Five Core Principles to Investing

Transcription

1 R E P R I N T E D F R O M J U N E 2 3, Five Core Principles to Investing TIM PIECHOWSKI is a Co-Portfolio Manager of the Equity Quality Return strategy at St. Louis, Missouri-based Alpine Capital Research. Prior to joining ACR, Mr. Piechowski worked on the financials team at San Diego-based Brandes Investment Partners. At Brandes Investment Partners, he analyzed banks, thrifts, insurers and holding companies on a global basis. Mr. Piechowski holds a J.D. from Saint Louis University School of Law and earned a B.S./B.A. with concentrations in finance and accounting from the McDonough School of Business at Georgetown University. Mr. Piechowski is a member of the Missouri Bar and has attained the Chartered Financial Analyst designation. SECTOR GENERAL INVESTING TWST: Let s begin with a brief history of Alpine Capital Research and an overview of your responsibilities. Mr. Piechowski: Alpine Capital Research, ACR, was founded by Nick Tompras in St. Louis in Prior to founding ACR, Nick was running a large-cap strategy for the asset management arm of a local bank, and as the tech bubble was peaking he found it difficult to put client capital to work, as normalized earnings on the S&P 500 were approaching 40 times. At the same time he noticed that there were a number of small and midcap companies trading at eight to 12 times earnings that were reasonably undervalued. His large-cap mandate didn t allow him to buy these companies, so he decided to leave the bank and found ACR, where the firm s flagship strategy, Equity Quality Return, EQR, is an all-cap strategy that can hold cash when attractive opportunities are unavailable. The EQR strategy s track record starts in April of 2000, which was a terrific time to be starting a strategy with a value philosophy, as there was the opportunity for meaningful absolute returns from small and midcap companies, and then relative outperformance as the Internet bubble popped and many names declined dramatically. The EQR strategy composite s returns since inception have been 13% gross of fees, while the S&P 500 total return index has achieved 3.6%. Some of the strategy s outperformance is due to good performance following the tech bubble, but the strategy also performed well in the financial crisis with a decline of 13.9% in 2008, versus 37% for the S&P 500, and outperformance in Today the firm has $1.5 billion in assets under management with 11 employees and two part-time consultants on staff. I serve as a Co-Portfolio Manager with Nick and Willem Schilpzand on our EQR strategy. We run the strategy with a 20- stock target, and as I mentioned before it is an all-cap strategy, and we hold cash when we cannot find ideas that we believe will earn returns above their cost of capital. Within the strategy I have up to five slots to invest in the portfolio, and then I work as an Analyst on five of the names that Nick puts in the portfolio. Willem Schilpzand has an identical role to mine, where he can put up to five names in the EQR strategy and works as Analyst on five of the positions selected by Nick. M O N E Y M A N A G E R I N T E R V I E W

2 TWST: How involved are you in adjusting the portfolio according to specific investment objectives? Mr. Piechowski: Though we know it may not be the case, we treat each client portfolio as if it were 100% of our clients capital. Typically this means that we only employ client capital in stocks when we believe they are trading at a price to intrinsic value of 0.80 times or less. For companies in our investment universe, we use a discount rate of 8% to 12%, so assuming for a moment a five- to seven-year holding period, which is consistent with our historical turnover, we are looking for our clients equity investments to generate a return in the low double digits to midteens. TWST: Can you give us a closer look at how your guiding investment philosophy and strategies influence your evaluation of portfolio holdings? Mr. Piechowski: We have five core investment principles when investing client capital. Our first core principle is that we focus on fundamental valuation. We spend 90% of our time reading about industries and companies and speaking to management teams. Everything we do is focused on determining the price at which what we would be willing to put client capital into the stock of a company. In many cases that process can take a very long time, particularly when we are looking at an industry previously unknown to us, as we want to understand the longterm economics of the industry in which a company operates, and what could change the dynamics of that industry over time. Highlights Tim Piechowski discusses his firm s all-cap value investment strategy, which employs five core investment principles. The first is a focus on fundamental valuation. Second is insisting on quality investments, where there will be little intrinsic value impairment when an economic storm hits. Third, staying within the firm s circle of competence. Fourth is balancing concentration and diversification, and fifth is communication, particularly at market extremes. Mr. Piechowski shares examples of top holdings that meet these core values and requirements. Companies discussed: Berkshire Hathaway (BRK-A); Johnson & Johnson (JNJ); JPMorgan Chase & Co. (JPM); Microsoft Corporation (MSFT); FAIRFAX FINANCIAL HOLDINGS LTD. (FFH.TO); Lockheed Martin Corporation (LMT) and Strayer Education (STRA). Our second core principle is that we insist on quality investments. For us quality has always meant that we want our clients portfolios to survive a one in a 100-year economic crisis. Certainly in a crisis environment the prices of the shares of our investee companies would go down for a period, but our goal across the portfolio is for there to be little intrinsic value impairment when an economic storm hits. Intrinsic value impairments typically come when you buy shares in companies that are weakly financed and have to raise capital through share issuances or assets sales at unattractive prices in a weak economy or market. The way that we focus on quality is by making sure that our clients capital is invested in companies that are very soundly financed, and predominately in companies that have very good pricing power in their industries to survive both weak economic times and high inflation. By focusing on these items, we believe that the EQR strategy will protect clients in a down market very well. Said differently, one way that we look at it is when we send clients their quarterly statement, and it says they own ABC stock, and that stock is trading at a $100, we view it as our job to make sure that the $100 listed on that statement is backed by $100 or more of intrinsic value, so that there are true cash flows behind whatever stock ownership that person has. Our third core principle is that we want to stay within our circle of competence. We want to understand what we are investing in, and we are willing to let perceived opportunities go by if we do not have comfort that a name is within our circle of competence. It Certainly in a crisis environment the prices of the shares of our investee companies would go down for a period, but our goal across the portfolio is for there to be little intrinsic value impairment when an economic storm hits. Oftentimes we will look at data from two or more decades to see cyclicality in a business, and to see how a management team reacted when there was adversity in the past. We are not looking at what earnings are going to be next year or what were they were last year. Instead we are trying to come up with a normalized valuation based on what the economics of an enterprise has been over a full cycle. Within the EQR strategy there have only been 52 holdings since inception in We only put client capital to work when we believe we understand a company very well, and try to buy with a margin of safety, and watch our clients returns grow as a company employs its capital wisely. can sound trite to say you are staying within your circle of competence, but I think the 2008 crisis showed that many investors did not understand the companies that they were invested in and strayed from their circle of competence. For instance, in the case of many of the banks, leading up to the crisis few investors were focusing on the poor quality of the loans and securities that many institutions were putting on their balance sheet. In our opinion banking has many nuances, and when a bank balance sheet has a line item loans, a great deal of work needs to go in to figuring out the nuances of the types of loans that an institution is making and whether the bank has underwritten them properly.

3 We try to understand the nuances, and we will not invest in a name unless we believe we understand the nuances well. If you do not know the fine details of a company it is easy to get into a lot of trouble when crisis hits, because you will be unlikely to understand what s going on with your investment and what a particular situation means for the longterm value of the investment. 1-Year Daily Chart of Berkshire Hathaway Chart provided by And at the same time, when there is a market rout, being able to communicate to our clients what we are doing on their behalf and how we believe that the investment ideas that we are putting forth are really going to have large outsized absolute returns in the future is important. The focus at those times is to give clients the knowledge they need to be comfortable with our approach so that they have the conviction to stay invested for the good returns that are likely to come from buying stocks at cheap prices in a market panic. TWST: And in what you see as an overvalued market, where are you finding value; any bargains? Mr. Piechowski: Well, as I have mentioned, we are an all-cap strategy. So when the EQR strategy started in 2000, small and midcap names were inexpensive, so from 2000 really until 2004, 2005, the weighted average market cap on the portfolio positions was $2.5 billion to $3.0 billion. And today we are at really our highest-weighted average market cap of all time, so the median market cap for companies that we own today is about $113 billion. We think the market is generally expensive across the board, but if there is bifurcation in the market it is that large-cap names are significantly cheaper on the whole than small-cap The market is generally expensive across the board, but if there is bifurcation in the market it is that large-cap names are significantly cheaper on the whole than small-cap names. Our fourth core principle is balancing concentration and diversification. From our perspective, there is a lot of value that comes from being concentrated in 20 names that we know very well. This knowledge is a huge advantage when there are dislocations in an individual company we own or in the market generally. It gives us the opportunity to capitalize on a potentially distressed price while others are panicking. However, at the same time we understand the need for diversification, and so we limit our industry holding sizes so that we will never be a strategy that has, for example, 50% if its positions in the technology sector. We try to make sure that when we buy positions in a given industry that they are the highest quality and cheapest names available. We do not want our seventh or eighth best idea in a given industry, and our concentration doesn t allow for it anyway. Finally, the fifth core principal at ACR is communication, and communication really for us comes out particularly at market extremes. So today we feel that the market is very expensive overall, and so using our bottom-up analysis of individual companies we are at a point where today we are holding about 40% cash across client accounts. Many clients get quite anxious when they are not 100% invested, as they feel they may be missing a bull market, so it is important for us to communicate why we aren t allocating money to ideas that we believe have the potential to impair our clients future financial health. 1-Year Daily Chart of FAIRFAX FINANCIAL HOLDINGS Chart provided by names. And so the way that that has shown itself in our portfolios is that we own a number of large-cap names, for example Berkshire Hathaway (BRK-A), Johnson & Johnson (JNJ), J.P. Morgan (JPM) and Microsoft (MSFT). TWST: Can you give us a closer look at one or two of your top holdings that meet all of your core values and requirements? Mr. Piechowski: The first company that I would mention is Fairfax Financial (FFH.TO), a Canadian insurer. Fairfax is a $10 billion market cap multiline insurer

4 that we believe is interesting for three reasons. First, historically FFH s insurance subsidiaries have had poor to mediocre underwriting results with combined ratios coming in at or above industry averages. However, much of this has been due to legacy business written at FFH s insurance subsidiaries before FFH acquired them. Many of the older policies at FFH have been settled out, and today we are starting to see the results of insurance underwritten by FFH s insurance managers shine through. For businesses that the company has owned for the past 10 years, FFH has written at a combined ratio of approximately 96%, versus a historical combined ratio of closer to 102% for FFH. Second, FFH today is writing very little insurance premium, approximately $6 billion on a net basis, or 0.8 times its statutory capital, and we believe that FFH could write $10 to $12 billion in a hard market, so revenue could double with no change to FFH s capital base. In the insurance world, when you increase premiums written your insurance float increases, so today FFH has approximately $735 in float per share. If FFH were able to write $10 to $12 billion for a few years, we believe float would approximately double to $1,400 per share. ratios in the low to mid-90s going forward, which is consistent with our understanding of what their management team wants to do, and even at the level of insurance they re writing today, for every 1% reduction in combined ratio they generate an extra $2 a share or so. If they can bring these combined ratios down to 90%, 95% you re talking another $10 or $20 on top of the $48 that they are generating today. We are not sure exactly what the future will look like at FFH, but we see a conservatively run business trading at an inexpensive price with lots of optionality to the upside. TWST: Do you see any notable macro trends or underlying economic conditions that are supporting the large caps versus smaller companies? How long do you think largecap outperformance will continue? Mr. Piechowski: I d say a couple of things. In general, large-cap companies tend to be more financially stable because they have more business lines and are better ingrained into the economy. Large caps tend to have better access to bank revolvers and capital markets. So typically we use lower discount rates for larger companies than smaller companies. This is part of why it is so interesting to us that we look at small caps that are trading at Large-cap companies tend to be more financially stable because they have more business lines and are better ingrained into the economy. Large caps tend to have better access to bank revolvers and capital markets. The final thing we like about FFH is its investment team. The team has driven FFH s portfolio to an 8.9% pretax return since inception in 1985, and we see a team of investors at FFH who have gone from knowing how to take small, nonactive, minority positions in value fixed income and equity investments, to investors who can take controlling positions in company or a class of its securities and really drive advantageous terms to FFH. We believe FFH has one of the best investment management firms in the world wrapped under its umbrella and exclusively investing FFH s capital. In terms of valuation, FFH trades at approximately $470 per share in the U.S. As I mentioned before, the company has approximately $735 in float per share, $385 in book value, and then $100 in debt on the books, which gets us to approximately $1,200 in investments per share. We believe the company can do 4% aftertax on its investment portfolio, which gets us to approximately $48 per share in earnings. So we think the company is trading at under 10 times a conservative estimate of normalized earnings. However, FFH could meaningfully increase float in the future, so we believe there is likely meaningful upside to this figure. And then finally, what is very exciting to us is that with FFH s insurance operation s improving so dramatically, we believe the company could write insurance at combined really substantial premiums to large caps and, even with the higher growth rates of many small caps, we don t understand what the average investor in a small-cap name is thinking versus looking at a larger-cap name today that trades at a lower multiple on the market. Today, the S&P 600 Small-Cap Index trades at a trailing p/e of 32 times. The S&P 500 trades at 18.5 times trailing earnings. The valuation discrepancy between the two indices is simply inexplicably large. And quite frankly, given the sluggish economic growth that we have seen post the 2008 crisis, we think larger companies will be better positioned than small caps to take advantage of their scale to continue cutting cost to drive profitability and capture further market share, all at the expense of smaller rivals. TWST: What have there been the notable shifts in your typical portfolios from early 2013 to present? Mr. Piechowski: There have been no wholesale changes in terms of secular shifts in the portfolio. One thing that I would say is that as time has gone on, especially given the market rally that we had in 2013, we have been selling more names than we ve been buying. And so if you were to go to December 31 of 2012, we would have been about 28%, 29% cash, and today, like I said, we re closer to 40% in client accounts. As the market has rallied we have found it difficult to find names that we want to reallocate

5 capital to with the cash that we raise. And from our perspective that s fine, so we ll hold the money in cash until we find the right idea that s going to generate the proper forward return. We understand the frustration that clients have in seeing a large portion of their portfolio holding in cash, and that there may be a short-term drag to performance. However, there is an option value for holding that cash, and we have found that if we wait to put that cash to work until we find the right investment idea, our return by finding the right name far exceeds the cost of holding cash for a three-month, six-month, one-year period, or the returns we would have received from investing in a marginal idea. TWST: Can you comment on what, if any, were your upside surprises in the recent past and what have been your most notable disappointments? Mr. Piechowski: One name that has worked out very well so far for us is Lockheed Martin (LMT). My colleague Willem Schilpzand identified LMT in 2011, and we started buying LMT in the high $70s and low $80s. And the story with LMT was, as sequestration was going through there were a lot of headlines that the defense companies were going to get hit very hard by budget cuts, and we did some analysis that looked at the makeup of the expected defense budget cuts, and what we found was that really most of the cuts were going to come from cuts to the supplemental budget that was paying for the U.S. s presence in Iraq and Afghanistan, and not to cutting LMT s F-35 program. At the time the stock was trading at about a 10x multiple on GAAP earnings, as investors were expecting no growth at LMT, whereas Willem s view was that LMT would continue to grow, but then on top of that we believed that cash flow was going to be substantially better for LMT than their GAAP earnings because the U.S. government reimburses Lockheed for their pension expense. And due to a timing mismatch between GAAP accounting and government accounting, Lockheed was owed a substantial amount by the U.S. government that Lockheed had already expensed their GAAP books but that they hadn t received the cash for. And right when we were starting to buy the stock this mismatch had started to reverse, with the U.S. government paying LMT back. For its part LMT was taking that cash and repurchasing stock pretty heavily. LMT was able to buy in a lot of stock while the market misunderstood that phenomenon, and when sequestration did not really materially affect the company s operations the stock price took off, and so now we are looking at an LMT that trades around $160 today. So that s one example of a name that worked out very well. A name that has been a recent disappointment here was Strayer Education (STRA). STRA operates in the for-profit education space, and really is a company that has been tarnished by the bad actors in its industry. STRA has lower default rates, higher graduation rates and higher increases in income after graduation than its peers. We started buying STRA in late January and early February of 2013, because we thought the stock could generate midteens returns for our clients over many years if student enrollment growth grew just a couple percent per year. We thought STRA would be a beneficiary of some regulatory actions in the industry to root out unscrupulous players, and that STRA s better student outcomes would eventually be recognized. Unfortunately, following our purchase, new student enrollments fell materially for three quarters in a row, and we could not get a handle on why, especially as some peers were reporting growth in enrollments, and we decided to exit the position in August and September of 2013 at a loss. 1-Year Daily Chart of Lockheed Martin Corporation Chart provided by TWST: So overall, given what you view as a richly valued market, what s your best advice to say the typical investor who would like to participate going forward? Mr. Piechowski: I think the best advice for an investor who wants to participate in the market going forward with highequity valuations today is to really focus on going name by name and/or finding a manager who goes security by security and does a bottom-up analysis and comes to an independent conclusion on each name that they look at. Investors need to be really diligent in making sure they only put money into names that, when using a conservative set of assumptions, they believe are going to compound at very nice rates over long periods of time. If they cannot find those ideas they are better off holding cash. One needs to ignore the mania and the market hype on CNBC day to day and just continue with the process of looking at one name at a time, turning over stones, and making sure that they only put capital to work when risk/ reward is in their favor. TWST: Do you also need to be sitting on cash in the hope of a meaningful correction? Mr. Piechowski: No. So our firm we don t have any particular views on whether a correction is right around the corner or five years out or if a correction will ever come, and we have this 20-stock target, so we don t need an environment where the stock market drops 20, 30, 40% to put all our capital

6 to work. What we need is for idiosyncratic things to happen in different sectors and different industries, and when that happens a few names will fall too far, and we ll find one name to allocate capital to at a time. TWST: To conclude, is there anything we ve missed that you would like investors to know about ACR? Mr. Piechowski: One thing about ACR is that we do everything on a bottom-up basis. However, that does not mean we put our head in the sand when it comes to the economy. Each quarter we have a macroeconomic roundtable where we discuss large macro events such as quantitative easing, consumer indebtedness, or the high levels of fiscal stimulus in the United States today. We don t use this analysis to make wholesale changes to the EQR strategy s holdings, the sizing of positions, or the amount of cash that we hold. Instead we incorporate our macroeconomic views on a company-by-company basis. For instance, if we believe the market is trading at too high of a P/E and we are looking at a publicly traded asset manager, we might assume assets under management should be 20% to 30% lower on a normalized basis. We believe this approach allows us to capture the benefits of doing very granular work on our investee companies while at the same time incorporating the economic environment in which we are investing. TWST: Thank you. (VSB) TIM PIECHOWSKI, CFA Co-Portfolio Manager ACR Alpine Capital Research 8000 Maryland Avenue Suite 700 Saint Louis, MO (314) (877) TOLL FREE (314) FAX ACR - Alpine Capital Research A valuation based asset management firm dedicated exclusively to the asset management business serving intermediaries and institutions. Our mission is to protect and maximize our clients purchasing power through integrity with essential investment principles and excellence in valuation. Sound estimates of intrinsic value require the right investment principles and analytical framework, as well as the discipline and capacity to execute. Ultimately, valuation excellence is evidenced in our long term investment performance record. acr-invest.com info@acr-invest.com 8000 Maryland Avenue, Suite 700 Saint Louis, MO t x This presentation may include forward-looking statements. All statements other than statements of historical fact are forwardlooking statements (including words such as believe, estimate, anticipate, may, will, should, and expect ). Although we believe that the expectations reflected in such forward-looking statements are reasonable, we can give no assurance that such expectations will prove to be correct. Various factors could cause actual results or performance to differ materially from those discussed in such forward-looking statements. Past results do not guarantee future performance. All investments involve risk, including loss of principal. Further, the investment return and principal value of an investment will fluctuate; thus investor s equity, when liquidated, may be worth more or less than the original cost. This document provides only impersonal advice and/or statistical data and is not intended to meet objectives or suitability requirements of any specified individual or account. Views regarding the economy, securities markets or other specialized areas, like all predictors of future events, cannot be guaranteed to be accurate and may result in economic loss to the investor The Wall Street Transcript, 622 3rd Avenue, New York, NY Tel: (212) Fax: (212) Website: