Introduction

Hello, I'm Steve Forbes. Our guest is Bruce Greenwald. Bruce is the director of
research at First Eagle Funds and the Robert Heilbrunn Professor of Finance and
Asset Management at the Columbia Business School.
Bruce is bringing some stock picks to the table. He's not a big fan of Ford, but
he likes niche players in the media business, like the Sci Fi channel.
As for the telecoms, he says the future is uncertain, but one thing is for sure
-- they really need to play nice with the cable guys in order to survive.
Bruce is also worried about what we call new bubbles, including Amazon.com. We'l
l tell you why next on Intelligent Investing.
True Value Investing
Steve Forbes: Well, Bruce, good to have you with us.
Bruce Greenwald: It's a pleasure to be back.
Forbes: You are a classic value investor, but as you've pointed out in the past,
no one says they're a non-value investor. And just like everyone says they're d
isciplined, until the market changes, everyone says, "Well, at heart, I'm a valu
e investor." What's your definition of a true value investor?
Greenwald: Okay, I think there are really two elements, or maybe three, to be ho
nest, that distinguish a true value investor. The first is where you look for op
portunities. It's just what your orientation is towards finding securities that
are likely to do better than the market. Because I think the fundamental fact ab
out investing that nobody can ever forget is that whenever you buy a stock think
ing it's going to do to well, somebody else is selling it, thinking it's going t
o do badly, and one of you is always wrong. Only in Lake Woebegone can all the m
anagers outperform the market. So you always have to ask the question, "Why am I
on the right side of this trade?" And this is a value approach to being on the
right side of the trade. And it is now rooted in a lot of work on individual inv
estor psychology. And it is, first, you want to stay away from the lottery ticke
t stocks.
People in every country have always paid for lottery tickets. They've always bee
n crappy investments and they're paying for the hope and the dream. So you want
to stay away from that. Second thing is in life, as in investing, people are ove
rly averse to what's ugly, disappointing, cheap and you really want to go there,
which is the corollary to staying away from the big upside stocks. And I think
the third thing that really value investors are aware of is that human beings ar
e constituted not to think in terms of uncertainty. If they think there are weap
ons of mass destruction in Iraq, they're sure there are weapons of mass destruct
ion in Iraq. Nobody thinks it's a 60% chance. If they think it's a good stock, t
hey think it's 100% chance that it's good stock. If they think it's a bad stock,
they think it's 100% chance it's a bad stock. What that means is that the good
stocks are overbought, and the bad stocks are oversold.
Forbes: So a value investor is not just being squishy by saying 70% chance of ra
in?
Greenwald: Unfortunately, he's being accurate because there is never 100% chance
of anything. So you want to go where all those factors lead you, which is, you
want to look for ugly, disappointing, diseased securities where you have a sense
that the disease is more than built into the price, which ultimately means chea
p. And that's the first thing that distinguishes a value investor. The second th
ing is --
Diseased Vs. Diseased
Forbes: So, in essence, you're saying emotions are your enemy.
Greenwald: Emotions are absolutely your enemy. You want to be a certain kind of
mutant who is just completely different in their orientation to what's an attrac
tive investment for the rest of the market. The second thing is that you want to
have even then, when you come to look at these securities, because some of them
are terminally ill.
Forbes: Some of them are really diseased.
Greenwald: Right, really diseased. And those you want to avoid. So what you want
is, you want a better methodology for figuring out what this security is worth,
and that's where you go back to Ben Graham and David Dodd. So all of the MBAs w
ho are taught to do discounted cash flows, or what is a shorthand for that ratio
, or multiple valuations, have been taught what may be a proper thing in theory,
but is for three basic reasons a terrible way to value securities in practice.
And the first and most fundamental is that when you do a discounted cash flow, y
ou take weighted averages of near term cash flows, which are projections, which
are very good information, and distant cash flow projections, which is very bad
information, and you add it together. And when you add bad information to good i
nformation, you wind up with bad information.
Secondly, they ignore balance sheets. It's all projected earnings and multiples
of earnings. And balance sheets are the most reliable, solid information you hav
e about a company. And the third thing is that if you look at the assumptions th
at go into a discounted cash flow model, they are profit margins, growth rates f
ar out into the future, costs of capital. Nobody knows what those are for a comp
any like Ford. But there are things you do know about Ford. Is this company goin
g to be economically viable? Probably not. Is this company going to have --
Forbes: Do you short Ford?
Greenwald: No, nobody is ever going to short something that's as highly leverage
d as Ford and still keep their shirt. Because all it takes is a little bit of op
timism and you're going to get killed. But it's a typical stock that's in the mu
ch too tough to call column. Does Ford have any competitive advantage over the o
ther big, global car companies? And the answer is no. So you'd like a methodolog
y that incorporates those kind of assumptions into your valuation. And that's wh
at Graham and Dodd developed. Always start with the assets. Then look at the ear
nings power and see if it's protected by the assets. And only then, and this is
what Buffett taught people to do, look to pay something for growth, because grow
th is only valuable if the investment in growth earns more than the cost of capi
tal. And if it doesn't, growth can destroy value. Growth is not a valuable thing
as a rule. So, and if you're going to buy that, you better be very sure of the
franchise. So that's what really constitutes a value investor.
Growth Invites Competition
Forbes: Before getting into what you look for, like barriers of entry, you just
mentioned something, growth invites competition. Can you elaborate on that?
Greenwald: Oh absolutely. I mean, opportunity invites competition. If you find s
omething new or something old that is attractive, that earns huge returns on inv
ested capital, everybody is going to see it. You can't hide things in a market e
conomy. And if you're not protected by economies of scale, by captive customers
or by patents and technology that's not available to the rest of the world, you'
re going to get copied. And that's especially true in rapidly growing markets wi
th a lot of new consumers.
Forbes: Which, by the way, is an argument against antitrust, because if somebody
has a monopoly that's not legally protected, people are going to kill you on it
.
Greenwald: I think that's absolutely right. Antitrust is completely, and has bee
n for years, incoherent. That where you don't have a natural monopoly, competiti
on will take of it. Where you do have a natural monopoly, having, breaking those
up and trying to regulate them is more trouble than it's worth.
Forbes: Now, you started to mention some of the things that truly constitute a c
ompany that won't be quickly done in by competition. Barriers to entry, you have
three others, supply, demand, economies to scale. Can you quickly go through th
ose?
Greenwald: Okay. Barriers to entry are exactly the same thing as incumbent compe
titive advantages. Because if you're, the newest guy has the competitive advanta
ge. It's just hyper competition. So it's got to be an incumbent competitive adva
ntage. What can the incumbent do that entrants can't do? And the first thing is,
they can have access to demand that entrants can't replicate. And that's called
customer captivity, they own their customers.
Forbes: For example?
Greenwald: Second -- oh, for example, your doctor. If you're satisfied with your
doctor, you're not going to leave. If you're satisfied with your health insuran
ce company, and most people are, it's, they're very reluctant to change, it's a
complicated process, there are big switching costs.
Forbes: Your IT systems.
Greenwald: Your IT systems, Coca Cola, you have a repeat taste. I mean, when you
go to a Mexican restaurant, you may order Mexican beer, but you don't order Mex
ican Coke because you have a taste for uniformity and that constitutes customer
captivity. Second thing is you can have technology they can't replicate. Patents
, or some sort of process factor, that they can't replicate, or some particular
very specific asset, like a terrific mind that they can't replicate. And the thi
rd thing, and in a way, the most important thing is, you can have a scale of ope
ration, usually locally, that they can't replicate. So when Wal-Mart dominates a
regional market, it builds an infrastructure.
If somebody wants to compete with them in that regional market, they've got to d
uplicate that infrastructure. To make it pay, they've got to get a share compara
ble to Wal-Mart's. And given habit formation in local shopping, that's going to
be essentially impossible to do.
And those are the three basic competitive advantages. If you don't have those, a
nd information is also an advantage in financial markets. But in most markets, i
f you don't have those three, you make a bad mistake to pay for growth.
Wall Street's Success
Forbes: So why did Wall Street do so well? Huge profits and a lot of bright peop
le around.
Greenwald: Right. And the question is, did Wall Street do that well? If you take
the losses, what Wall Street does is, and I think a good example is AIG. AIG ma
kes a lot of money while they're writing these derivative contracts that are ess
entially insurance. If I'm an insurance company, and I write an insurance policy
on your house, I have to reserve against the losses.
Forbes: Sure.
Greenwald: If I'm a financial company, and I write a policy against your portfol
io, so I write a credit default swap, the market falls apart, is going to go way
up and protect your portfolio, I don't have to reserve against the losses on th
at. I write the whole premium as profit. Well, if insurance companies did that i
n the good years, they would make unbelievable amounts of money. And then they'd
go bankrupt in the bad years. And guess what happened to Wall Street?
Forbes: So doesn't that argue that like rules of the road, I mean, when cars cam
e along, you had to put in, you know, rules. You don't drive when you're drunk,
speeds limits and the like. When derivatives, like credit default swaps, they're
, in essence, like futures, we've had them forever, put margin requirements on t
hem, things like that.
Greenwald: You can do that. You can do accounting reporting, so they have to bas
ically establish a reserve for losses.
Forbes: Yeah.
Greenwald: I mean, they had, there are a lot of things. But mostly, and this is,
again, getting back to value investing. People are predisposed to do stupid thi
ngs. That when they think markets are going well, they're sure, like long-term c
apital management was, that risk has gone away. It's not just, by the way, in ho
using markets. If you look at credit default swaps on sovereign debt in 2007, Du
bai sovereign debt was trading at four basis points.
That is, you could buy insurance against a default on Dubai sovereign debt for f
our one-hundredths of a percent. That means you were betting that there was less
than a chance, if you wrote that insurance, in 2,500 years that a country like
Dubai, in the most unstable region of the Earth, based on the most unstable comm
odity at a peak price, had a less, had a one chance in 2,500 years of defaulting
. I'd love to know who wrote that contract. And I think they wrote it because no
thing bad had happened for a long time. People extrapolated and they forgot that
there are probabilities. And, you know, subsequently, Dubai sovereign debt trad
es at, you know, the CDS, the credit default swaps trade at 600 to 1,000 basis p
oints.
Forbes: So I'd have been better off with Indonesia.
Greenwald: Of course. And I don't know how you stop that. I mean, I think that y
ou want to arrange the people who make those mistakes pay the price.
Future Of The Media
Forbes: One thing on that, talking about barriers to entry being obliterated, me
dia companies. You've never been a big fan of them anyway because --
Greenwald: I think that is not necessarily true. I think it's like all things. T
here are media companies with extraordinary monopolies.
Forbes: You point out that a lot of them haven't done very well.
Greenwald: Right. And then there are media companies that everybody thinks shoul
d have monopolies, like content companies.
Forbes: So, Bloomberg versus --
Greenwald: Well, or Comcast, which has a monopoly cable. It's only competitive w
ith the phone company. And if they can get along, it's a duopoly, versus the mov
ie business where everybody can get into it, and you can see it in the movie bus
iness. This ought not to be a surprise. So everything that could go well for the
movies goes well for the movies. They get DVD distribution. They get cable dist
ribution. They get foreign rights in a serious way.
Revenues grow at eight and a half percent a year for a very long time. Costs gro
w at 11%, because they bid for the stars, they produce more movies and the entry
eliminates the profitability. And content is king? I don't think so. Unless the
re are barriers to entry in producing that content, so you've got to get a scale
like Bloomberg and the kind of customer captivity that Bloomberg has.
Forbes: So looking at the media landscape today, what do you see unfolding?
Greenwald: Okay, first thing is that you've got to break it up into parts. So th
e first part is just content production.
One-off content production, where every little thing like records, or movies or
books is an individual production, has no barriers to entry, it's going to be a
crappy business. Fortunately, it's always been a crappy business. Now, it's wors
e a little bit because of piracy.
Forbes: So if it wasn't for hobbies, that would have dried up a long time ago.
Greenwald: Right. Specialized continuous information content, where you're proba
bly going to have one provider, providing bond prices for the Turkish market, sa
y, are going to do really well, because for a long time, they're going to be abl
e to keep people out. They're going to be the only provider, they're going to ha
ve local economies of scale, and people are going to depend on them.
In wholesaling, again, people who put together specialized content, like the Sci
-Fi Channel, are going to do much better than people who do generalized content
and are competing with eight or nine channels. Finally, on the distribution end,
the people are going to make money there are, of course, not the old physical d
istribution people, but the people who own the electronic wire, and that's the t
elcos, to the extent they do it, and Comcast. And those are going to be hugely v
aluable monopolies. When we all live in caves for global warming or whatever rea
son, that wire is going to be our lifeline. And if those two guys can cooperate,
a large share of our income is going to go to that.
Telecoms Of The Future
Forbes: So do companies like Verizon and AT&T have a future?
Greenwald: If two things happen. One is they have the infrastructure to provide
fast Internet accesses essentially. And that will be a cost-free infrastructure,
it'll be a fiber backbone, and it'll be over the air transmission, so it will n
ever break, and will be completely software defined. So nobody will work there,
and it will be hugely valuable, because it's a huge fixed cost. That's the first
thing. If they can get that infrastructure in place, they'll do really well.
Second thing is they have to be able to get along with the cable companies. Beca
use that's a shared monopoly, and if those guys are testosterone-crazed jackasse
s, and compete with each other, they will convert it into an unprofitable, compe
titive business. If they can get along, implicitly, they will make a ton of mone
y.
Forbes: So, what areas do you like right now, as a value investor?
Greenwald: Well, I mean, I think cable is much despised. Telcos are much despise
d all over the world.
Forbes: Right.
Greenwald: And you want to do the work to see which are the telcos that are like
ly to, first, be in a position with this basic infrastructure, which is going to
be universal. And I think there are foreign telcos that look like they're able
to do that. I mean, France Telecom may eventually get there. Turkey Telecom has
got a lot of fiber infrastructure and cable infrastructure, and may get there. S
o you want cheap telcos with a future, because the future is essentially, they'r
e essentially trading it, like, eight to 10% dividend yields, as if they're dyin
g, and some of them are not. And the other one is the cable companies. I think C
omcast is --
Forbes: So, if you're on the highway, collect the tolls.
Greenwald: Of course. Exactly. And if you're on the highway at a really low pric
e, because everybody else thinks the highway is going to fall apart and be reall
y expensive, that's a lovely place to be.
Apple And Amazon Bubbles
Forbes: So what bubbles do you see out there in the financial market?
Greenwald: I mean, aright, I'll do the one that I've been wrong on for years. I'
ve always thought Amazon is a bubble. They have no customer captivity. They don'
t have enough scale that it's hard to replicate. They occupy a really big market
. They're not specialized at all.
Forbes: So how have they done so well for so long?
Greenwald: Well, first of all, they're, I think if you actually look at their re
ported profits, they haven't done that well.
Forbes: Okay.
Greenwald: What they're selling is this idea that they're going to continue to g
row and they're going to have negative working capital. Negative working capital
's an invitation to competition, right? So why they think that ultimately is not
going to be competed away is beyond me. So that, I think, is a bubble.
I mean, I've been semi wrong about Apple, which I think is a bubble, because we
have a lot of experience with consumer electronics companies. We have a lot of e
xperience with cell phone companies. And that experience says that there are no
barriers to entry to consumer devices. Now, in the computer market, they may do
much better for longer, because brand names are more persistent there. That Dell
, for example, has had a dominant position in the corporate market, and direct s
ales to that market for years. But ultimately, I think that's an area where comp
etition is going to tell. And paying the multiples people are paying for Apple i
s absurd.
The other one I think, and this is along the lines of growth not always being va
luable, people are paying a lot of money for companies in Brazil and in China th
at are subject to competition.
Chinese manufacturers have to compete with other Chinese manufacturers. And the
growth just gets competed away by entry, like it did for the movie business. So
I think you would be well advised, especially given the political uncertainties,
 and everything else in the fundamental economics, not to pay a ton of money for
China. And I think there's something else that is going to kill China too, whic
h is that if you remember, if we had been sitting here in 1989, everybody though
t the United States was going to consist of people who flipped burgers at Disney
land for Japanese tourists.
Forbes: I didn't, but others did.
Greenwald: Others did and they were wrong. And they were wrong, because the Japa
nese were in manufacturing. And manufacturing is an area where productivity grow
th is much higher than demand growth, and it means, like agriculture.
Forbes: Make a quick point on that. Caterpillar, Deere and others, make the mone
y not selling moving equipment so much as servicing it, which is local markets.
Greenwald: Exactly. Which is local markets that they can dominate. Global making
markets are subject to what happened to agriculture in the 1920s and '30s, whic
h is, everybody left it. Everybody could do it. Productivity growth was enormous
, and it died.
And I think Japan has basically had this very long period of malaise because the
y have decided they're going to be the preeminent manufacturer in the world. It'
s like in 1940, the United States deciding they're going to dominate the world b
y being the preeminent agricultural producer. And that would've led no place. An
d I think China's in the same game. So, I think you're going to have real troubl
e in China.
China Hindered By Education
Forbes: Elaborate just on that one minute on China. Authoritarian government, hu
ge success so far. Are you saying they don't have the kind of flexibility and th
e true, free market that allows the economies to like we've done over time?
Greenwald: I think it's not so much that, although I think there's an element of
that to it. First of all, on the huge success, they still have an output per ca
pita that's probably a third to a half of Taiwan's. So the direction is good, bu
t the level is still nothing to write home about.
Forbes: Right.
Greenwald: Secondly, I think that they have done it by specializing in industrie
s which are manufacturing industries and it's a manufacturing, export-driven eco
nomy that are going to get automated. If you go into a Japanese factory today, I
mean, and this is the problem with Japan. There are more people on the loading
dock than there are in the factory. And the loading dock is this service functio
n that you talked about with Caterpillar, and so on. There is no evidence yet th
at they've moved into developing a vibrant, innovative service sector.
And there is equally, I think, little evidence that they've actually developed l
eading edge manufacturing compared to the Japanese. They've done better at the l
ow end than anybody expected, but they're not the star manufacturing companies t
hat the Japanese are. And a lot of good that's done the Japanese. And I think th
e third and most important thing is what you're talking about. That ultimately t
o support a standard of living that's high in this environment, you not only hav
e to have a service infrastructure, but you have to produce intellectual capital
. And the striking thing about the Japanese is they did not produce great univer
sities. And I don't see any evidence that the Chinese are producing great univer
sities either because the truth is, and this is related, I think, to the politic
al system, that the very best graduates who come to the United States, and a lot
of them come, all want to stay here.
Forbes: Still?
Greenwald: Of course. Wouldn't you? And you talk to them, and you say, "You want
to go back to China?" And they say, "Not if I can help it."
Forbes: So does that mean India has an advantage over China that they are more m
ind-oriented and not to mention the rule of law?
Greenwald: I think there are two reasons. I mean, we're, first is, that they are
much more service oriented. And I think that's going to help them.
They're not committed to doing the kind of, sort of mindless manufacturing that
the Chinese are doing, or blindly pursuing that alley. And secondly, I think tha
t, yes, the politically vibrant culture that's there is going to make a big diff
erence. On the other hand, if you look back 70 to 80 years, the dominant univers
ities in the world today are the dominant universities then. So I think India is
not going to necessarily succeed in displacing the great American and the few g
reat European universities. But the Indians ultimately want to go back in a way
that the Chinese don't necessarily want to.
Western Europe's Lagging
Forbes: And talking about Europe, why has Western Europe been such a laggard? I
mean, they should've been at the forefront.
Greenwald: Again, I think that there are two reasons for that. And they're exact
ly the reasons we've talked about. I mean, that in a sense, the future is servic
es, which are locally produced and consumed, and production of intellectual capi
tal. And those are both state-dominated sectors. And they have not produced succ
essful universities because they have egalitarian overlays on things that mitiga
te against the kind of excellence that you have at Oxford and Cambridge and in t
he U.S. universities.
So they haven't been producing the kind of intellectual capital they need to pro
duce. And it's not so clear that they're going to be good at that. And the secon
d thing is that services, and the big services are, of course, education, medica
l care and housing, are government dominated. Either run with very tight zoning
restrictions, or they're directly run by the government, and I don't think that
helps you.
Forbes: So, quickly looking at the U.S., if we want to continue to be a real lea
der, shouldn't we be going to opposite direction on health care? Opening it up t
o entrepreneurs and get a real rip in innovation and production and like we do e
verywhere else?
Greenwald: I mean, I, of course, I think that's true. I mean, and if I can say s
omething about the United States, because I think it's important. There are in t
he world two basic ways you control human behavior and have societies function.
One is material incentives. And that includes, obviously, not just money but, yo
u know, all sorts of material sanctions. And the other is social incentives. And
the U.S. is an economy that has been selected for not having social incentives
because if you were an Italian, and you didn't like the social restrictions in y
our village, you came to the United States to do well. And what that's done is c
reated a culture because you don't have to enforce more obedience in the schools
the way they do in Europe, that is a wonderful culture.
I mean, in the United States, you can screw up till you're 35-years-old. And if
you're hard-working enough and smart enough at that point, you'll do well. In Fr
ance, or in Germany, or in England, or in Japan, or in China, if you screw up by
 19, and in France, don't get into a grand ecole, you're finished for life. And
there is no equivalent of Animal House or the huge literature on high school and
college experience in the United States both in films and books in Europe. I me
an, school is a grim experience in Europe. And I think that it is that attribute
of U.S. society that we don't want to kill in any dimension.
Forbes: So even though a lot of our especially inner city schools mess up, if th
e kids are playing games, their mind develops?
Greenwald: It's not just that. I mean, there, look, there are people who develop
at 15, I mean, there are people, there's a famous investor called Seth Klarman,
I knew him when he was an MBA student at Harvard. He was the same then, he was
as capable then, he was as brilliant then as he is today. He developed very earl
y in life. But there are other people who develop much later in life. They devel
op not at 15, but at 20, at 25, at 30, at 35. And I think trying to force everyb
ody into a European mold, where if you aren't doing well by 19, we're going to w
rite you off, is crazy. I mean, I would let those people out of school, and let
them come back to school later. It's funny, I talked to somebody here who starte
d out, she left home at 16, to be a rock star. And she tried that for four years
and then she went to NYU and obviously did well and she works for you now as a
journalist.
That is not possible in Europe. And I think that's one of the glories of the Uni
ted States that you want to make sure is not eliminated by trying to pursue a Eu
ropean model of service and welfare provision. I mean, there's a downside to it,
but I think there's a wonderful upside to it.
Forbes: Bruce, thank you very much.
Greenwald: Thank you.