Q: The complexity of funds at Kinetics is certainly interesting. Why are you more comfortable talking about the New Paradigm fund instead of the Internet fund? A: It's actually been renamed the Paradigm Fund. The reason I feel more comfortable is because it's not a sector fund. It's not limiting its exposure to medical, the Internet or something like that. We can look wherever we see opportunities. We can look across all sectors and across all market caps. Q: A review of the top 10 holdings tells me the strategy of the fund allows it to go anywhere in the market, including foreign securities. What is the overall strategy? A: The overall investment strategy is to acquire companies that have a high degree of predictability from their operational standpoint that trade at a discount to their intrinsic value; that trade with a margin of safety and also have returns on invested capital. Q: The Berkshire Hathaway B Class shares would be a good example of a company delivering a high return on invested capital. A: That's right. We have some utility holdings. They trade at a substantial discount to their book value. Q: Something tells me you examined Warren Buffett's holdings and examined why you wanted to own them, too. A: There's a little bit of that. And a little bit of it we actually got positions before he had. We've written reports where six months later, on three different occasions, he's come in and bid for the entire company. He's a smart, disciplined investor. Q: Also, these particular stocks dividends. A: That's right. You'll see some other names that show up. Centerpoint, the second company, is actually an incredibly interesting company. It is the electric and gas utility monopoly of the Houston, Texas area. The stock owns 81% of another publicly traded company called Texas Genco. When you back out Texas Genco, you're buying Centerpoint, the local monopoly business I just mentioned, for about $3.50. We believe that it will become very obvious that this business has earnings capability starting in 2005 of two dollars per share. So, you're buying a business for basically less than one and a half times earnings, or a little less than two times earnings. It is ridiculously priced. The company is actually going to receive over $5 billion in 2004 as a result of the deregulation program that went on in Houston. When they get that money, it will completely deleverage their balance sheet. The earnings that I just mentioned will start to be very obvious to the vast majority of the world. I think that a very conservative investment like that will have a legitimate shot over the next two to three years of making four or five times your money. At that point, Centerpoint would be a good, well-run utility, but it's not the high return on equity business that we want. But, if you're buying at such a discount, when they get that additional $5 billion next year, the book value is going up tremendously. Q: You own White Mountain Insurance in which Berkshire Hathaway has also invested. A: What you don't see on the screen, but will be in our top holdings, they own a 21% stake in a company called Montpellier Re. White Mountain brought it public. It's the same management team. If you look at the earnings, Montpellier Re trades at about nine times earnings, ridiculous for an insurance company. And the earnings are growing dramatically. Johns Burns who runs White Mountain and also oversees Montpellier writes insurance to make a profit. He's been doing it for his whole career. He's like Berkshire Hathaway, like Warren Buffett. They don't write bad insurance. If you write good insurance, and you take reasonable reserves and you're reasonable with your investments, it's a great business. They're smart and they're disciplined. They don't get caught up in the hype. That's really what this fund is all about. It's the same thing. Boring is what makes you money. Q: Aside from the top holdings, is there is anything else? A: We also bought some Finova bonds at 33 cents on the dollar. These are the bonds that Berkshire Hathaway owns. They are 7.5% coupons. The current yield when we were buying them was 22%. If it stays in business and you actually got paid off in par, your annualized yield would be about 42%. Q: That is difficult to do with a bond. Looking at the typical stocks that I follow, large-cap stocks like IBM or General Electric hardly ever return 40% a year. That is asking a lot of a big company stock. A: That is asking a lot. I personally believe that the typical large-cap company is not going to provide you with any type of real return for the next decade. I say that based on the valuation and what the economics of the businesses are. I'm not suggesting that Pfizer is going out of business, but Pfizer is just not a cheap stock. You buy a great company at the wrong price and you're not going to do that well as an investor. Q: And you're saying that you do? A: You can't uncouple your expected return with the valuation that you buy in at. Warren Buffett can buy Washington Post at $18 and you buy it at $220, you're going to have a different return. There is no question that you cannot uncouple price and expected return. And I think that is what people think. People will say that stocks give you 11% annually, but if the market is now at four times book value and 25 times trailing earnings, it's not the same thing as buying it at 10 times earnings and one times book value. You're not going to get the same return. Q: You've told me a bit of how you conduct your research and how you determine your valuations. A: That's right. We're looking to buy at margin of safety where we're buying below intrinsic value of the companies. Q: How do you determine the intrinsic value of a company? A: That is subjective. No question about it. In some cases, like Centerpoint Energy, if you tried to replicate their business, it would cost you literally tens of billions of dollars to do and you're buying the company with a market cap at its low of about $1.2 billion. It was just absurd. You knew that the earnings from the company looking out over two years were going to be over $600 million. Even though that is very subjective, I mean there is a certain economic reality that gives you confidence that you're doing it and you are buying something well below what it's fairly valued at. Q: You've also told me you look at the numbers closely. A: No question about it. We do all primary work. We rip apart balance sheets, income statements, cash flow statements, and we try to understand what we own. Berkshire Hathaway sits on $63 billion of equity. I'll give you a concept of margin of safety as conceived by Ben Graham. If you make an assumption that he [Buffett] gets a return on equity of 15% and historically he's gotten over 22%. Let’s say because of the size and everything else, he's not going to get quite as high a return. Fifteen percent is a pretty big haircut for him and I think he's actually pretty talented. That gives you earnings capability on Berkshire Hathaway of $9.4 billion. If you take the market cap of Berkshire Hathaway, which is about $105 billion, that gives you an earnings yield of 9%. The concept of margin of safety as Ben Graham perceived it was that he felt that you could get a diversified portfolio that gave you an earnings yield five percentage points above the risk free rate on the yield on the 10-year treasury. You need an earnings yield of 9% in a diversified list of common stocks to have what he perceived to be a margin of safety, where the earnings power over the course of a decade would provide you with more than enough margin of safety and almost guarantee that you are going to have a better return than being in the treasuries. So that's really what we try to look at. Q: Now it tells you to look at the numbers first before you even consider talking to managements, which is Buffett's style. A: What we try to do even before we look at the numbers is we're trying to think qualitatively. What exactly does the company do? What are the competitive threats? Is this a business that five years from now is more or less going to be the same type of business that it is today? Warren Buffett said that one of the things that has made him so successful is that he buys companies that are highly predictive. And he doesn't stray too far from that. When he buys a shoe company, he realizes that five years from now people are going to be basically buying shoes. It doesn't mean that they have to be buying his shoes, but at least he knows that the business is going to be around. Q: How do you screen for companies? A: Primarily, what we're looking for is high returns on invested capital without having to use substantial leverage. We're willing to take a lower return on equity if we believe we're buying in well below book value. Let’s say the regulated return on Centerpoint is going to be 11%, but if you believe that the book value is 16%, because they're owed that $5 billion and you're buying in at $7, your real return on equity is 23%. We don't use computer screens. We do fundamental analysis. We write a lot of research. We look at the world in ways where we think there are inefficiencies, so we write on spin offs. We write on contrarian research. If the world needs something, we have an interest in it. Sometimes they dislike it for very legitimate reasons because the operations of the companies are in decline. Sometimes they dislike it because it now falls outside of their time horizon. If you own undervalued situations and if you have patience, they will get revalued over the course of time. Q: Who schooled you in this method of stock valuation? [A: One of my professors at St. John's University was in the same class as Warren Buffett. They took a class at Columbia with Ben Graham. I'm a disciple of Graham and Dodd. I have read The Intelligent Investors probably 25 times. The interesting thing is the book is written for the layperson. On its surface, it looks like a very simple book. But the more you know, the more you appreciate how profound it is: I would actually say The Intelligent Investor is the best book on investments ever written. And Warren Buffett writes that in the forward of the book. I actually agree with him. If you reread it, the more you know and the more you learn, the more you appreciate how smart he is. He was a bright, smart guy and he approached owning stocks the way you should from a businesslike perspective. He's saying what would I pay for the entire company? And if he came up with a price and found that he could buy the stock for half of what he could pay for the entire company then he would say that it's a great deal. In the case of Centerpoint, I would tell you that if I had the money and the public utilities company holding act would allow me to do it, I would buy the whole thing. At $1.2 billion, in two years' time, I would be making $600 million in net income. Q: You're still young. You have plenty of time to get to that point in your fund where you can buy a company outright. A: I fully expect it to happen at some time in the future. We're just not there yet. What happens is that basically people are looking around to see who has held up over the last several years. That fund is starting to get more interest. We could have had the same performance if we were $600 million just in that fund. Everything we own is large, liquid, so we have no problem buying as much of El Paso, Centerpoint or Williams. Q: It sounds like you will probably outperform most of the major indexes. A: If you look at the performance of the Paradigm Fund over the last years, it's basically in the top 1% in the category called mid-cap blend. Whatever it is, the vast majority of funds aren't beating it. Let’s put it that way. When I look at what they own and what we own, and I say there is no way in the world they're going to come close to us. People's expectations are way out of line with reality. It's that you can't uncouple valuations with the expected return. People are confusing good companies with overvalued stock prices. Warren Buffett said not too many months ago that the vast majority of stocks that he's analyzing are overvalued. I couldn't agree more. Q: This fund is definitely different. It's more fascinating than the Internet Fund. A: The Internet fund is interesting. But I tell people that they shouldn't have more than 10% equity of their equity in that fund and that they really should have closer to 5%. It's constrained by where we can go and be creative about getting value. And why put that limitation on yourself?