FOOL ON THE HILL
Go Against the Grain

Whitney Tilson shares his thoughts on variant perceptions, what he learned from Michael Steinhardt's autobiography, and recommends other books by or about investment greats.

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By Whitney Tilson
January 8, 2002

If you were a serious baseball player, would you make it a point to read The Science of Hitting by Ted Williams (the last man to bat .400) and other books by history's greatest hitters? Of course you would, in the hopes of maximizing your chances of repeating their successes -- and avoiding their mistakes. For the same reason, I think all serious investors should read as much by and about the most successful investors of all time. My favorite books in this category are:

  • The Intelligent Investor, by Ben Graham. Graham was Warren Buffett's teacher at Columbia Business School and lifetime mentor. I agree with Buffett that this is the best book ever on investing.
  • Common Stocks and Uncommon Profits, by Philip Fisher. Fisher, regarded as one of the pioneers of modern investment theory, may be the most underrated investment thinker of all time. He focuses on identifying growth stocks that can be held for the long run.
  • The Money Masters, by John Train. Nine chapters -- one each on nine of the world's great investors (Buffett, Fisher, Graham, Templeton, Cabot, T. Rowe Price, Tisch, Kroll, and Wilson).
  • You Can Be a Stock Market Genius, by Joel Greenblatt. You've probably never heard of him or his book, but Greenblatt has compounded money at over 40% annually for the past 17 years, primarily by investing in special situations like spin-offs, restructurings, and rights offerings.

Additional favorites along these lines are: One Up on Wall Street and Beating the Street by Peter Lynch, John Neff on Investing by John Neff, Margin of Safety by Seth Klarman, and Value Investing by Marty Whitman.

Michael Steinhardt
Over the holidays I read another book of this type, Michael Steinhardt's autobiography, No Bull. His hedge funds compounded at about 30% annually (24% net to investors) for nearly 30 years ending in 1995. Put another way, he made investors about 500 times their money.

The book was an interesting read though I didn't learn much that will help make me a better investor, given that my style of investing is vastly different than Steinhardt's (he traded heavily and sometimes made big macro bets). There were a number of gems, however, such as this one:

"I told [a summer intern] that ideally he should be able to tell me, in two minutes, four things: 1) the idea; 2) the consensus view; 3) his variant perception; and 4) a trigger event. No mean feat. In those instances where there was no variant perception -- that is, solid growth recommendations within consensus -- I generally had no interest and would discourage investing."

Variant perceptions
In #2 and #3, Steinhardt makes a very simple point: To make money investing, you must have a view that differs from that of the herd. If you think a company is great, yet everyone agrees with you -- such that its stock is priced for perfection -- then you are unlikely to make much money on the stock even if the company achieves perfection. And if the company fails to do so -- a likely event; how many perpetually perfect companies are you aware of? -- you're going to lose your shirt. Just ask those who invested a year ago in Cisco and other similarly beloved tech stocks.

Before I buy any stock, I have to answer to my satisfaction the following question: "What, exactly, is it that I understand or believe about this company that differs from the consensus view?" In other words, what's my variant perception?

Of course, having a variant perception is easy. Having one and being right is a lot harder. While it's easy to mock those who blindly follow the herd, this natural human instinct has developed since the dawn of human existence for a good reason: the herd is right most of the time. Just ask those who bet on a turnaround at Polaroid, Excite@Home, and other companies that have now gone bankrupt.

One can make big money betting against the consensus on turnarounds, but it's risky. Let me share an example of one successful such bet I made: buying Office Depot a year ago at $8. The investment turned out far better than I ever anticipated, ending up 2001 as the second-best performing stock in the S&P 500. At the time I bought Office Depot, the stock was horribly out of favor, having fallen nearly 70% from its all-time peak a few years before. The company was widely viewed as a weak competitor in a saturated, unattractive industry.

So why did I buy the stock? In large part because I believed that the new CEO, Bruce Nelson, had adopted the right strategy. Rather than investing in growing the low-margin North American retail store base, he planned to run it to generate cash. The company closed underperforming stores and improved operations -- to be reinvested into the higher-margin, faster-growing catalog, contract, Internet, and international businesses, where Office Depot has real competitive advantages. I also didn't think Office Depot was a bad business -- it's not a great one, but it's decent. Even before Nelson took over, when the company was badly managed and had the wrong strategy, it was still profitable and produced a lot of cash flow. Thus, very little had to go right for the stock to be a profitable investment.

Polaroid, in contrast, had a lousy business, bad management, high debt and consistently produced negative cash flow. Even a new strategy wouldn't have saved the company, so I wasn't tempted to bet against the consensus and buy the stock, even at $1.

Betting against the consensus
Emotionally, it's hard betting against the crowd. I recall sharing the Office Depot idea with at least two dozen other value-oriented money managers and not one of them invested alongside me (in fact, one of them shorted the stock). I felt pretty lonely and worried that I was making a big mistake. Steinhardt had similar feelings throughout his career:

"The hardest thing over the years has been having the courage to go against the dominant wisdom of the time, to have a view that is at variance with the present consensus and bet that view. The hard part is that an investor must measure himself not by his own perceptions of his performance but by the objective measure of the market. The market has its own reality. In an immediate, emotional sense, the market is always right. So if you take a variant point of view, you will always be bombarded for some period of time by the conventional wisdom as expressed by the market."

To be a successful investor, you must be smarter than the herd -- not all the time, just a few times a year -- and also have the courage to bet on a variant perception.

I neither take comfort from standing with the crowd nor pride in standing alone. Though I tend to be a contrarian, that's simply because I've found that the best opportunities lie in carefully buying high-quality companies that have fallen out of favor, whereas the greatest risks generally lie in buying the most popular companies in the hottest sectors.

-- Whitney Tilson

Guest columnist Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. He owned shares of Office Depot at press time. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous columns for The Motley Fool and other writings, visit http://www.tilsonfunds.com/.