David Abrams - Applying a Fundamental and Value-Oriented Approach to Investing (Apple Podcasts)

Value investing is more than an investment strategy. It's a fundamental way of thinking about finance. Welcome to Value Investing with Legends, a podcast hosted by Tano Santos, the David L. and Diana L. Temple Professor of Finance at the Heilbrunn Center for Graham and Dodd Investing at Columbia Business School. Our mission today is to promote the study and practice of Graham and Dodd's original investing principles and to improve investing with world-class education, research, and practitioner-academic dialogue. In this podcast, you'll hear from some of the world's greatest investors, their views on the investment management industry, how they develop their investment process, and how they see the field changing over time.

To learn more and to subscribe to this podcast, please visit GrahamAndDodd.com.

Welcome to a new edition of the Value Investing with Legends podcast. I'm your host, Tano Santos, the David L. and Diana L. Temple Professor of Finance at Columbia Business School and the Faculty Director at the Heilbrunn Center for Graham and Dodd Investing. In an article in June 2014, the Wall Street Journal described my guest today as the "one-man wealth machine," an investor who had returned over 15% since the founding of his investment vehicle in 1999. He's a quiet and understated man, one that is rare to catch, and he's not keen on interviews or appearances, so I'm particularly thankful for his presence here today and for the many occasions in which he has participated in many Columbia Business School events, whether at the CIMA conference or the first time I saw him, which was at the hugely entertaining panel on the financial crisis with Congressman Barney Frank.

David Abrams, welcome to the Value Investing with Legends podcast.

Thank you.

David Abrams is the managing partner of Abrams Capital, an investment firm that currently manages about $9 billion across a wide spectrum of investments. Mr. Abrams serves as a director of several private companies. He's a member of the board of trustees of Berklee College of Music and an overseer of the College of Arts and Sciences at the University of Pennsylvania. He holds a BA in history from the University of Pennsylvania, and he started his career with another value investing legend, Seth Klarman, at Baupost in 1988. He said of Mr. Abrams—and I love this quote—"He loves a good puzzle and a good treasure hunt. He doesn't get more Ben Graham than that." He's also the author of one of my favorite quotes on value investing, which is one that I've stolen many times for my students.

Value investing is the E equals mc squared of investing, Albert Einstein's famous equation linking mass to energy through the speed of light. So welcome again, David. Thank you so much for being here with us today. Oh, thank you. So I want to start, as always when doing this podcast, with your intellectual beginnings in the field of asset management, of investing. You, as I said, you graduated in history from the University of Pennsylvania. I'm completely curious about your intellectual trip from history to asset management.

I got into, unlike a lot of people, I got into investing really by accident. It wasn't something that I had a long-time interest or passion for. I simply graduated college and was looking for a job and was fortunate enough to find some people that were starting a firm. And the way I like to put it is that they were looking for cheap labor and I was looking for a job. So I actually didn't start with Seth. I started here in New York with a couple of jobs before I got to Baupost. The first was with a firm that at that time was known as Oxford Arbitrage Associates. And I was doing merger arbitrage, risk arbitrage transactions.

And you had no background whatsoever?

I had no background whatsoever. And as I said, they were mostly looking for cheap labor. And really, when I started, I didn't know. I had never taken a business course. I didn't know what a stock was. I didn't know what a bond was. I didn't know the difference between the two. I knew nothing about accounting. My boss was a little bit horrified when he said, 'You don't know what the basic accounting equation is, that assets equals liabilities plus equities?' And I didn't know what any of those things were. But fortunately, they stayed with me and I read a lot and learned a lot in the first two years. And what were you doing?

Just basically basic analysis on firms and stuff like that?

I was doing analysis on merger and arbitrage deals. So, you know, I think that it turned out to be a great training. You see all kinds of different industries. You focus on the transactions, which is a little bit different. And in some ways, that's a mode of thinking that I sometimes use today, not all the time. You see a lot of different types of securities because sometimes in mergers you get warrants issued or spinoffs or whatnot. You see a whole spectrum of things. The thing you don't get is that you tend to be involved in these companies for pretty short periods of time. So you don't get to see them over time. That's something I learned later on. But in terms of a training ground, it was a great start.

I also benefited because at the firm, the firm—it was broader than that. And so there were people doing options arbitrage. So that was interesting. There was a guy who traded distressed bonds. There was a merchant banking group. I didn't interact too much with them, but I saw a little bit of what they were doing.

So it was a relatively large operation then?

No, it was a pretty small operation that did a lot of different things, actually. I see. I think they started—at the time it was a decent amount of capital, but today it seems like a very small amount of capital. I think they had $10 million that they raised, and we went from there.

I see. So you stayed there for a couple of years?

I stayed there for a couple of years and then joined another guy by the name of Mark Dickstein to do essentially merger arbitrage and distressed bonds. I see. And then you stayed there for another short period of time, and then finally you went to Baupost. Right. So I was in New York for about five or six years before I went up to Boston. Okay. So when you went up to Boston with Seth, now you have a more solid background, so to speak, on investment and finance.

What were your responsibilities when you arrived at Baupost? What did they make you do? What did Seth make you do?

Well, one of the attractive things—I didn't really want to leave New York. I love New York. Are you a New Yorker, by the way? I grew up in New Jersey. I see. So the attractive thing about Baupost at that time was that Seth—I met Seth, and he seemed like an incredible guy. And everybody who knows Seth knows that he is both—not only just a brilliant investor, but an incredible person. Yeah, the man leaves an impression. And he's so involved with the community and all that kind of thing. Part of the attraction was that I was the third investment professional at Baupost. It was Seth, it was another guy, and then I was the third person. So it seemed like an opportunity to get in on something at a pretty early phase.

It wasn't day one, but it was—in hindsight now, it was very early days. But they had—at that time, they had what seemed like a huge amount of money. I think it was $180 million when I joined. In 1988?

The beginning of '88. Right. So, Baupost had been around for five or six years by then.

It had been about, yeah, they had been about for, yeah, about four or five years.

And you were doing yet again.

So, what I was doing then, the attraction was that they had a very broad mandate. And I could see early on that arbitrage was, was going to be limiting. Even though I came in 1983 not knowing anything, by 1985, I kind of figured a few things out. And I could figure out that arbitrage wasn't exactly what people were billing it as. The idea initially behind arbitrage, if you went back before my time to people like Gus Levy at Goldman Sachs, was a transaction would be announced at, at $20 a share, and people would sell at $19 because there was only a dollar left and they wanted to move on to something else. And that dollar, that 5%, was a pretty big spread, and that was how arbitrage began. But over time, people figured that out, and it morphed into something really different.

And by 1985 or '86, people weren't buying $20 deals at 18 and a half or 19. They were buying $20 deals at 20 and a half or 21, hoping that Mike Milken would finance somebody else to pay 24 for the same company. Exactly. So, I early on identified the need to broaden myself out. And Seth had a really broad mandate. And so that was the combination of Seth being a great guy, a lot of money, early days, and the broad mandate was what drew me to Boston.

That's great. So, I mean, this is kind of interesting. And we'll come back to this issue of, you know, this is one of the things that I like very much about, obviously, you, but also Seth and many others, is kind of this generalist approach that is not dead. And I want to return to this topic. But I want to keep with your professional career first before we move into more methodological issues. So you stayed essentially for a decade at Baupost, moving up, essentially, and you ended up, I guess, running a significant fraction of the portfolio. Is that correct? Yeah.

I wouldn't say that I ran a fraction of the portfolio. I was an important person there. I mean, ultimately, Seth was the portfolio manager, so he ran the whole portfolio. It wasn't the kind of place where they say, 'OK, Abrams, you take X dollars and good luck to you.'

So it was a collaborative effort. Ultimately, Seth was the portfolio manager. Very good. And by then, you've extended your expertise hugely.

Yeah. In the course of 10 years, we had done stocks. We had done merger deals. We had done bankruptcies. We had done bank bailout deals. We had done real estate. We had done, in the whole course of the 10 years, we had done Japanese warrants. We had done all kinds of things. I see.

Now, you leave in 1998. You had the idea of Abrams Capital Management right away, or what is what?

When I left Baupost, I really didn't leave to start an investment firm. I left to just take time off. I had been working nonstop for, since a week after graduation, for 15 years and just wanted to take some time to gather my thoughts and figure out what the next phase of my life would be. I thought there would be a good chance I would do something different than investing. As I said, I had gotten into investing purely by accident, really. And I liked it very much. But I thought, well, there are other things in the world one can do with one's life. And so I took some time off. I left in early '98. And then ultimately, the markets crashed in the summer of '98. And I couldn't think of things that I would like to do more on a day-to-day basis.

There are things that interest me, a lot of things that interest me, but not that I want to get up every day and do for 40, 50, 60 hours a week. So in the end, about a year later, I decided to come back into the asset management business effectively.

And when you start your firm, let's start talking a little bit about investing philosophy and about investing in particular. Again, you're thinking about a generalist asset management company that is opportunistic, that is willing to basically get into a variety of situations. You come in at a very peculiar moment. I mean, you know, there's a correction in the markets, but the markets keep going up quite a bit until the crash. How did you live those late years of the tech bubble cycle? I mean, what were you thinking at the time? What kind of things were you finding out? Was it a good time to get in? I'm sure it was a good time to raise perhaps money for a new fund, given the booming stock market.

I mean, a couple of things. First of all, it wasn't a good time to raise money. It was actually one of the worst times in history to raise money because what had happened, I went out, the market crashed in the summer of '98 based on Long-Term Capital blowing up. Right. And so I went out.

And people hated hedge funds. And when I went out to raise money in the fall of '98, people didn't want to hear about hedge funds. They didn't want to hear about one with a broad mandate. And I didn't have a track record. I had been at Baupost and been successful there. But as I said, Baupost is really Seth's track record. And he was the portfolio manager. So it was not a good time to raise money. But it was a very good time to invest. And I think that's something that's typically true. The best times to invest are the hardest times to raise money and the worst times to invest are when it's easiest to raise money.

I had forgotten exactly about how volatile markets were in 1998 with the Russian situation, LTCM. The Asian crisis of '97 was still lingering and the resolution of that mess and what a big effect it had. I guess that's perhaps what I was not aware of, what a big effect it had on the hedge fund industry, on raising capital for the hedge fund industry in relatively benign macroeconomic conditions in the United States.

Right. I mean, it was really people did not want to hear about my venture. We raised on day one, we started with $25 million. I was far and away the largest investor. So I raised roughly $10 million outside. So I mean, that kind of tells you, you know, after six months of trying and 10 years of Baupost, I raised $10 million. So it's a little bit different than people might have in their minds. Right. I went to Baupost because I liked the broad mandate. And that's something that I always believed in and still believe in. So certainly that was something I was going to adopt. And Seth and I think a lot alike. So a lot of the things that I do are things that Baupost does that I had in my mind and I learned at Baupost.

So there's a lot of similarities. I mean, obviously, there's some differences. We're much smaller. But there's a lot of similarities to the approach. Right.

So let's start talking then a little bit about issues of method and how you construct a portfolio, how you come up with ideas and so on and so forth. There are many issues that I want to get into with you. Before we get into the specifics of the valuation analysis and how you think about that, how you think about price and stuff like that, I want to understand, you've mentioned in a couple of interviews or a couple of occasions, I don't remember whether interviews or things that I've heard you say before, this thing of the deep analysis of the business operations of the firm, that you have to understand the economics of the situation at hand. You know, why is it that this is a good business that you want to be invested in or an interesting situation that you want to be invested in?

What do you mean by that, given that I know you've been involved in many different situations? What kind of analysis do you do? Perhaps you can give us an example regarding a specific firm, perhaps, or a specific situation that you found particularly enlightening. What do you mean by that understanding of the economics of the situation at hand?

I think that we invest in a wide array of things. So there's sometimes there's assets. Sometimes we buy things in distress. Sometimes we buy things that are good and growing. In all cases, we do want to understand the the fundamental economics, because it's easy to tell what has been, it's easy to tell what is today. We're always trying to deal as an investor with what's going to be in two years or tomorrow or five years from today. So to understand like the dynamics about what's going on, and, uh, who has power in relationships, what people's alternatives are, what the value to the customers, what the value to the employees. So you try to understand that as opposed to just taking historical numbers and projecting them forward.

What do you mean by this thing of who has the power in a relationship? Are you referring, for instance, to whether a company, say, has some pricing power, whether customers have an alternative to the product?

Yeah, so pricing power is an interesting one. So a lot of people, ourselves included, You like to find businesses, companies with pricing power. So that's good. But to say that something has pricing power and to leave it there, I think, is really an incomplete line of thinking. Because no, but it has unlimited pricing power. Of course. And then the question is, what can help you and what can hurt you? I mean, I think in a way you're trying to ask yourself, okay, why? What can help you? What can hurt you? And so to kind of understand those things at a deeper level is really crucial.

So let me understand that a little bit further. So when you actually approach a company and you see, well, you know, this company is kind of protected by perhaps some barriers to entry, something that gives them the ability to price above average marginal cost. I mean, something then that you do is, well, which are the substitutes to this particular product or service? You know, who can come in and contest that market? And is the force of, you know, is it really a barrier to entry? Is it something that capital is going to be invested in order to circumvent? So you do a lot of analysis around this question. Is that what you're referring to?

We do. And we think about it. A lot of times the analysis is as much just thinking it through. I mean, there's plenty of times when there's information and data that you can get around this. But in the end, you're trying to form a judgment about something. And I don't think that the judgments are going to be found on an Excel spreadsheet. So it's about thinking those things through as much as anything.

Right. You have this very nice line, actually, that there's no algorithm for investing. And I guess this is particularly for many of our students. Sometimes, you know, you have to tell them, look, this is exactly that. There's no algorithm. There's no one, two, three, you do this, you will be a successful investor from then on, essentially. There's a lot of qualitative analysis. And I feel that this is particularly true when it comes to the business operations of the firm. On many occasions, you won't have the hard data. You won't be able to estimate a demand curve that the firm is exposed to. So you're left a little bit with some qualitative analysis, and you have to live with that. You have to live with the consequences of, you know, there's something that is not as precise as you would want it to be, but is equally firm as the basis for investments.

Do you agree with that?

I think you absolutely have to live with qualitative analysis. There's uncertainty, there's competition. I think that one of the things that is obvious to everybody, probably forever, but particularly in the last 10 or 15 years, is that capitalism is very competitive, and there's a lot of change, and that there's change going on every day all around us. And maybe because of technology, it's a little bit easier to see. I think it's always been the case. Sometimes it moves more quickly, and other times it moves more slowly. Today, it certainly feels like it's moving more quickly, but maybe that's just what people always say in their moment.

I think you're absolutely right. One of the things that is distinctive about the world we live in today is this enormous amount of capital willing to essentially finance entry in a variety of industries, essentially, and to, you know, I think yields are relatively low in many domains. So capital is willing to take on bets, essentially, that perhaps 20, 30 years ago, it was more than willing to take.

That's certainly true. I mean, they're also willing to take bets with, if you look at it as the capital investment themselves, but they're also willing to take bets with intellectual capital that they weren't willing to take 30 years ago. So people will back 22-year-olds and 20-year-olds and 25-year-olds in a way that they probably wouldn't before. I think overall, it's a good thing, but it makes it more intensive. The other thing, too, is that a lot of the businesses that have arisen in the last few years, which one of the things that's absolutely fascinating about them is that if you look at some of the super profitable ones, they didn't require much capital to get going, and they required the intellectual capital.

And that's why there's a lot of capital to say, "I'll take a shot on a team, on a person, on a young person or a young team," because the potential payoffs—everybody can see what the potential payoffs are. Whereas in the past, if you're building whatever, if you went back into the '70s and '80s and oil prices were really high and people wanted to maybe get into the oil game, well, back then, I mean, that was like a big ticket to get into. And the only way you could get into that game was spending a lot of money because otherwise you're not going to get anywhere. Today, with what's going on with technology and whatnot, there's much broader opportunities.

Yeah, I mean, this is a very good point in a way that what is interesting about the business environment today is a lot of it already comes financed because it's the human capital, which perhaps these kids took on some loans themselves in order to put themselves through college or through the master's program. So, in a way, the capital that is needed to actually invest in the physical needs of that new firm is limited, relatively limited in a way, which is going to put a lot of pressure on valuations almost by construction.

It does. And so much also, even more and more, even with the cloud, even people that were wanting to get into technology used to have to buy their own servers and whatnot, now that you can plug into AWS or Azure or whatever. So, it's a very fertile environment for innovation and people trying to. And the other thing, too, is that the world's changed. Like, it used to be if you worked for a company that went bankrupt, people would hold it against you maybe for a very long time. And I think it's one of the more positive changes is that people don't necessarily hold that against you. It's like, "Okay, you tried something. It didn't work out. Let's go on to the next. Let's move on." In that sense, it's very positive.

Well, I always thought that this is one of the great things about the American capital markets, which is this second and third chance that you get here relative to, say, Europe, where the chances are much more limited. And I agree with you that, again, there's a connection between that and taking chances on people who've tried several things before and the amount of capital. Let me bring you back just one second to one thing that I don't want to leave unaddressed, which is this issue of the generalist. And in relation to how competitive things are these days, you said that you see eye to eye with Seth Klarman on this issue of being a generalist, being able to find value across a range of situations, of industries, of countries, and so on and so forth.

Is that how you see it? I mean, the generalist is still alive and well, or you think going forward, we're going to need as well investors to specialize in order to find value?

I think that both models can work. I don't think it's one or the other. I think it's a little bit depends on your temperament. It depends on your organization. And I think there's tradeoffs. So benefits of being the generalist is that you're comparing this beat-up stock to that growth stock to this asset to this bond. And maybe you get a broader perspective, and that can be helpful. The obvious negative to being a generalist is that when you get into new areas, you're going to be at an information disadvantage. A lot of people are going to know a lot more about the specific XYZ of various industries or various companies than you are. So you need to... You always need to approach markets and business with a lot of humility, but I think as a generalist, even more so.

Right. I agree with that. And this brings me to this issue that Bruce and I always tell the students of the program, which is you have to ask yourself always when you enter into a particular position in a stock or you take a particular position in a distressed situation, what is it the other side of the market knows that you don't? That is... making it sell that position to you rather than buying with you. What is your differing view relative to the market, and why is it that you find value where others do not?

Yes. I mean, I think you have to really be, as you said very well, you have to be cognizant of what's the other side of the story. I mean, every stock, I like to say, is at least two stories: a bull story and a bear story. And you need to understand both very well. And you need to understand what the true risks you are assuming and how they can play out. And so they won't fare well. So, yeah, I think that is really true. You can carry this a little too far in the end. If there's 100 million shares of stock of some company outstanding, somebody owns them. They may be good or bad, and it may be good or bad at the current price, but somebody owns them. And we don't go too crazy with worrying about what other people think.

And we're trying to determine what people think not by reading reports or anything like that, but really by understanding the economics of the business and comparing it to the securities prices. And that will really tell you what people are really thinking.

Okay, so let's talk a little bit about that. Let's talk a little bit about this issue of valuation. So you find, and we'll come back to the issue of search and how you find ideas in a moment, but you've decided that you like this company. You find it attractive, you know, something interesting to think about. You cannot make quite sense of the price that the market is quoting for you for this particular company. Walk us a little bit into the type of analysis that now you do in order to assess what should be the fundamental value of that company. How much are you willing to pay for that company?

The first question that we always ask in any analysis is, what's the risk? So is it a kind of asset, a kind of business where you could lose all your money if things go badly? Is it the kind of asset where you could lose a little bit of money? Is it the kind of asset where you know you're going to make money? And then once you do that, then the question is, okay, this is what the upside is, and is the return commensurate with that? We look at really such a wide array of things, like I said before. So we look at credit, and we look at equities, and we look at companies that are growing, and we look at companies that are stable, and sometimes the companies that are shrinking. And for each one, you need to kind of—there's a bit of a different mental model.

If I have a company that's growing, I think the question is, how fast is it going to grow? What could make it not grow? Some of those business dynamics we were discussing before—if it's a pretty stable thing, obviously, it's something that could make it not stable. What could make it do better than what you're assuming?

So you're thinking about a specific—can I ask you a little bit about this? You're thinking about specific things that can happen to this company. In a way, it's kind of an exercise on contingent forecasting, for lack of a better word. Yeah.

What you're trying to think about is the multiple paths that could happen. So there's not one path that can happen in the future. When you look back, there's one path that happened. But that doesn't mean that going forward, there's only one path. And in the future, there's multiple paths. So you need to have in your own mind the range about what that could be. Right.

I guess that if you're thinking—I like very much this way of thinking about, almost like you start with a risk. What can go wrong with this company? What can make you lose a bit of money, all your capital? What can go right with this company? And then kind of interacting it with a mental model. If the company is shrinking, well, you know, shrinking industries are not likely to attract capital. So you need to worry about that a little bit less than a growing industry, which is likely to attract capital. So now we kind of shift and bring the tools that we have or the lessons that we've learned from situations in growing industries where capital came in, contested the market, made life difficult for our company, and so on and so forth.

That's really well said. Exactly. If you have a shrinking industry and it's dying, it's like people are not dying to get into that. So if you own Alphabet and Google, right, people are dying to get into that. So those are like really different things. Right.

And then you have really to think carefully, you know, thinking about that company, of course, you know, what is going to protect this company from all these entrants that are really going to throw a lot of capital at these situations?

One of the things I like to say is if you look back at the history of network broadcasting, right, there was initially—there were three networks. Right. And everybody looked at that and said, 'Oh, boy, they have it made in the shade,' and, 'Like, how do I get into it?' Nobody could figure out how to do it until some guy named Rupert Murdoch figured out how to do it. And what he did was really brilliant. And then he created the fourth network. And then he did really well. And that went really well for a while until cable television came along, and now there's 500 possibilities. And then the internet came along, kind of blew up everything, and now he's dismantling his empire. And that sort of goes to the point of change as well.

Yeah.

I mean, this is an interesting point, that in a way, the forces of competition are relentless. You know, you always have to take them into account, because people will figure out a way. I was telling my students recently about coffee consumption in Asia, and I challenged them to think about tea consumption in Europe in the 17th and 18th centuries. And the monopoly the Chinese had for a long time of tea production, and how the English were able to circumvent that monopoly by essentially developing the Indian tea industry. And it took a long time, actually, to actually do this. But eventually the benefits, the surplus to be made was so enormous that a lot of capital was spent in developing an alternative industry in a completely different country that became the pearl of the Empire,

of the British Empire, just almost on account of this, you know, that it was just driven to some extent by the need to break up this monopoly. So very good. So now you have a sense through, I guess, how you think about the business on a sustainable basis and see, well, you know, if this business doesn't grow, how much would I be willing to pay for it, given the operating margins that it's posting currently, the type of revenues that they have, reinvestment expenses, blah, blah, blah, those with their proper corrections. Is that how you think about it first? Or you go and do a full-fledged discounted cash flow model? I mean, how do you go about this?

Well, here's what I would say about this. So if we buy things with what we call a hard catalyst, so some kind of event that's going to close the gap between what you bought it at and what it's worth. We also buy things where there's no catalyst. So we're just owning businesses. In the first category, if there's a catalyst, we don't need that much growth. We need to buy it cheap and get out. Got it. In the second category, where there's no catalyst, we absolutely need growth. Yeah. And now the growth can come in all kinds of ways. It doesn't have to come through increased revenues, although a lot of times it does, but it can come from running operations more efficiently. It can come from acquisitions.

It can come from buying back shares really cheap. But if there's no catalyst, we absolutely need growth.

So let's talk a little bit about this issue of growth. So I understand this issue of the catalyst, and perhaps there are situations where you can identify what is kind of the event that is going to trigger value for yourself and your investors. When thinking about growth, kind of, management plays an important role somehow in capital allocation. How do you think about that? How do you approach the issue of management? Do you talk with them? Do you try to assess their quality? How prominent is the future in your valuation analysis?

Not everything fits this bill, but we have a bias towards liking companies where the management owns a lot of stock and has created value. The idea is fairly simple, and there's a lot of people that understand this, is that having people that have created value have a way of figuring out what will do it more in the future, that they're focused on that. So not everything falls into that bucket, but we certainly have a lot of our companies that do. And that's something that we think is really important because, again, and this point's been noted many times, it's if you have a management team where their primary economics are coming through salary and bonus, you can be at odds versus being a shareholder.

So that's the first point. The second point was about how we interact with companies. I'm thinking about actually writing something or maybe doing a talk sometime on what I call the G in ESG, the governance side of ESG, because I think there's a space that we occupy somewhere between, say, index funds and Fidelity on the one hand—and Fidelity doesn't want to make anybody upset because everybody has to come back and go to their headquarters, and if you start ruffling feathers, people aren't going to do that. So that's the one end of the spectrum. And on the other end of the spectrum, you have people like Carl Icahn that are very abrasive. And Carl's done a great job making money for himself and his investors.

So there's nothing—I'm not saying in any disparaging way, that's just not my personal style. I think there's a middle ground between of being constructive with people, and then if you have a different point of view, finding a way to express that respectfully and try to move forward. And that's what we try to do. So we don't shy away from things. We try to get involved in situations where they don't need our advice or anything like that. We try to get involved in things that are well-run and people have lots of stock, so they're trying to do the right thing. But we are willing to have conversations with people.

If I can summarize it then, is you prefer the passive attitude, but if need be, you're happy to engage constructively with management. Yeah. You will never cross the line into kind of a fully-fledged activist investor like Icahn or Ackman or...

We don't have that general approach, but we—we've been known to exercise our rights, and we have done things, and we have agitated for change. So it's not that we would never do anything, because we have done things. And I think that if you don't, you're perhaps—at least, we're not. Let me put it this way: we're not comfortable with that. Like, we think it's a legal, ethical, economic responsibility to do a good job for our investors. And if management is doing something that you really don't like, then you find a way to hopefully alter that course.

Let me understand a little bit about the issue of exit. How do you exit a position? So I understand that if you have a position that to some extent is catalyst-driven, kind of, well, the actual realization drives the exit decision.

Yeah.

Potentially can drive it. What about the growth business? I mean, are you guys...

I think in the end, you're reliant in part on the market. But if the value is growing and you hold long enough, it's very rare that it's not going to be reflected in the marketplace. And if you throw on top of that, if you have a management team and board of directors that owns a lot of stock and the stock's really cheap and they've created, say you've been in it for a while and they've doubled the value of the company in a way that everybody could agree on, but the stock hasn't moved, usually they're going to come and start to buy back stock and that's going to hypercharge the growth even more. So it'll work out in that way.

It's funny that whenever I ask this question about exiting investments, many of the value investors I've come across on this podcast, but also that come to class, this is the one that, you know, I always find that the responses are less clear, if you allow me to put it this way. It's difficult to sometimes—what is the right moment to exit an investment? Is it when the market is telling you the valuation is really expensive relative to fundamentals? Is it because you believe risks are materializing to the fundamental thesis of the company? It's kind of tricky absent those things.

Well, I think, first of all, I think your point is well taken. I think exiting good companies is really tricky because they're good. And when do you get off? Now, we do ourselves put in place a discipline that says, 'Okay, at some price holding it, even as good as it will be, won't give us enough of a return. So we will sell it.' Right. The other thing, obviously, if a thesis changes, it's different. But I think your point that the answers about exits are more squishy is because I would say, at least for us, I think a lot less about exits than I think about all the other stuff. It's—I feel like if you have a good, growing, profitable business, you'll have all kinds of alternatives to exit. And that's sort of the easy part.

Right.

I mean, he's absolutely right about this, that whenever I read value investing books—and of course, the classics, but also the new stuff that comes out almost every day—you know, it's a topic that goes largely unaddressed. You know, students ask a lot about this, and rightly so, but it's a difficult one to even think about, sometimes conceptually, beyond the obvious one of the...

Well, I think it's harder in stuff that's what I call the hard catalyst, the so-called event-driven space. Betting on an event, the event happens, you get out, whatever. If you have other ones that you mentioned before, like my friend Tom Russo—Tom invests in very good companies, he holds them for a really long period of time—he's got a much harder time figuring out when to exit. Now, we do some of that, and that is—it is harder to figure out. And—and you—you grapple with that, and there aren't clear answers. If you go take a step back, say you're trading in bonds, whether distressed or investment-grade bonds, because it's a contractual payment, it's very easy to figure entries and exits. Like, you can be extremely mathematical and extremely quantitative about it.

And any good bond investor is extremely quantitative.

It's almost like the math is driving the decision.

The math drives it 100%. Yeah, absolutely. The hard thing about stocks and better companies is that the future is unknowable. So you don't know, like, is a five-year track record the beginning or is it the end? And you won't know that until you're in year 10, and that makes it harder. Right.

So let's move on a little bit, and I want to ask you a little bit about this complicated issue as well. So where do ideas come from for David Abrams?

For us, there's maybe three or four different buckets of things. So there's one bucket, which is—we like to look at stuff in distress. And you don't know in advance what's going to be in distress. But if you like to look at distress, it's not hard to figure out at any given moment what's in that bucket. And then it's fairly easy to sort through that bucket. "Things that are approaching distress or that are currently in distress?" "That are currently distressed. I think trying to predict where distress will happen is a very difficult business. That's not something we really do. I think that you could waste a lot of time doing that."

Alternatively, we like to buy better things, and it's easier to identify those things ahead. Usually everybody knows they're better, so they're not necessarily trading attractively priced at any given moment, but prices bounce around a lot, and you can keep an eye on those things and try to figure out when they come into your price range.

Can I ask you about this? Do you have, like, a wish list of things you would like to—" "We do."

We have a list of things that we're always updating it and adding and subtracting to the list about businesses that we'd like to buy or people that we'd like to invest in.

Let me ask you something very practical about this because sometimes I get asked this question and I don't know how to answer it. How deep do you go? You know, I have a wish list of companies that I would like to own because I think they're wonderful businesses. Mm-hmm. But of course, there are many wonderful companies out there in the world. How deep do you go in doing that analysis? Do you know exactly, look, here's my wish list, and I know exactly what is the price at which I would be willing to enter into each of these companies?

Not exactly. I mean, we ballpark it. And then to the extent you're interested in companies, to the extent you hear people talk about them, you pay closer attention. You read the article more thoroughly. You listen to the conversation more deeply than if it's something that you know you'd never buy. I see. And then you catalog that away. And a lot of our research takes many years, sometimes more than a decade, before we, from when we first look at something to when we actually buy it. Right, right.

And in terms of reading, what is—you wake up in the morning and you read, apart from the financial press, obviously—but what is driving a little bit, kind of, the broader outlook, the themes that are driving this, your thinking these days? Do you have any systematic way of going about it?

I think a little bit of a mix between the two. So I try to keep a lot of things coming in in the intellectual funnel. And then I try to have a pretty good screen so I can sort through. So I do things like I invest personally in a wide range of things. And most of my money is invested in the fund. But about 20 years ago, I started putting small amounts of money into some venture capital funds. And that got me a little bit more in the flow of what was going on in Silicon Valley. And then other people come along and they do things and I find them interesting. So sometimes I put some money in there. And then I travel and I try to expose myself to people thinking really differently. So sometimes it's something like a Grant's Interest Rate Conference, where they tend to have a more negative view of the world.

Sometimes it's growth equity guys that have a very positive view of the world. Sometimes getting out around the world gives you a different perspective. Even within the United States, traveling to different places gives you a different perspective, and just seeing that and talking to people and hearing what they're doing. But then also, once we find something we like, then we drop everything and we—we're focusing on that. Right.

Let me ask you then a little bit about portfolio construction, position sizing. How do you think about the overall portfolio? Issues of diversification, issues of portfolio turnover. Let's start with position sizing. How do you think about that? Is that you're willing to bias your portfolio dramatically relative to the strength of your conviction on the idea? Or you follow a disciplined approach and say, 'No, no, I cannot judge how strong my conviction is, so let me...'

try to put more money into the things that we have more conviction about. We do stocks and we do debt. When you're doing debt, you're at the top of the capital structure. So that tends to be less risky. So sometimes those positions get larger than the stock positions do. We'll tend to top out the stock positions at cost around 6% or 7%. We can hold them if they go up, but we'll tend to top them out around their cost. In terms of industry diversification, I mean, how do you think about it? I know that you have a very broad—you have energy infrastructure, you have bookstores, you have everything there. We look at industry concentration, and... Sometimes those industry concentration levels can get higher than I mentioned before.

So it's something we loosely keep an eye on to make sure that—we want to be fairly concentrated, but maybe not as much by today's standards. I see people have 60% of their money in three stocks or something like that, which is not my cup of tea.

But it's not something you target. It's not that you want to have an industry-diversified portfolio at all.

I want it to be somewhat diversified, but if we had 10% or 12% in an industry—sometimes we've had, like, in '08 in the debt, we probably had closer to 30% in one industry. It's sort of one industry, I guess, but it was mostly bonds. But I don't target industry diversification. I just keep an eye on it to make sure we're not getting... too concentrated in a particular way.

How do you think about the issue of risk management for your portfolio? I mean, so if you have investments, say, in different currencies, I mean, how do you deal with that? Are you happy to take the currency exposure? Are you happy to hedge it?

We don't tend to have that much outside of the U.S. We do have some. What we'll tend to do is, if we're owning a business without any catalyst, we'll tend to not hedge the currency risk, in the same way that if you own a big U.S. company like Microsoft or something like that, you have a lot of currency risk because they're making money around the world. If we have a situation where the catalyst or the upside is more capped and it's in foreign currencies, we then will tend to hedge the currency.

I see.

So it's really kind of situation-specific, depending on whether you think... I think if there's a catalyst, you tend to have capped upside. So I don't want to give it back or a lot of it back with a big move in the currency. If I don't have a catalyst, there's more upside. I'm probably holding it for a longer period of time.

I figure it will wash out over time. Over time. And in terms of other risk exposures, you know, say you take a position on a farm equipment company that you think is great and you want to hedge out kind of the farm price risk or something along those lines.

I'm not a huge fan of that kind of thing. I think that sometimes the strategies can make people enter into them with the idea that they're reducing risk, but they actually might be increasing risk if you have these various hedges. Some people, a lot of people do that. It's not my cup of tea. I mean, what I always say: if we're not comfortable with the risk, the best and easiest way is to not take that risk.

Now, you're on record as having said that, you know, you don't take any leverage whatsoever. You don't like—in fact, you have probably negative leverage right now. Are you holding—is the fund holding cash? And how is the cash position determined? Is it a product of the valuation? Or is that something that you're targeting depending on how you see opportunities lining up your way?

We don't use leverage in the portfolio, and that's just a basic philosophical decision on my part. I don't want to have to meet a margin call at the wrong time.

I mean, I think the lesson there—I always thought about it this way—that leverage introduces time in the equation, which is something very difficult to think about, that your position has to work out in a particular timeframe, certainly before that margin call, to some extent.

A couple of things. First of all, when we try to study disasters and financial disasters, Then you studied all people who had huge financial issues. And then you said, what was the reason why they had those huge issues? And leverage was one reason. That would probably capture about 90% of all the disasters. So in that sense, it seems fairly easy and straightforward to stay away from the one thing that causes most of the distress. And then I think maybe it was Buffett who said something about, you know, If you're smart, you don't need it. And if you're dumb, you don't want to use it. And I think that also sort of captures up the idea, too.

So let's just take the last minutes of this wonderful conversation to kind of close a little bit with how you see the future of value investing, of asset management in general, of course. And I want to start with connecting it with our previous segment on risk management. How much do you think—I mean, particularly given what we lived through in 2008. We started this conversation talking about 1998, when you started your own firm, and that it was a peculiar moment in terms of world markets with the Russian crisis, the '97 Asian crisis, LTCM, and so on and so forth. How much do you think about the economy at large? And how much does it feature in your investment process?

Only moderately. I think that we've mostly invested in the U.S. And the thing that we think about is that the U.S. has been a very good place to do business for a long period of time. So we do think, what could change that? And there are things that could change. There are things that could make it a lot worse. And if those things were to happen, then one would have to, I think, reevaluate investing in the U.S. in general. So I think about that. And what are those things?

Now you leave me with great curiosity.

Well, I mean, there's recent tax proposals. For example, if people thought that they wanted to drive tax rates up to 70% or 90% or something like that, I think you would see a big impact on that. And I think similarly, there's a proposal that I think is really misguided, that corporations should be responsible to everybody in a legal way. What that misses, by the way, is that corporate companies are responsible to all their constituents. So if you don't have a good product or a good service, you won't have any customers. And if you don't treat your employees well, they're going to leave. And if you don't do all of that, you won't make any money and you won't attract any capital. You won't have any investors.

So it's not perfect. There's a lot of issues, but it works pretty well. And it works pretty well for that reason. And it's better to let people, companies, individuals figure that out than mandating, like they do in Germany, works councils. And there's not a lot of, like, new business formation and innovation in Europe. And there's a big reason for it. So our country has been a home for risk-taking and innovation. And it's, if anything, it's picked up speed. But there are proposals out there that could really dent that.

I think that's exactly right, that anything that compromises that culture of risk-taking behavior. We talked at some point during this conversation about this thing of having a second or third or fourth chance to try it out, which is so important in the American economy, that anything that messes up with that, I think it's really misguided. I mean, it's not only the U.S. economy, but I actually think the world economy benefits enormously from this risk-taking behavior by the U.S. economy, U.S. entrepreneurs. Hugely.

It's one reason why U.S. companies have been at the forefront of spreading global capitalism and raising people's standards of living throughout the world.

Yeah, absolutely. Can I focus you in these last minutes on the future of value investing, of the asset management industry in general? What are your thoughts on this? And, you know, specifically about this issue that has come up repeatedly on the growth of quant, of smart beta, all those things. To what extent are they changing the nature of markets? To what extent are they making life difficult for you or for value investors in general? How do you think about that going forward? Will there be a role for traditional value investors going forward?

I would say that markets ebb and flow, competition ebbs and flows. Markets go up and down, and so sometimes... People confuse bull markets or bear markets with other phenomenon. I think as we've seen advances in technology, everybody has to look. And we are all aware of things that people were doing that machines could do much better. And it would be arrogant and a mistake to not think that it couldn't happen to oneself and one's own industry. So we do think about it. At the same time, we also do a lot of private ventures. And even in publicly traded companies, we do get more and more closer to our companies and to the people. And I think it's certain that the human relations, the human factor is not something that a computer is ever going to disintermediate.

So I think things will ebb and flow. I'm not overly concerned about quants. I think some of this is making markets less liquid. That's not necessarily a bad thing from my standpoint. Some days it can be frustrating, other days it can be great. So I think you do have to take an honest look at what you're doing and are you adding value to your customers? So am I adding value to my customers? Am I adding value to the companies that I'm invested in? And it's not true in every case that we're doing that, but we're doing it in a lot of cases. So, again, you don't want to be Pollyannaish about it. You don't want to be arrogant. You don't want to be in denial about these changes. They're really important.

But people have been looking for black boxes for investing since the day I got on Wall Street and well before. They'll always look for it. And the reason why it's very unlikely to really happen is that behind every pool of money, there's people. And so whether they're endowments or foundations or pension plans or individual accounts, quant strategies are interesting and they absolutely shouldn't be ignored. But they can only grow in popularity when they're working in the moment. What do you mean by that? So in other words, if they haven't produced good results in the short term, people are going to throw them out. I see. And I think to this whole point about mental models, what I would say is the markets are neither perfectly efficient or wildly inefficient, but they kind of fluctuate back and forth.

And values can be growing and stocks may not reflect that. And stocks can be too high as well as too low. Of course, yes. And so—and you see all the pressures that people have. I mean, look at all the—Columbia is part of this group, the Ivy League institutions. Every year they have these endowment pools of capital, and every year people are ranking them one to eight. And if you're number one, you're feeling great and your people are feeling great. And if you're number eight, you're feeling terrible. But there's a lot of money that can get lost by doing that. I see.

This is a wonderful note to end the conversation on, David Abrams. Thank you so much.

Thank you. Thank you. Thanks. Thank you for listening to this episode of Value Investing with Legends podcast. To subscribe to the show or to learn more about the Heilbrunn Center for Graham and Dodd Investing at Columbia Business School, please visit grahamanddodd.com. Thank you.