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Have you ever heard of George Michaelis?
The leader of a closed end fund, endorsed by Buffett and Munger, that returned 3x the S&P over his tenure.
Getting lost in an investing rabbit hole is an enjoyment of mine. I feel most at play when I am out learning about new companies and finding new investment managers and styles. Throw in anything Warren Buffett and it’s a damn party.
I can’t remember the exact details of this given day but I was walking around in the abyss and stumbled onto the fact that in 1973-1974 there was a closed-end fund selling for 50% of NAV and Buffett and Munger concluded they could 1) buy these assets for the cheap and 2) buy enough f them to take control of the investment process and shepherd it into the investment style they were akin to. The fund was called Source Capital and the guy put in charge of the fund was George Michaelis.
The name was interesting then after a little bit of searching through his few interviews I stumbled on the book from 1989 titled, The New Money Masters by John Train and one of the investors profiled was Michaelis. I bought the book, studied the guy, and walked away impressed. The simplicity of his thinking and the track record to prove it works was something I thought needed to be shared.
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The Early Years
Two weeks after moving to America, Michaelis lost his Father at the age of 4 leaving him and his mother to fend fr themselves in a country so new the time spent could have been considered a vacation. She came from Russia and made it to California after her husband was released from a 6-month stint in Prison ordered by the Vichy Government.
He thought for most of his life he would be a painter but after discovering living on a painter’s wage was going to be a hard endeavor he switched and studied engineering at UCLA from 1954 to 1957 and then went on to graduate from Harvard Business School in 1960.
The start of his career had little to do with investments as he worked in a series of financial and operational jobs ending with a stint working for a cotton broking business that wanted to get into venture capital. But in 1971, a good friend of his was hired by a firm called Source Capital. He reached out to George with a job offer.
The Investment Years
A fellow named Fred Carr started Source Capital in 1968 with the intention of forcing superior performance through speculation in unseasoned issues, private placements, and letter stock. Letter Stock was an instrument that could be appraised at any value, therefore, the manager had the ability to give the stock any value they wanted, it’s obvious where this story is going. When the market declined in ’69-’70 the fund collapsed and the investment management turned over. In ’71 Michaelis was brought in and injected an investment philosophy that could not have been more different than the one Carr followed.
Warren Buffett enters the story during the bear market from January 1973 to December 1974. During this time the Dow suffered a 45% drawdown and Source Capital traded well below the Net Asset Value peaking at a discount of 50%. Buffett and Munger saw they could purchase an investment company for $.50 on the Dollar. On top of that, they could buy enough shares to effectively change the investment management of the company to their liking. Once introduced the “Buffett Way” Michaelis latched on and it became the rule of law at Source. The following 15 years culminating in the summer of 1988 the total return of Source Capital was 1,200% three times the total return of the S&P 500 of 400%.
I have a few questions regarding small details during the beginning years of the “Buffett Way”. I am wondering if Michaelis ended up at Source by luck and then stumbled into a relationship with Buffett who then, gave Michaelis a masterclass in investing. Based on the approach explained by Michaelis in the book, my gut tells me yes. Michaelis was made president of the fund and the parent company in 1977, with Buffett’s blessing I am sure, and during the time frame “77 to ’87 the total return compounded at 19%, ranking first among close-end funds during that time frame.
The total return performance is exceptional, what makes it even crazier is the rule implemented by management in 1976. Source Capital was selling at a discount to NAV for many years. To combat this Management put in place a 10% annual distribution based on the NAV of the fund. The plan worked and the discount gap closed. The flip side was, if they didn’t produce a 10% performance they would have to dip into capital to pay the distribution. Talk about an incentive system for performance. They only had to reach not the cookie jar once in 1987. For the 12 years after the rule was set the dividend increased 14 times for a total increase of 150%.
The Michaelis Way
There are two overarching characteristics used in the strategy implemented by Michaelis at Source Capital. 1) Extreme risk aversion and 2) focus on the returns on equity. Sound familiar?
Play Hard Defense
“You must invest with a 100-year storm in mind” - Michaelis
Instead of trying to shoot the lights out Michaelis’s style is more on the defensive front. In his mind, it is more important to avoid massive losers than to find massive winners. The positions he holds are in well-established businesses with long operating histories. He maintained a list of about 300 companies and had price targets for all of them. When they would drop below his target he would begin to accumulate shares. He doesn’t buy a ton at once but more of a slow accumulation over a period of time. There is no effort to try and bottom tick the Investment but he hopes he is still a buyer when the bottom is reached. To highlight his thinking here is a quote from a Fortune Magazine Interview in August of 1988.
“Once a company meets these criteria, what do you look for in the stock?”
“It has to be cheap. There are probably 300 to 400 stocks we would like to own, but only at the right price. With 30-year Treasury bonds yielding over 9% these days, the stock should be able to generate at least a 13% total return. We almost never buy stocks at or above the market multiple. A recent and rare exception is Bristol-Myers. The company has an absolutely unblemished long-term record: 35 consecutive years of earnings growth, virtually no debt, and 25% return on equity. We've long wanted to own this company, and now is one of those rare times when it is selling near a market multiple.”
Focused on the pitch he wants to hit, this “don’t lose” mindset led to only underperforming the S&P 500 during only 1 quarter during the 15 year period from ’73 to ’88.
When you play a conservative game and are constrained to a 10% payout each year the portfolio setup is uncommon amonst your peers. Michaelis maintained a much larger cash position than the industry average always having a 10% cash position at a minimum. He was 20% in cash before the 1987 crash and had 18% cash in the summer of ’88. (I am assuming the interview for the book occurred during this time) The companies he held in his portfolio also put and empahsis on cash and averaged a debt load of around 15% of total assets, this is compared to the average of 25% in the S&P 500 during this time.
When you take the time to study the investments made by Michaelis during his tenure at Source the common theme among all of them is the emphasis on company earning power. It seems Michaelis had little trouble forgoing the Cigar Butt stage of investing and opted for bigger investments in better businesses.
“Earning power is as valuable as assets, try to buy earning power at a discount”
I can only imagine how this thinking was formed.
During the interview with Train, Michaelis outlined 3 specific features that tend to be consistent for all his companies. 1) They are highly profitable with sustainable high returns on equity and returns on assets, 2) the earnings power is not held hostage to a business cycle, and 3) They are successful because of identifiable reasons. He wants to understand the secret sauce.
Here is an excerpt from the book where he breaks down his investment in Melville.
“The return on Melville’s equity has averaged 24% for the last decade and 23% for the last 5 years. Eanings have increased in each of the last 14 years, and in twenty-three of the last twenty-four years. Sales, earnings, dividends and book value have all grown at approximately 15 percent per year for the past decade.
Ten years ago, Melville had $354 million of equity capital, $74 million f long-term debt, and $129 million of cash and equivalents. This last decade Melville has internally financed over $1 billion in net capital investments and acquisitions, and paid about $600 million in dividends, while reducing debt by $20 million and adding over $200 million to cash. This extraordinary cash generation is the result go Melville’s high return on capital.
We foresaw the growth in earnings and dividends which Melville’s profitability would create. Over the past four years, this investment has given us a 21-percent compound annual return, not achieved through market reevaluation of an initially undervalued stock. There’s been some revaluation- from 10.5 to 12.0 times earnings- but even without that the investment would have earned up 18 percent over the period. In other words our 21 percent return derived from the successful operation of the buisness over this period rather than from any ability to predict stock price movements.”
A simple, complete, summary of an investment. No noise, all signal.
The Best Argument is a Good Example
Reading the way Michaelis invests money is like sipping a good whiskey, smooth, and proves you don’t need anything flashy to have a good time. When we lift up the hood on this investor we see a simple guy who invests his money the same way. I am sure the influence of Buffett was tremendous but he followed the Mungerism of “Take a simple idea and take it seriously”.
The simple ideas you ask? Avoid losing money and buy high-quality businesses at a discount. If there is ever an example of how powerful it is to follow the rules above it is Michaelis and the path he followed while managing Source Capital.
In closing, I would highly recommend you check out The New Money Masters by John Train. It’s an old book but the wisdom is timeless. Had it not been for this book this knowledge would not have been possible.
Peace and Love,
Please be advised, Wall St Gunslinger is not an investment advisor and does not give personal investment advice. All content is for educational and entertainment purposes only and should not be interpreted as anything other than such. Investing entails a lot of risks and should be managed appropriately. Please do your own research and consult with an investment professional before making any investing decisions. Thank you.