it's in their input prices and not the competitive output products since 2003, and they do just fine.

We've seen, do they face recession risk? No, we've seen the worst recession since the depression, in '08-'09, and they do just fine.

You have to ask yourself, what's the long-term risk in owning those things? Where I would come out and say, "Look, what's clear is that the debt returns, even at these levels, don't compensate you for the risk you're taking on." That's clear, No. 1. Those are overvalued assets.

Koppenheffer: It's not as much a risk-free return as people might think it is.

Greenwald: Right, as they want to believe. OK.

But I think the second side of it, ask yourself this. Even by historical standards, in a very diversified company like Nestle, in very stable product markets where the damage they can do from the current stupidities is fairly limited because there's a long history of their learning about the stupidities after a while, with very low leverage, is a 10% return a good return by historical standards?

I think the answer is yes, it is. What you're talking about is that that's a stock that probably is, in some long-run sense, a good buy.

Koppenheffer: OK. Now, you were talking about different ways to value companies and you mentioned price-to-tangible book value, which brings me around to... I spend most of my time working with financial companies. That's a metric that I end up focusing on a lot.

I'm curious if you have been watching the financial sector at all lately, and have any thoughts on ... there are a lot of people, myself included, that think that the sector may be undervalued, but there's also a possibility that that's a value trap with this.

Greenwald: Oh come on. No, no. Can I talk about what the big problem with that is?

Koppenheffer: Sure. Yeah.

Greenwald: There is one fact about investing, and it's the most important fact that you can never forget, and there are two ways of saying it.

There's the Lake Wobegon way: The average performance of all managers before fees has to be the average performance of all assets. Now, that's not the same as academic market efficiency, which we know is not true, but if you're going to outperform, somebody else has got to underperform.

I think the best way to think about that operationally is that every time you buy a stock thinking it's going to do well, somebody else is selling it to you thinking it's going to do badly. You have to ask: What is going to put you on the right side of that transaction?

What's the most obvious way to do that? It's a way that, to an extraordinary extent, people in finance ignore. The answer is to be a specialist.

If I've been doing South Texas Gulf Coast onshore oil leases for 20 years and I know the geology and I know the sellers and I know the whole market, and you come down from New York and bid against me for a lease, if you buy that lease, if you win that auction, you've made a bad mistake because effectively, in some sense, I sold it to you.

You always are going to do better if you're a specialist. That is especially the case in financial services. A sensible way to value insurance companies is very different from a sensible way to value banks, is very different from a sensible way to value credit card processors, and on and on.

I think if you find yourself doing the shortcut and saying, "Ah, this is cheap because it's low market to tangible book," and you apply it across the sector, and the guy on the other side of the trade understands the difference between insurance companies and banks, you're going to get yourself in real trouble. That's the first thing.

On the other hand, when you look for opportunities from a value perspective, you're looking at what's despised and people want to shy away from.

Well, that's a good description of the financial sector, but what I would do is I would say, "OK, the financial sector is a good idea. Who are the best financial sector investors?" It would be Davis in insurance; they've done insurance for a long time. It would be people who have concentrated in banks if we're doing banks, and that's the way I would do it.

I would not do this at home, kids.

Koppenheffer: Oh, sure.

Greenwald: OK?

Koppenheffer: Yeah.

In a similar vein -- this actually could apply to any sector -- but you've had a lot of headline risk, reputational risk for the financial sector. We just saw today, the headlines are coming out about JPMorgan settling the big fines for the London Whale trade.

When you're thinking about the value of a company, does reputational risk and headline risk come into that at all?

Greenwald: In the long run, the evidence seems to be that -- as long as it stays out of bankruptcy -- reputational risk does not that significantly impair the situation of a company. I'll give you a couple of examples of that.

The first was American Express in 1964 -- and Buffett talks about all this -- the Salad Oil Scandal, the stock price falls. Ten years later, nobody gives a crap. It just doesn't have an effect.

The latest one, if you think about it, is AIG. Now, AIG does lose a lot of money but the reputational risk doesn't seem to be the problem anymore, so that even five years after probably the worst malfeasance that's out there, it just is not visible in the overall profitability numbers.

I think reputational risk... and by the way, if Jamie Dimon has learned nothing from this, it's that you don't want to criticize the administration because they'll kill you. Now, assuming he's learned that lesson...

Koppenheffer: Hopefully he's learned that lesson by now.

Greenwald: The reputational risk is not ... again, do the numbers. He's paid $100 million in the fine. What is their quarterly earnings, $4-5 billion? It's just not a big number and it's not a repeatable number.

Usually, that kind of thing is your friend because what you want to buy is diseased stocks that are beaten down in price and are a bargain because we know people irrationally shy away from those stocks. They tend to assume that the problems today are going to be the problems forever because they overemphasize certainty.

That's where, in general, you want to look. Reputational risk, perversely, is your friend. But you still have to have the expertise to tell the difference between terminally diseased and slightly, just temporarily diseased.

Koppenheffer: OK. Thinking about the insurance sector, you mentioned Chris Davis is very great in the insurance sector.

Greenwald: And Warren Buffett is pretty good in it.

Koppenheffer: Warren Buffett is, but actually my question was that there are a lot of great investors; Prem Watsa up in Canada, you've got Tom Gayner at Markel, you had Lou Simpson working with Warren Buffett at Berkshire Hathaway.

What do you think it is that attracts value investors -- and these are all value investors in particular, or most of them -- what attracts them to that business?

Greenwald: I think what you're describing is an optical illusion. I'm going to say something nice about The Motley Fool, so you can always edit it out.

The Motley Fool has a terrific, I think, performance record because it's fundamentally value oriented, and it's flexibly value oriented, which I think is very important. You know that the Russo Gardner & Russo, that the Gardner, which is a famous value firm -- or it's Gardner Russo & Gardner, sorry -- is the uncle of the Gardners who are your founders.

I think the people they would look at in the insurance business are the people who are the value-oriented investors, but who invests the money at MetLife? Who the hell knows? Who invests the money at Prudential? Who the hell knows? Who invests the money at AIG? Who the hell knows?

Koppenheffer: Good point.

Greenwald: Don't forget, it's a vast industry out there.

Now, there are other no-name companies that actually have pretty good value orientations. Northwestern Mutual is a terrific operator, but they're also value-oriented investors. It's just they never sell anything, which is not necessarily a good idea.

But you can go through the list of insurance companies and there are a lot of them who are just pretty ordinary, common or garden investors.

Koppenheffer: OK. I guess the question wasn't so much that all insurance companies are getting great investors, but that a lot of these investors seem to end up latched onto an insurance company.

Greenwald: Well, it's a very stable investor base. That's the good news.

Look. It is conceivable, under a set of political circumstances in Europe, something terrible happening in Switzerland -- even though they don't sell anything there -- that Nestle could fall from, what, 62 Swiss francs today to 40 Swiss francs tomorrow. But the underlying business isn't going to be impaired.

You need investors who are not going to go nuts and sell you out at those ridiculously low valuations, and are going to be willing, or are stable enough, to provide you with the resources to make good decisions at that point.

I think insurance companies tend to have those characteristics because they're a stream of policy premiums that are pretty stable.

Actually, something really good is happening in insurance these days, which I think all the insurance companies have noticed. That is, in the old days when insurance companies made a lot of money because premiums were high and their operating ratios were good, they kept hold of the money. Their capital base went up and their ability to write insurance went up.

They're insurance guys. If they can write insurance, they'll write insurance and they don't care much about the price. What you've seen, starting with Travelers, but in all the insurance companies, is they're returning the capital to the stockholders.

If that trend holds, you're going to get a lot more pricing discipline and you're going to get a lot better operating ratios than you've had historically, throughout the industry.

Koppenheffer: It seemed that it's a lot more difficult lately to make up for bad underwriting with good investing.

Greenwald: Right, and that's also supported.

Koppenheffer: That makes sense, though.

Greenwald: The good underwriting.

Koppenheffer: Warren Buffett often talks about educating his shareholders, so I guess when you're an insurer and you have that float and it's sticking around, then you don't really have to worry about that.

Greenwald: And that's a $70 billion float that's growing over time.

Koppenheffer: Sure.

Greenwald: You look at that float on the balance sheet, it's a very stable float.

Koppenheffer: It's not a bad asset for Berkshire shareholders.

Greenwald: No. And you didn't lose two-thirds of your investors or two-thirds of that float in 2008.

Koppenheffer: Exactly, exactly.

In terms of the changes that have taken place since the financial crisis... before the financial crisis and still through today there are a lot of value investors that appreciate that the macro environment makes a difference to how their investments are going to perform, but at the same time say, "Well, we don't know how to predict the macro environment."

And yet, there are a lot of investors that are now saying, "You're crazy to not try to predict what's going on in the macro environment." Has it changed? Is it different now?

Greenwald: I think that, for the sensible value investors, trying to predict the macro environment is not what they do. I think what they've done is they've adjusted their risk management techniques to recognize what the macro environment can do to them.

Let me talk about what is the value approach to risk management. It starts not from variance. Variance assumes, by the way, that upward and downward movements are symmetrical, and we know they're not.

It also assumes that, over time, things are serially uncorrelated so if it drops this period -- if you have a 5% price drop -- that's the new base, so essentially all movements are permanent movements, and we know that there's reversion to the mean, especially in individual stocks, which is what value investors depend on to some extent.

The value approach to investment is to protect yourself against permanent impairment of capital. If you think about that, there are three basic ways to permanently impair your capital.

The fastest way to do it is to pay $100 for something that's worth $50. That's why the biggest value technique for risk management is margin of safety. It's to make sure, as sure as you can be, that you're paying less than what the long-term value of that asset is. That's really what they depended on, always, in the first instance. It's what Ben Graham talked about.

The second thing is that what will convert a temporary loss into a permanent loss is if you have to sell out or you go bankrupt. Leverage, at either the company level or the portfolio level, is something you want to avoid.

Koppenheffer: That's getting back to that permanence of capital.

Greenwald: Avoiding permanent impairment of capital.

The second thing I think value investors look for is relatively clean balance sheets and/or stable enough earnings to support comfortably any debt that's on the balance sheet, and not leveraging themselves up too much.

The third is diversification. Not full diversification, but you're going to make mistakes in valuation. You're going to be wrong, so you don't want to have a 2-3 stock portfolio. But when you get above a 15-20 stock portfolio, you're pretty well as diversified as you're going to get in terms of spreading out the errors. And mistakes in valuation ought to be unsystematic errors.

If you do those three things, what you're left with is the macro risk. I think historically what value investors were prepared to do is say, "OK, macro changes are temporary changes. I can live with those. I'm not going to worry about them."

I think what we understand now is they can be very, very long-lived, both in terms of the unemployment, which is the real fluctuations, and in terms of what they can do to interest rates in trying to fight that. We've had five years of interest rates that nobody would have believed were possible.

That means you've got now, I think, to take a fourth step as a value investor and ask yourself what's your vulnerability to inflation, on the one hand, and chronic deflation on the other?

I think they've always been sort of inflation sensitive, but I think there you'll see that there are three asset classes that you have.

You have real assets -- natural resources, companies that are competitive companies, real estate -- and there you're going to do really well in an inflationary environment and you're going to suffer in a deflationary environment.

The second category are fixed income, and that does relatively well in a deflationary environment, and very badly in an inflationary environment.

Then there are the Nestles of the world, the franchise businesses, and they do well in both.

I think where value investors now start is, they either formally or informally do an inventory of their portfolio. How much of it -- and actually still, by historical standards, the franchise businesses are surprisingly cheap -- so they buy the cheap businesses with a good margin of safety, either in returns space or in value space for the non-franchise stocks.

They look at what they're left with, and they look at their vulnerability to inflation, and they look at their vulnerability to deflation. Then I think they think about hedging those things. There are three ways that you can hedge.

One is assets like gold that will do, typically, well if everything turns to crap. I think that's why you want to hold gold.

Now, there, there are two reasons. One is that it'll stabilize the notional value, but really the reason you want to have gold is everything turns to crap, it's not going to turn to crap permanently. It may turn to crap for a long time, but if you have the gold and you have the purchasing power you'll get some real bargains.

On the other hand if you're not psychologically conditioned so you can sell the gold and buy the stock in March of 2009, that substantially impairs the value of holding assets that are resistant to these systematic failures.

Koppenheffer: You just end up keep holding that gold.

Greenwald: Right. You keep holding the gold, it's not as valuable as if you're somebody who can use it when it's most valuable in terms of what you can buy for it. That's one way to do it, is by assets that have negative correlations to bad economic conditions.

The second way to do it is with shorts. The problem with shorts is the tax treatment is terrible, that in general stocks outperform short-term, which is typically what you're going to hold it in, so that you've got a headwind that's pretty substantial, at least 2-4%, and the risk characteristics are terrible because if it doubles your position is twice the size, not half the size.

The third way is with derivatives; puts of various sorts. The nice thing about derivatives is, if you look at 2007, derivatives were incredibly cheap. The implied volatility on the options that you could buy was under 10%.

It turns out the most dangerous times are when nobody thinks there's any danger, and those are the times where derivatives are cheapest. I think that's what good value investors have been led to think about, which is in these very fraught macro situations, what are the cheapest derivatives that you can get?

If they're very expensive, hey, you may just have to live with the gold as an alternative, or if there are some small shorts, you may have to live with that. But I think people have learned to think about their macro vulnerabilities when they think about managing risk, whereas I think in the past they just would have ignored them.

Koppenheffer: OK.

A lot of our readers, and a lot of the people watching this, are sometimes newer investors and may hear you say "derivatives" -- referring to options -- and think about that famous Warren Buffett quote, "Derivatives are financial weapons of mass destruction."

I was just going to ask, probably instructive to differentiate what Buffett was talking about, versus ...

Greenwald: OK. What Buffett is talking about is people speculating by using derivatives. A typical call option will be a call option to buy 100 IBM shares at a price ... today it would probably be of $175, say.

There's a huge amount of leverage in that. If IBM goes up to $225, you'll make several times your money. If IBM goes down, you'll just be wiped out.

They're extraordinarily highly leveraged instruments, and I think people who buy them to make money, it's like buying gold to make money. You're really taking on much more risk than you should be, because you can't make a good judgment about what's going to happen in the limited term of the options, and that's not the reason to buy derivatives.

What you want to buy derivatives for is if you own the stock and you want to protect yourself. You could sell a call so that if you thought, at 25% above the current price, you'd be happy to sell it. You can sell a call at 25% above the current price, which gives somebody the option to buy it from you if the price goes up by more than 25%. You're happy with that. You can calculate what the effect is.

If the stock price goes down, you just collect the premium and you're not in any trouble. If it's a covered call, you just sell your stock at that price and you don't have any risk.

I think people exaggerate the sophistication that's required if you think about buying options that are tied to your existing portfolio and insure against adverse movements in that existing portfolio. Stock market goes down, the call expires worthless and you've collected the premium.

You have a put at $200, the stock market goes down, you make the difference between the, say, $150 price of IBM and the put price of $200. You pay something for that. Maybe you can finance it with a call.

But if you look at it in terms of an explicit risk management tool, I think you'll do much better than if you say, "Hey, this is a complicated way to make really good money."

Koppenheffer: OK. With the derivatives, one of the things that we heard a lot at the Value Investing Congress is about the catalysts for an investment. You buy a stock, you think it's cheap, and you look for the catalyst that's going to get it there. Do you think it's necessary for an investor to have a catalyst, or have a catalyst in mind?

Greenwald: OK, that's a really good question because again it comes back to valuation.

If your valuation is transaction-based, for example, so you're looking at recent transactions -- by even informed buyers -- for cash, the problem with that is it's always driven by market valuations to some extent. If you're doing that, there is a lot of implied risk in that valuation and you really want a catalyst.

That's the basic insight that Mario Gabelli had, because he believed in private market value and he also understood that private market values were not that stable, so he wanted catalysts that would realize them as soon as possible and if nobody else had them, he was going to try and create them either by touting the stock to somebody who would buy it out, or going to the management and asking them to do something.

I think that, in general, if you don't have a lot of confidence in the valuation then you've got to have a catalyst.

On the other hand, if you have a good margin of safety in even a non-franchise stock, where you're not growing -- so the stock, you're pretty sure there are real assets there, it's going to be worth $100 a share and you're buying it for $50 -- if you keep that investment for three years and it takes three years to realize that value, well a double in three years is a 24% return a year.

Koppenheffer: Not bad.

Greenwald: If it's four years, it's an 18% return a year. If it's five years there's a 14% return, plus whatever dividends you're getting in the meantime.

I think that, if you've got a reliable valuation, you ought to have a lot of staying power and still get a decent return. I think one of the advantages of a big margin of safety is it gives you three to five years for the market to come around.

If you have patient investors, they're not going to give you a hard time in the meantime. I think, again, back to the question of insurance, that's the nice thing about having an insurance float.

I think the issue of catalyst ultimately comes down to an issue of confidence in your valuation. If it's a franchise business and you're getting a decent return; if we're getting our 10% a year for Nestle and we also think that it's 25% undervalued -- how we'd arrive at that calculation, who knows -- but we're also waiting for a 25% bump, don't forget we're getting 10% a year while we wait, as value accrues.

There, we can wait five to seven years and we're fine. Again, it depends on the nature of the company, the nature of the valuation that you're doing, and the reliability of that valuation. You don't want to just say, "Oh, I'm only going to do things with a catalyst."

Koppenheffer: Let me finish up with kind of a fun one here. We heard the Cameron and Tyler Winklevoss talking about Bitcoin. They're backing and have gotten involved in Bitcoin. Do you think that this is something that has legs, maybe can steal some market share from traditional banking?

Greenwald: I don't think it's traditional banking. Don't forget that what traditional banking does is, it enables you to write checks or do wire transfers. There is a transaction infrastructure.

If you go back to the traditional definition of money, it's as a medium of exchange, it's as a measure of value, and it's as a store of value. It's a unit of account, it's a medium of exchange, and it's a store of value.

It turns out, as a unit of account, nobody's going to price anything in bitcoins. It's always going to be the currency because that's just the dominant way to do it, and there are big network effects from that. It's very hard to get people to change.

In fact, they measure the value of bitcoins in -- you guessed it -- dollars, or whatever currency it is, so you're not going to get it as a unit of account.

It's not a medium of exchange. You don't have to keep a bitcoin balance to pay your bills, so what you're left with is a store of value.

We've got lots of stores of value. We've got gold, we've got all sorts of other kinds of real assets that you can have. We have inflation, we have TIPS, we have all sorts of real stores of value that are probably more liquid than the bitcoins, and are less easy to manipulate, and are less subject to insider trading.

Look, in the old days every bank used to issue its own currency.

Koppenheffer: Oh, right. Yeah.

Greenwald: It was very unstable what the relationships between the currencies were. Having lots of different bitcoins has a lot of the flavor of that, but it's got no natural advantages over gold or any other real measure of value.

Koppenheffer: It's fun to talk about in the meantime.

Greenwald: I think there's a rule. If the Winklevoss twins are talking about it, it's almost certainly opportunistic and they almost certainly are not the people who know how to make money out of that idea, as Facebook showed.

Koppenheffer: That's very fair.

Greenwald: You don't want to invest with them.

Koppenheffer: All right, Professor Greenwald, we really appreciate you talking to us. Thank you so much.

Greenwald: It's always a pleasure to talk to you guys!

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Read/Post Comments (15) | Recommend This Article (48)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 15, 2013, at 11:43 AM, drax7 wrote:

    Pure mumbo jumbo in my view.

  • Report this Comment On October 15, 2013, at 12:28 PM, drax7 wrote:

    Take it back, spoke too soon. Brilliant mind.

  • Report this Comment On October 15, 2013, at 2:19 PM, daltxhowie101 wrote:

    i was just wondering if he is speaking english..

  • Report this Comment On October 15, 2013, at 2:20 PM, daltxhowie101 wrote:

    and i have a finance advanced degree... obviously didn't study the right stuff..

  • Report this Comment On October 15, 2013, at 6:37 PM, abcvb wrote:

    Maybe a 47 minute interview was a bit too long, so I went back and read parts of the transcript where I needed clarification. There is a lot of good info on value investing, and since Nestle is a major part of my portfolio I liked what he said.

  • Report this Comment On October 15, 2013, at 6:45 PM, NZPatrimpas wrote:

    Loved it! Great interview, wonderful ideas. Can be darn hard to put it to real investing work, but wonderful framework for that non the less.

  • Report this Comment On October 16, 2013, at 7:10 AM, Khizhim wrote:

    What a spectacular asset! A comprehensive, extended conversation with an esteemed authority! WOW! Wonderful! AND a COMPLETE transcript! Did I say "Wow"?!

    THANK YOU MATT KOPPENHEFFER!

  • Report this Comment On October 16, 2013, at 7:35 PM, JTValue wrote:

    Thank you for posting an in depth interview with significant substance. Please do more of these extended discussions.

  • Report this Comment On October 17, 2013, at 12:16 PM, drax7 wrote:

    Disagree that IBM has a sustainable model that has superiority over apple. Bad theory leads to bad practice.

  • Report this Comment On October 18, 2013, at 3:16 PM, 123spot wrote:

    Talk about value. This is worth more than I paid for my annual subscription to Stock Advisor. Thank you so much Mr.Koppenheffer and Professor Greenwald. Matt, you did a great job with the interview. Spot

  • Report this Comment On October 18, 2013, at 3:51 PM, TMFHurricane wrote:

    We also spoke with Columbia's real estate professor while we were on campus. The video and transcript can be found here:

    http://www.fool.com/investing/general/2013/10/11/an-intervie...

    Fool on!

  • Report this Comment On October 18, 2013, at 6:05 PM, 092326 wrote:

    Too, too long. Much of what was said could be covered in far fewer words.

  • Report this Comment On October 19, 2013, at 8:25 AM, zeezeebop100 wrote:

    Maybe I'm having a slow day. I didn't follow the discussion where a Cost of Capital (CC) of 8% and an earnings growth rate (G) of 5% translates to a valuation multiple of 33X as there seems to be no discussion of valuation. He continues that a CC of 7% combined with G of 6% translates to 100X and similarly 9% and 5% translates to 25X.

    Does anyone follow this?

  • Report this Comment On October 19, 2013, at 7:15 PM, AG1476 wrote:

    Wonderful, thanks

  • Report this Comment On October 24, 2013, at 9:24 AM, paulalbert wrote:

    Great interview with Professor Greenwald! As a Columbia Business School MBA, I get to hear him frequently at various school events; I didn't get to take his courses because I was at Columbia way before he arrived.

    I was surprised by some of the other comments. What he was discussing seemed to me to be basic business economics and risk, return, and valuation considerations of serious investing.

    By the way on the issue of Cost of Capital, Growth, and PE, the idea is simple:

    Say CC is 10% and G is 5% so 5% of 10% required return come from the growth but other 5% must come from the existing base you buy, so reciprocal is 1 over .05 or a PE of 20. This is of course just a back of the envelope kind of calculation, assuming a perpetual growth rate, a dangerous assumption and why value investors are very cautious about the risk of attributing too much value to growth, as Professor Greenwald discusses.

    Very astute discussion of derivatives: I have enhanced my returns considerably particularly by writing out of the money covered calls.

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