Guru Zeke Ashton: Q&A Answers
This is the response from Zeke Ashton to users' questions.
1. Any reasoning for the holding Terra Nova Royalty Corp. (TTT)?
We owned Terra Nova Royalty Corp. originally back when it was KHD Humboldt Wedag AG, and the management had articulated a plan to separate the businesses into two different public companies to try to better reflect the value at each component. Back then there were three significant assets, namely a German industrial company, an iron ore royalty and a bunch of excess cash. The management separated some of the cash and the royalty from the industrial company. The industrial company was then publicly listed in Germany, where it was thought that a more natural buying constituency might exist. It turns out that this separation did in fact create some value for shareholders of the original KHD Humboldt Wedag AG. After the separation, the remaining assets at Terra Nova Royalty Corp. were the royalties and cash.
The reason we hold Terra Nova Royalty now is that we believe the recent combination of the Mass Financial business with the royalty and cash that were in Terra Nova Royalty will be a value producing combination for Terra Nova Royalty shareholders. We believe that the Chairman of the company, Michael Smith, has shown some skill as a capital allocator in the past, and we believe the chances are good he will continue to do so going forward.
2. I was wondering about the Terra Nova Royalty stock. I find it hard to find information on Michael Smith. I was wondering what you know about him. Where I could find more information about him? Are you holding on to the KHD Humboldt Wedag AG dividend or did you sell it?
We sold the KHD Humboldt Wedag AG shares, given that we believed we were receiving full value for them. Michael Smith is indeed a somewhat enigmatic figure, but we were familiar with him through our prior ownership of Mass Financial, which he has run in one form or another for over 20 years. Mass Financial was an Austrian-listed company that traded in small volume on the pink sheets in the United States prior to the combination. We will undoubtedly find out more about Mr. Smith as we go. He’s running a NYSE-listed company now, so there should be much more transparency and disclosure.
3. GuruFocus posts current portfolios on their website, and I see in your portfolio that you have puts on the SPDR KBW Regional Banking ETF (KRE). Since I think financials are slightly undervalued, can you discuss the bearish call? Thanks.
We owned some long positions in companies with lending-based businesses, and our SPDR KBW Regional Banking ETF put represented a tiny position that was designed to partially hedge against our longs. It has since expired.
4. What is the most important ratio you look at when valuing a company?
I don’t believe in the superiority of any one metric. Rather, our investment process relies on a qualitative understanding of the business and then an effort to assess what the business is worth. This usually entails considerable thought about the business and then choosing the most appropriate valuation method available. We prefer if we can find a couple of different methods of valuation that we can use to get additional comfort with our assessment.
That said, we find that looking at multiples of future normalized cash flow or normalized earnings power is a metric that is applicable to a wide variety of companies. For financial businesses, another method we use often is the price as compared to a conservative estimate of book value (with appropriate adjustments made to the reported figure based on our assessments of the book).
5. I see Best Buy Co. Inc. (BBY) as one of your important holdings. I have been looking closely at Best Buy Co. Inc. from last few months specifically when it has declined more than 20% since December 2010.
Market is really worried about Best Buy losing market share to discounters like Walmart (WMT) and Target (TGT) as well as to the online titan Amazon (AMZN). My analysis suggest that Best Buy is losing share only in the price-sensitive entry-level gadgets as it focuses on improving its profitability (margins have improved over last couple of years and gross profit margins have also improved). Also, YOY declines have come due to delay in adoption of 3D and IPTVs in the TV market segment (biggest for Best Buy), most probably due to weak consumer spending on the discretionary items like TV. Best Buy has also faced difficult comparisons due to high increase in same store sales in 2009 (bankruptcy of Circuit City).
Believe Best Buy is most focused on providing latest and greatest technology to early adopters and its competitive advantage lies in people having the ability to go the store and try the different gadgets and get their questions answered from a knowledgeable staff and that his helping Best Buy hold their end of the market. I also believe this shift towards mobile technologies and small store formats is a step in right direction.
I also analyzed ROIC for Best Buy and it is in upper teens again providing ample proof that their competitive advantage is intact and business model is sound.
What are your views on Best Buy?
Best Buy is not one of our important holdings any more. I’m not sure if we were wrong on Best Buy or just early, but either way we decided to sacrifice our Best Buy position to the investing gods and move the capital to other ideas. We may re-visit it at some point.
6. ZEKE - I notice you are holding calls on Cisco Systems Inc. (CSCO) & Microsoft Corporation (MSFT). What is your outlook for each of these companies over the next 12 months? Thanks.
I don’t have a 12-month outlook. I just think both of them are very out of favor and cheap if the companies can continue to generate cash at anything close to historical levels. We hope that the next 12 months provides further evidence that we are correct in our assessments of the qualitative soundness of these two businesses.
7. You did very well in 2008, when the market lost 37%. What do you think you did right in 2008? If there is a lesson you learned in 2008, what is it? What would you do differently?
I would say that we benefited in the hedge fund from being able to go short, which helped us tremendously in 2008. In our mutual fund, we were careful to own businesses without excess debt on the balance sheet. While owning cheap and high-quality stocks didn’t protect us as much as we would have liked, it did mean that we didn’t suffer permanent capital loss to the degree that many other investors experienced.
As far as what we would do differently, I don’t believe that 2008 highlighted any terrible weakness in our investing framework. While I would like to have some individual decisions back, overall we survived and recovered the lost ground relatively quickly.
8. 1.) You have a lot puts and calls in your portfolio. Do you use them for the purposing of hedging?
2.) Can you explain how you hedge your portfolio risk?
3.) What do you like about Laboratory Corp (LH)? It is your largest holding?
I think Laboratory Corp. of America and Quest Diagnostics (DGX) are both high quality businesses and they are obviously extremely similar. I’ve always personally been more comfortable with Laboratory Corp. of America because my perception is that they’ve executed a bit better and have historically used less leverage. Also, Laboratory Corp. of America has historically traded at a discount to Quest Diagnostics. Today, Quest Diagnostics trades at a discount to Laboratory Corp. of America, and therefore the two stocks are pretty close in terms of attractiveness in my mind.
We would have no trouble taking positions in two similar companies so long as we didn’t feel the total capital exposure to the industry was excessive and there was reason to believe that they might work out at different times for different reasons. However, it is certainly more time and research efficient to simply choose one and make it a sizable position.
9. Thanks for taking the time to answer our questions. What is your process for analyzing qualitative aspects of a business (do you read annual reports, investor presentations, etc.)? Given the many different companies and industries you analyze, what helps you get up to speed quickly in understanding company and industry specifics?
After studying different investment gurus I’ve noticed that some utilize DCF models, while others prefer to utilize a target rate of return based on Free Cash Flow Yield plus a conservative long term growth rate. Are these both sound strategies? What method do you utilize for valuation?
We basically try to gain the benefit of as much information as we can that seems germane to the effort of trying to understand the business. So we read annual reports, investor presentations, conference call transcripts, and typically look at some competitors. We also look at the company’s financials going back at least seven years (if the business hasn’t changed a lot) so we can see how it has done over time. As for your second question, I would refer you back to my answer to question #4.
10. What is your take on looking at Seadrill Limited (SDRL) and Ship Finance International Limited (SFL) as an income plus growth stock?
I haven’t looked at either one in detail. I am highly sensitive to companies that have a lot of debt on the balance sheet and generally avoid them. I would refer you back to my answer to question #7.
11. I find that perhaps the most difficult aspect of investing is screening for good investment ideas. Could you discuss some ways a small investor without access to resources such as Capital IQ or Compustat can effectively find potential investments? Would you recommend a top-down approach (developing a broad thesis based on macro ideas then drilling down to specific companies), a bottom-up approach (finding individual stocks that appear undervalued based on some ratio) or something entirely different?
I would suggest doing a small industry study where you find an industry that you think is attractive, and simply look at the players in the industry. We find a lot of interesting stocks that way, and often are able to set up a simple valuation table that includes a dozen or so companies. Usually, one or two jump out at us as being cheap or at least interesting.
I don’t know how to do a top-down approach, so I can’t help you there. Some macro trends are fairly easy to identify (i.e., demographic trends, increasing internet traffic, etc) but most aren’t so easy. We’d rather hunt for good businesses at cheap prices as a starting point.
12. 1) Do you look for the same margin of safety on each stock you buy or does it depend on the industry, predictability of the past results of the company in question?
2) Does growth play a part in your stock selection and the valuation of the stock in question?
3) What is your preferred valuation method?
4) Do you pay attention to macro events and how does it help your investing?5) Apart from buying, it is very important to stay abreast of your portfolio companies and also know when to sell. Can you provide some insights on how you stay current with your investments and also how you determine the time to sell?
That’s a lot of questions. As far as the looking for the “same” margin of safety on each stock, I’d argue that stocks don’t lend themselves to anything like that level of precision. We aim to get a big enough margin of safety on each idea that we won’t suffer a terrible loss if we are completely wrong, unlucky, or have terrible timing. Some ideas we know are riskier than others, so we size them differently based on our overall assessment of value and risk.
Growth absolutely plays a big part in our valuation efforts and in our stock selection. However, we have learned that paying a price that requires an extended period of high growth will cause very large percentage declines if the growth doesn’t materialize. We’d rather find situations where we think there is likely to be decent growth without paying for it.
As far as maintaining our ideas, we do written updates on our ideas over time to incorporate new information as needed and to adjust our valuation estimates and risk assessments over time.
13. Why did Matt Richey leave Centaur to return to the Motley Fool?
Have you been able to generate and analyze investment ideas without his input?
What was your process when you were partners and has that undergone significant changes with his departure?
After six-plus very productive years at Centaur, Matthew expressed a desire to move his family and to have the opportunity to run his own portfolio. I think it is a natural desire for any talented investor to want his or her own investing canvas at some point. It seems to me that The Motley Fool provided the perfect opportunity to accomplish those things. Matthew retains an ownership stake in Centaur Capital Partners and as such we expect a continuation of what has been a long and productive relationship. The change has worked out fine for everybody.
The investing process here at Centaur has not changed much and we continue to benefit from Matthew’s insights through our subscription to his new Motley Fool service.
14. 1.) You have a lot puts and calls in your portfolio. Do you use them for the purposing of hedging?
2.) Can you explain how you hedge your portfolio risk?
3.) What do you like about Laboratory Corp.? It is your largest holding?
We use puts and calls generally when we feel they offer us the best way to play our underlying thesis on a given investment idea. Most of them are not for hedging, but occasionally we use puts to hedge either a specific risk or broad market risk. As far as hedging, we like to have some individual short positions that we believe will produce profits for us that will also provide a natural hedge against market declines. Also, we do get some hedging benefits from selling covered calls. Finally, we will buy index puts if we feel the need to get broad market risk protection. I will say that hedging is not an exact science and that it doesn’t always work with the precision or timing that we’d like.
Lab Corp is a well-run, cash-flow generative business with a tremendously advantaged competitive position. It competes in an industry with great demographic and technology tailwinds, and it has been run well. It has often traded at prices we considered quite cheap for such a reliable business. It isn’t our biggest position today because the price has increased relative to our fair value estimate, and we have r-sized the position to reflect our current view of the risk/reward profile Lab Corp offers at today’s price.
Thanks again to everyone for your interest and your questions.