On Tuesday, October 11th, I attended a Value Investing Panel sponsored by the CFA Society of Cincinnati. The event, moderated by Chris Meyer of the Fund Evaluation Group, featured renowned small cap investor John Rogers of Ariel Investments and James Thompson, senior analyst at Southeastern Asset Management. While less known than Rogers, Thompson has spent 12 years under the tutelage of the legendary Mason Hawkins at Southeastern (you can see the holdings of Rogers here and Southeastern here). The session covered everything from investment philosophy to choosing portfolio managers to finding value in today’s market. My notes are below, broken down by category. I used quotation marks for any direct quotes. Any errors in the notes are mine.
Overview of Firms and General Investing Philosophy
John Rogers: Founded Ariel in 1983 focusing on value investing from microcap to large cap. He feels that Ariel is different than most money managers because of their intense focus on patience (“waiting for the right pitch”), a long investing timeframe, in depth research, and deep relationships with the management teams of portfolio companies. “Merrill Lynch has the bull, T. Rowe Price has the ram, Ariel has the turtle… that sums up our investment approach.”
Jim Thompson: Southeastern is focused on finding companies selling for 60 cents on the dollar. They seek to invest with a Graham-style margin of safety from their conservatively estimated intrinsic value. Managing the investments by committee, the team values companies using an 8 year discounted cash flow model. They’ll then “cross-check” that value with private market values (precedent M&A transactions). When asked if recent macro trends have impacted their discount rate in the DCF model, Thompson replied, “It doesn’t. We use a sticky 9% for US based companies… I guess you can use CAPM which would get you 6%, but we don’t do that.” He emphasized that Southeastern focuses on three key things when evaluating an investment: the market price, the intrinsic value, and the growth in intrinsic value. Not only do they want to buy 60 cent dollars, but also want the value of those dollars to grow.
Rogers: In his opinion, management evaluation is critical, because ultimately they are in control of the shareholders’ capital. “Every company has problems, what we need to know is if the management is capable of getting through those problems.” He interviews management like an admissions officer would question a college applicant. He wants to know what challenges they’ve overcome in their lives and how they did it. He studies body language, inflections, word choices, etc to help decide if the managers are trustworthy. He quoted Lyndon Johnson, “The most important thing a man will tell you is what he least wants to talk about.” Over time he has come up with various techniques (not waterboarding) to get managers to open up.
Thompson: Seconded Rogers’ points but added that most CEOs are very good salesmen with loads of charisma. “The ultimate check on management statements are the incentives and the cash flow statement.” The cashflow statement will show how they’ve invested the company’s capital and if they’ve returned it to shareholders.
Since no management has ever thought their stock wasn’t undervalued, Thompson likes to ask them why it deserves a higher valuation. He doesn’t want to hear the management say “its at a PE of 12 versus the market 15”, he wants them to be able to walk him through the key drivers of the valuation. This is where he can understand if management “gets it”.
Differentiating Investing Style & Selecting a Portfolio Manager
Rogers: Believes in the Buffett/Munger theory of “circle of competence” and practices it through a focused portfolio. While most fund managers today “hug the benchmarks”, he is willing to take benchmark risk by investing heavily in areas where he feels comfortable and knowledgeable. He recommended to everyone that they work on expanding their circle of competence by “not just looking at data all day but by getting out into the world and thinking like a businessman.” He is on several corporate boards and foundations and has learned better ways to solve problems, ask questions, and manage a business. He quoted Buffett, “I’m a better investor because I’m a businessman, and I’m a better businessman because I’m an investor.”
When selecting external portfolio managers for clients, he looks for:
1) Experience at the top to set a firm-wide philosophy (citing Mason Hawkins)
2) Long-term track records– he called 1 and 5 year performance “irrelevant”.
3) Intellectual Rigor– he feels the best way to find this is by reading shareholder letters. If the portfolio manager can articulate his thought process well in writing, he can be a person to entrust with your money.
4) Passion. When he talks to managers like Tom Russo and Richard Pzena he can feel their passion. They endlessly talk about stocks and markets, what they are buying and aren’t buying. They talk about articles and books they’ve recently read. “You can tell that they’re in the game.”
Thompson: Reiterated most of Rogers’ points, but also stressed the importance of setting expectations with potential clients. In this short term focused environment, its important that your partners understand the long-term focused philosophy. Southeastern talks with clients a lot about price, value, and patience. He said, “divorces are more problematic than weddings, so try and make a good match.”
He makes sure that companies he may invest in are aware of the long term approach too. Because they are so focused, Southeastern will often end up being the #1 or #2 shareholder. Around earnings time, management is usually in a “blackout period” so Southeastern schedules meetings with them and says “throw us out if we talk about the next 60 days.” He wants to know the long term secular trends of the business and identify the competitive advantages or “moats”.
On Today’s Markets
Rogers: Though he is a bottom up stockpicker, he admittedly pays more attention to macro then ever before. He believes that sentiment is as bad as he’s ever seen. At investment committee meetings for foundations he works with, “Everyone is bragging about the alternatives in their portfolios. All the negativity makes me optimistic.” He agrees with Buffett’s contention that the United States’ best days are ahead, so he is looking for companies that will benefit from a robust rebound and ultimately sees the macro backdrop as an opportunity to buy cyclical firms on the cheap.
He currently sees value in fee generating financial services companies like Lazard (LAZ), Blackstone (BX), and KKR (KKR). He thinks private equity firms BX and KKR are being valued as if they’ll never be able to monetize their portfolio companies. Other favorites include real estate firms Jones Lang Lasalle (JLL) and Grubb & Ellis (GBE) for their strong balance sheets and diversified business models. Rogers also mentioned Contango Oil and Gas (MCF) as his favorite energy pick because of their low cost model and good management team.
Rogers doesn’t like gold or silver investments primarily because everyone is talking about them, but also because there is no economic value added by precious metals. He also thinks “Steady Eddie” consumer companies like Smuckers (SJM) and Clorox (CLX) have gotten too expensive lately from investors’ flight to safety.
Thompson: In response to a question about how he overlays his macro view on his individual company analysis, he said that pre-2008 he would’ve replied “macro schmacro” but now it has to be incorporated into a DCF. For example, European exposure will likely lead to slower growth assumptions in the next couple of years. He does think that most of the macro concerns are currently priced in and said, “Greek default would be the biggest non-surprise of all time.” Overall the price to value ratio of their current portfolio is in the low to mid 50s, the lowest ever outside of the late 2008/early 2009 time period. He’s seeing “pockets of value” around, but has a relatively high concentration in two areas: property and casualty insurers and cement aggregates.
Thompson said that P&C insurers have really low combined ratios so they should be near the end of the cycle and that low interest rates provide an industry headwind. He stressed that the turn of the cycle could still be a while, but he is willing to be patient and will benefit when rates and pricing increase.
The cement aggregates (he didn’t mention any in particular, but Cemex (CX) and Vulcan (VMC) are holdings) have strong moats within 150 miles and will benefit from an economic rebound. He pointed out that housing starts are around 600k where the long term trend is between 1 to 1.5 million, so getting anywhere near that will increase company values (this is nearly identical to what Andrew August has mentioned recently). He stressed reversion to the mean and the dangers of extrapolating the Great Recession into the distant future. When questioned about a Japan-style 20 year recession, Thompson stated that it won’t be as bad here because of population growth and strong household formation in the US over time. He feels the cement aggregates and other suppliers are better investments than homebuilders because they’re more diversified and have wider moats.
Thompson also mentioned Dell (DELL) as a company with a moat. He thinks they are protected by industry changes because of their great strength in manufacturing and distribution (Rogers also holds Dell and just commented “its cheap”). Thompson contrasted Dell with Apple (AAPL) which is much more focused on hit products and innovation. He’s a huge fan of their products, but can’t figure a way to value it when other companies can come up with a similar device quickly.
Thompson also agreed with Rogers on gold, saying “when there are people on the side of the road offering to buy your gold, its a bad sign.” Thompson concluded his remarks by saying that “undervaluation is the best catalyst because it drives M&A, share repurchases, and activist investors.”