The Education of a Value Investor

My Transformative Quest for Wealth, Wisdom, and Enlightenment

St. Martin's Press

Contents

FROM THE BELLY OF THE BEAST TO WARREN BUFFETT

O that this too too sullied flesh would melt,
Thaw and resolve itself into a dew!
...
How weary, stale, flat, and unprofitable,
Seem to me all the uses of this world!
Fie on't! ah fie! 'tis an unweeded garden,
That grows to seed; things rank and gross in nature
Possess it merely.

— Hamlet, act 1, scene 2, lines 129–130 and 133–137

Have you ever felt that way? Utter self-loathing. Unlike Hamlet, at least I wasn't suicidal. But I felt almost as wretched. I was disgusted with investment bankers as a breed, and especially the ones I worked with. I felt the same way about my investment banking firm. Worst of all, though, I was disgusted with myself.

Less than two years earlier, I had felt ready to conquer the world. Back then, I was a student at Harvard Business School (HBS). For good measure, I also had a degree from Oxford University, where I'd come top of my class in economics. Everything had seemed possible — until I threw it all away with one recklessly foolish career move.

In 1993, a few months before I graduated from Harvard, I stumbled upon a job listing for an assistant to the chairman at D. H. Blair Investment Banking Corp. I'd read a bit about investment banking and fancied myself as one of these budding Masters of the Universe.

Brimming with youthful confidence, I headed to New York City to meet with D. H. Blair's chairman, J. Morton Davis. Morty had started out as a poor Jewish kid from Brooklyn. He graduated from Harvard Business School in 1959 and went on to become the owner and chairman of D. H. Blair, which had been founded in 1904. People told me that he'd made hundreds of millions for himself.

I met with him in his wood-paneled corner office at 44 Wall Street. The place hadn't been renovated in years, and it looked like a traditional investment banking partnership from John Pierpont Morgan's era. In fact, J. P. Morgan's headquarters were almost next door.

Morty was a consummate salesman, and he did a brilliant job of beguiling me. He talked to me about some of the great deals he'd pulled off in hot areas like biotech, adding, "You'll be doing deals right away, working directly with me." He assured me that there was "no limit" to what I could achieve there with him and later gave me a book by Frank Bettger called How I Raised Myself from Failure to Success in Selling. I liked the fact that Morty was an outsider — unconventional, self-made, and highly successful.

Shortly afterward, I read a New York Times article that referred to D. H. Blair as an "infamous" brokerage house whose "brokers have been known to refuse to let customers sell when they request that a stock be liquidated." The article also mentioned that securities regulators in Delaware had "tried to revoke Blair's license" and that regulators in Hawaii "said Blair was using fraudulent and deceptive sales practices." When I went back to ask him about the article, Morty told me that people envy success and try to take you down. I was gullible enough to believe whatever he told me.

Some of my friends from Harvard raised their eyebrows when they heard that I was going to work for D. H. Blair, but I ignored their warnings. I was arrogant and slightly rebellious, and I was determined not to follow the standard route to establishment firms like Goldman Sachs and J. P. Morgan. I wanted to blaze my own trail and be more entrepreneurial. It felt as if Morty had made me an offer that I couldn't refuse, although I should have. So I signed on, thinking that I was golden, expecting Wall Street to show me the money.

High on hope, I joined D. H. Blair in September 1993 with the grand title of vice president. I shared a dimly lit, wood-paneled room on the second floor with a kind, elderly banker. He hadn't done a deal in years, but he was part of the scenery, burnishing the investment bank's sheen of respectability.

Only six months into the job, I was miserable. I had received and continued to receive a series of hard knocks. For a start, I had thought that I'd be the chairman's sole assistant and that I'd have the opportunity to observe and learn from the master by helping him analyze the multitude of opportunities coming his way. Instead, it turned out that he had two other assistants.

All three of us had shiny new MBAs: Len had gone to Harvard Business School; Drew was from Wharton. This was a dog-eat-dog environment, and the three of us were not a team. As I soon realized, there was absolutely no need for me on the analysis front. I was learning the hard way about what is normal on Wall Street. There are always more people available, and they are abundantly capable of doing the job that needs to be done. The competition is intense. And there are dozens of people lined up right behind you, ready to take your place.

The only way I could add any value in this environment, and what the firm really needed me to do, was to bring in deals. I thought that I was up to the challenge. After all, it was a big selling point of the job. But the competition was fierce, both inside and outside the firm. And I was new. New to D. H. Blair, new to investment banking and finance, and new to New York.

I was determined not to quit, though. That would have been an admission of defeat. I would have been mortified to let my classmates know that I'd made a mistake. Even worse, I would have been called a quitter, and that reputation might have followed me. More than anything, what motivated me was how other people viewed me rather than how I viewed myself. If this had been reversed, I don't think I would have stuck around that place for a minute; I would have simply ditched. But I was desperate to look successful.

My singular goal became to get a deal done. That way, I could declare victory and then choose to leave. So I smiled and dialed and pounded the pavement for many months, following up on every deal lead I possibly could. But I still came up empty-handed. Despite my massive testosterone-fueled determination to succeed in this, my first job after graduating with an MBA, I was hopelessly flailing.

My problem wasn't just that the best deals got nabbed by the big names like Goldman Sachs and Morgan Stanley, although that was true. There were plenty of other opportunities around. But successfully bringing those deals into D. H. Blair required me to do things with facts that I had never done.

D. H. Blair's specialty was venture capital and banking. It was one of the things that had attracted me to the firm: the opportunity to be on the cutting edge, funding start-ups with new technologies that would change the world. Oh, and did I mention that I would also get filthy rich in the process? In addition to my arrogance and hubris, I also had my fair share of Wall Street greed. I was convinced that I was on the quick path to Nirvana.

The harsh reality was that companies with technologies or innovations that really worked and were certain to succeed were extremely rare — even among the crowd that got its funding from more prominent investment banks like Goldman Sachs and Morgan Stanley.

Instead, the vast majority fell into the category of "might succeed." There were a great many management teams that desperately wanted to pursue their dreams and that were willing to do and say pretty much anything if it meant getting funding. Before I knew it, I was drowning in a sea of crappy deals, assailed by entrepreneurs who hoped that I would look kindly upon them.

The inexorable logic of expected probability that I had first learned about in high school and then studied at Harvard in a course called "Decision Theory" was that if I was going to recommend a deal, it had to have at least a fair chance of making money. Given how many deals failed, and the very small number that made investors a multiple of their original investment, my rough calculation was that the probability of success had to be at least 50 percent for the thing to get funded. But after a while, I came to believe that D. H. Blair's standards were far lower.

On one memorable occasion I was called into a meeting between the bank and an outfit looking to raise money for a cold fusion venture. Having studied the materials and read up a little on the background, I blurted out, "But the science just doesn't make sense!"

Implicitly, what I meant was, "Do you really expect me to keep a straight face and tell our salespeople that this crap is going to fly?"

In another example, our firm IPO'd a company that was going to build a new space station — in conjunction with the Baikonur Cosmodrome in Kazakhstan — based on contracts with companies and entities formed by ex-government officials of this former Soviet republic. The company's only assets seemed to be sketchy contracts written in a foreign language that were unlikely to be enforceable in a Kazakh court, let alone in New York or London. Like the cold fusion nonsense, the probability that this thing would take flight was pretty low.

But this was the business of D. H. Blair: find some of the more extraordinary outlier opportunities, then hawk them to a naïve and hopeful investing public that knew no better.

To be fair, even though many of these "opportunities" turned out to be duds and eventually failed, the firm also scored a big hit every now and then. For example, it had taken public one of the firstbiotech companies, Enzo Biochem, at a time when it was unthinkable to do an IPO for a company without earnings. And from time to time, D. H. Blair even IPO'd businesses that generated real and growing earnings. But in between the good deals, the firm needed fodder to feed the money-making machine.

On the deal side, in addition to cash investment banking fees, D. H. Blair would take a healthy chunk of warrants in the companies that it financed. And on the investment side, D. H. Blair was often the only market maker in the shares that it took public. With bid-ask spreads as high as 20 percent, there were fat profits to be made just buying and selling the companies that went public. Like so many institutions on Wall Street, D. H. Blair had a nice edge on its clients.

But generating trading volume in the stocks and getting a broader group of people interested in them required a lot of stage management. Dressing up an opportunity with questionable odds of success and turning it into something that the public was enthusiastic about buying was part of the role of D. H. Blair's analysts and investment bankers. To make one of these deals succeed and to grease the wheels of finance, various people needed to play their part.

The cold fusion and Cosmodrome deals were not going to earn any money soon, if ever. But they did have sizzle. These companies represented ideas that could capture the public's imagination. If an enthusiastic investing public ended up developing a mania for cold fusion or space stations, this could easily propel the newly IPO'd stock into the stratosphere, to many multiples of its IPO price. From an investment banking standpoint, this sort of price action would make the deal a runaway success — even if the company eventually failed. As the stock rose, the bank would cash in on the warrants and make a profit trading the shares. If the company ultimately went bust, the shares would be broadly held, and it would not be D. H. Blair or its clients that bore the brunt of the loss.

To get these sorts of situations going required aggressive salesmanship of every kind. So D. H. Blair had a retail brokerage unit filled with hard-charging brokers who called clients from a boiler room on the 14th floor. They were physically and legally separated from the investment bankers like me, and they officially worked for another company. While they were part of D. H. Blair & Co., I was employed by D. H. Blair Investment Banking Corp.

Our tiny team of bankers constituted the acceptable, respectable face of the company, while the brokers were the backroom boys, touting these dubious deals to unsophisticated retail investors. They were chillingly reminiscent of the brokers in Martin Scorsese's movie The Wolf of Wall Street, which was exaggerated but not misleading. The 14th floor of D. H. Blair was a swirling sea of testosterone; someone once told me that hookers would sometimes go up there to reward the most successful salesman of the day.

I had no direct dealings with these guys, but they depended on our investment banking team to come up with deals for them to tout. The bankers could live with themselves because they were holed up in the handsome, wood-paneled cocoon of the second floor, while the really eye-opening activities went on 12 floors above. Still, the brokers needed us bankers as enablers.

It was only after a year or so at D. H. Blair that it really started to dawn on me that this was a big part of the role I was expected to play. I was supposed to dress up the least sketchy of these deals in such a way that the downsides were heavily de-emphasized or ignored while the sizzle — the blue-sky upside — was highlighted.

I wasn't there to act as a careful, well-trained analyst. They had no use for a forensic arbiter who painstakingly researched an idea, examined the opportunity, and pronounced, as accurately and honestly as possible, what this thing really was. In hindsight, I can see with clarity that the real value to the firm of my Oxford degree and my Harvard MBA was to adorn its deals and documents with my pristine credentials. I thereby provided a kind of Ivy League fig leaf.

When I look back to our meeting with the cold fusion company, I can see how naïve I was. In truth, everyone there was expecting me to play my part. The elephant in the room was an unspoken dialogue that went something like this:

Cold fusion company management: Execs of D. H. Blair, yes, we are bullshitting you. This is almost certainly not going to work, but we've been working on it for years and have invested substantial personal funds in it. In any case, nobody can prove 100 percent that it won't work. Moreover, think of the excitement that this thing will cause among investors and the press. It would be the only publicly traded nuclear fusion power company in the world!

Other D. H. Blair investment bankers: Yes, this is extremely unlikely to fly, but we need to fill our pipeline of deals so that you, the company management, can get rich on the founder stock and we, the investment bank, can get rich on fees and from trading the stock. And who knows, it might even succeed, in which case our clients might even make money too.

In the midst of this cynical ritual, I was oblivious enough to mention that the physics was apparently bogus, remarking, "There are so many people out there who've claimed that they have made cold fusion work, and there's nothing new here." I was so tactless that I actually laughed out loud.

Only in retrospect did I realize that I had instantly become the most hated person in that room. How could this deal ever fly if nitwits like me couldn't keep their big mouths shut? There was no way I was going to succeed in this environment with that kind of reckless honesty.

But I didn't want to concede defeat. So I doubled down on my efforts, girding myself for more toil and trouble. I smiled some more and dialed some more. And I pounded many more pavements.

Eventually, I found a deal with far better chances than most. This time, I could put my hand on my heart and say that, in spite of the risks, it deserved to get funding. The company was called Telechips, and in 1994 it had a communications device that was both a computer and a telephone. The management team was led by C. A. ("Al") Burns, formerly at Bell Labs, and Randy Pinato, a former salesman for one of the Baby Bells. The idea was solid, although well before its time. This was before the commercialization of the Internet, and cell phones had only recently been introduced.

I had also found an experienced investment banker, Howard Phillips, who was willing to work with me in structuring the deal and raising the funding. Phillips had a solid background at Oppenheimer and had come to D. H. Blair in semiretirement. He worked in the office two or three days a week, and he had taken a mild liking to me.

But having found a solid management team and convinced them that Phillips and I were their path to funding, I discovered a whole new realm of pain and unpleasantness. In spite of my understanding that Phillips and I were equal partners, I soon discovered that our fee split for doing the deal wasn't going to be 50–50, after all. He was taking the lion's share. I felt the hit to my pride more keenly than the one to my pocketbook. Still, if the deal was going to get done, I had no choice but to accept this.

The next step was to get the deal approved. I imagined that, given some of the dreck I'd seen in my short time there, this more plausible deal would just sail through. Phillips and I went through the investment committee and got a letter of intent stating the valuation and the amount we would raise for Telechips, subject to some cursory due-diligence checks. I was ecstatic.