Investing Great Donald Yacktman Answers GuruFocus Readers' Questions
Here are the responses from the three co-managers of Yacktman Fund to readers' questions. Special thanks to Co-manager Jason Subotky for his quick responses to GuruFocus' requests.
[Question]: Mr. Yacktman, how did you become a value investor? Any books or people that influenced your investing philosophy? Any recommended readings to young investors?
[Mr. Yacktman]: I studied economics as an undergraduate and went to Harvard Business School. I enjoyed analyzing businesses and thought I had a patient and objective temperament which was well-suited for a successful investment career. It always made sense to me that good investing was about purchasing things on sale.
For reading, Ben Graham’s Security Analysis, Berkshire Hathaway Annual Reports, and John Train’s The Money Masters are all good. I would also recommend Poor Charlie’s Almanack.
[Question]: How do you think about PepsiCo's long-term growth potential? Are you concerned about the potential for value destruction as management continues the push towards "Good for You" products (the JV with Mueller in yogurt that was discussed in October of last year comes to mind)?
[Mr. Yacktman]: PepsiCo has a diverse group of food and beverage businesses that offer a high degree of predictability and have solid growth potential over time. The long-term growth potential comes in large part from continued international expansion and product innovation. Management has a mixed track record with its “Good for You” strategy and its recent acquisitions. We believe the company will need to show improved results from several of the key areas of strategic focus or there may be a new management team in place in the near future. The potential for the stock is less about the growth, which we think is mid-to high single-digit per year, and more about the combination of valuation and quality of business.
[Question]: Thank you for taking the time to share your wisdom and experiences. You mentioned recently that purchasing Pepsi at today's prices is like shooting fish in a barrel. You have since significantly increased your position in Avon (AVP). Can you please share your thoughts on Avon including how you would characterize the investment opportunity in AVP at today's prices? Thank you.
[Mr. Yacktman]: At our firm we often say “It’s almost all about the price.” Avon today sells at an attractive multiple of our projection of free cash flow. For many years, Avon was one of the higher multiple consumer staples businesses because of its attractive exposure to emerging markets, especially Brazil. Although Avon has had many recent challenges, we think the issues are manageable and the shares are inexpensive. The recently rejected acquisition proposal by Coty demonstrates that others view the company as attractive at these prices. We are excited about the quality of the new management that has recently joined Avon.
[Question]: (Question from T. Blake, Blake Brothers Capital.) Don, thank you for leadership and guidance at the Yacktman Funds. My son is enjoying his college years at Texas A&M utilizing our investment returns from your funds. Keep up the good work! Question - I understand that Pepsi is a core holding at Yacktman Funds. I've reviewed the numbers, key metrics and reports and concluded that management's ability to attain significant cost savings in the months and years ahead is job No. 1 for Pepsi management. You must be very supportive of CEO Indra Nooyi and her team. Would you give her an "A" grade today? Give me the name of one company from prior decades that Pepsi reminds you of today. And why?
[Mr. Yacktman]: Thank you. Nice to hear our work helped with your son’s education expenses. Generously, I would say the grade would be incomplete. We own Pepsi for its quality franchises and low valuation. I would say management execution has had challenges in the last few years. The beverage business has been significantly outperformed by Coca-Cola (KO), and the acquisitions have not proven to be the best uses of capital. Pepsi reminds us of Coca-Cola 10-15 years ago when Coke had a few false starts before finding the right management team.
[Question]: Whitney Tilson of T2 Partners has said that Microsoft (MSFT) should borrow against their O.U.S. cash, and use the billions in debt proceeds to seriously increase their cash to shareholders via dividends and buybacks; what are your thoughts on this proposal?
[Mr. Yacktman]: It makes sense but we think it is unlikely to happen. At the current low debt rates, we think many of our portfolio companies that have cash overseas for tax reasons would benefit by leveraging up with cheap, fixed rate, long-term debt, and retiring shares. In our opinion, the investment case for Microsoft is valid with or without the strategy Whitney Tilson wrote about.
[Question]: Procter & Gamble (PG) is currently dealing with some competitors who are cutting prices in the face of commodity cost increases in an attempt to grab share, and has announced price increase reversals in certain categories as a result; what are your thoughts about P&G's moat in terms of some increasingly commodity-like industries such as hand soap, cough syrup, etc., which are subject to private label competition? While innovation can win on the higher end (Tide Pods, for example), how do you think they'll fair with their lower-end brands as retailers continue to push their own products?
[Mr. Yacktman]: Procter & Gamble is much like PepsiCo. It is attractively priced so the business requires only modest growth to have an attractive return. Like we do with PepsiCo, we significantly value P&G’s business predictability and quality. During difficult economic times, branded companies generally face some pressures as consumers trade down to lower cost alternatives, however we think that the trade-down will prove temporary. P&G’s portfolio of businesses is high-quality, durable, and has strong emerging market exposure.
[Question]: You added to your position in Avon. When evaluating Avon, what consideration do you give to if/when Avon cuts their dividend? How concerned are you that it appears that Avon is funding some of its dividend by issuing debt?
[Mr. Yacktman]: We care less about the current dividend yield of a company than the capacity to pay a dividend. We believe Avon can support its annual dividend largely through the cash from operations and the company has debt capacity if, in the short-term, they have other uses for capital and want to maintain the dividend. If tax rates change and dividends are again taxed to individuals as ordinary income, we would prefer companies pay out a large one time dividend up front and then cut the annual dividend. Unfortunately, we do not expect many companies will consider this idea.
[Question]: There has been so much written analyzing Apple (AAPL) and its stock. Many seem to believe it is still massively undervalued. How do you view Apple and what is your opinion of the stock price?
[Mr. Yacktman]: Apple is a company that has executed brilliantly and looks inexpensive if you believe its sales will continue to be robust and profit margins will stay at current levels. Is the business is more durable than cyclical? We do not think that Apple will be able to sustain its profitability over time as the rate of product innovation slows and/or competition catches up. Consumer electronics, computers, and the cell phone markets all have had rapid boom/bust cycles previously. In addition to potential business challenges, at the current size, the high rate of growth is likely over.
[Question]: According to the last YAFFX report the second-largest position is News Corp. (NWS) I guess the scandal with the UK news created the opportunity. Can you please share the fundamentals that attract you to invest in this company?
[Mr. Yacktman]: We studied News Corp for many years before purchasing shares in 2008 below $10 per share. We used the challenges last year to purchase additional shares. We got to know the company especially well as it was an important component of value for Liberty Media (LCAPA), one of our larger portfolio positions several years back. News Corp is one of the few newspaper oriented companies to successfully transition to newer media. Today the cable and television content divisions are where the most significant value exists. On a stand-alone basis, the cable content unit has been growing pre-tax profits at more than 25% a year for more than a decade, a claim few other large businesses or business units can make.
News Corp generates significant free cash flow and sells at a low multiple of free cash flow. The cable content business offers significant predictability with more than 2/3rds of the unit’s revenues from predictable monthly fees. News Corp also has significant value in non-core investments which we think the company does not get full credit for in its share price.
We think News Corporation has significant growth opportunities in the future. The core cable content should experience solid growth in the U.S. and especially overseas where pay television and content have much lower penetration and consumption rates than the United States. In the last few years, News Corporation and other network television companies successfully negotiated monthly transmission fees. The monthly payments will be increase earnings and create more predictability for The Fox Network and Fox television stations.
[Question]: What do you think are the primary reasons why Wal-Mart (WMT)'s P/E ratio has declined so consistently over time (practically a straight line since 2000)? Thank you very much.
[Mr. Yacktman]: Investors were pricing the stock like the company could continue to grow in the future like it had in the past even though the business had matured. Over time the multiple declined as investors slowly recognized the growth would be modest. The business executed fairly well during the period of multiple compression which is probably why the multiple came down slowly.
[Question]: When do you decide to switch to low quality stocks? Like you did with AmeriCredit (ACF) in 2009? What kind of risk premium do you require for low quality companies?
[Mr. Yacktman]: There is no magic decision point, however when the potential rate of return becomes significantly higher on a less predictable security, we may be willing to trade quality for valuation. Each situation is unique to the security we appraise. In 2008-2009, we think we generally moved from high quality to slightly lower quality that was offering significantly better rates of return. We generally avoid low quality unless we expect that we can manage the downside and get paid extremely well compared to alternatives.
[Question]: Do you consider the Shiller P/E market valuation method as a valid, accurate measure of the market?
[Mr. Yacktman]: We think the Shiller Cyclically Adjusted P/E formula is a fairly good long term valuation tool if you are looking to project market rates of return. We have used other, more difficult to obtain data, and achieved largely the same results as Shiller. Ultimately, however, investing for us is about valuing individual businesses. If we find good investment opportunities we are not generally concerned if with think the overall market is overpriced.
[Question]: I have previously read some very interesting articles in which you discussed how you calculate the forward rate of return. However, I would like to ask if you could go into a bit more detail, and then also indicate how you adjust for risk... and whether the risk adjustment is purely a subjective calculation. Thank you very much in advance for taking the time to give this interview.
[Mr. Yacktman]: This number is a calculation of a normalized free cash flow yield plus real growth plus inflation. If the business is stable, this calculation is fairly straight forward. For instance, on the S&P 500 we would normalize earnings. We would then calculate what percentage of those earnings are not reinvested in the underlying businesses and are therefore free. Historically, for the S&P 500, this has been just under 50% of earnings. Currently, we expect the S&P to earn about 70 on a normalized basis, a number which is far below reported earnings due to our adjusting for record high profit margins. $70 X ½ / 1400 gives you a normalized free cash flow yield of approximately 2.5%.
The historical real growth rate of the S&P 500 is about 1.5%. Assuming an inflation rate of 2.5%, the forward rate of return on an investment in the S&P 500 is about 6.5% today (2.5% free cash flow yield plus 1.5% real growth plus 2.5% inflation).
We prefer companies that have historically grown faster than the S&P 500 and can pay out 80-90% of their earnings. Today, several of our favorite companies, including Sysco (SYY), Clorox (CLX), Pepsi, and P&G meet this hurdle and trade at a discount to the market on normalized earnings. We use these types of businesses as our baseline discount rate.
Back to October of 2008, P&G had a forward rate of return of about 9-10% while Viacom on depressed results offered a higher free cash flow yield than our total rate of return calculation for P&G. This did not even considering growth potential for Viacom (VIA) which we thought was significant from the depressed earnings level. This is an example of an easy swap that yielded huge results.
[Question]: What is the level of required return you demand for the best business today?
When you normalize earnings, how do you treat and incorporate one or two years of loss a company experienced in the past? Best regards.
[Mr. Yacktman]: We generally demand an annual high single-digit or low double digit forward rate of return for a high quality business and more for one we think is lower quality. Normalizing earnings is dependent on the specifics of each company. Generally, we avoid businesses that produce operating losses, however determining a normal margin depends on what caused the losses and the likelihood of those events recurring.
[Question]: Congratulations on a phenomenal track record. I own YAFFX. Have you any thoughts on how you can avoid the tendency of most successful fund managers to revert toward the mean in their results the longer they manage a fund?
[Mr. Yacktman]: We think continuity of the investment team is one of the keys to long-term success. All of the key members of our investment team today have been at the firm for more than a decade and are significant owners of the firm. We also think good investing is about being flexible. Many firms have experienced performance reversion because what is successful in one period often fails to sustain. We also think it is important to recognize that producing strong results over time does not mean that your investment style will work in every short period of time.
[Question]: The fund has seen tremendous inflows. Do you think the fund is now too large? Will you close the fund to new investors at some point?
[Mr. Yacktman]: Given our emphasis on large companies combined with our well below average turnover, we believe we have plenty of capacity currently. We are further helped because our turnover tends to increase during market dislocations when liquidity is generally very high.
[Question]: Can you share your perspective on the publishing segment? (Maybe “Can you share your perspective on the publishing segment of News Corp.") They have $8.8 billion in revenue from publishing, or 26% of total revenue. As an investor that buys positions for the long term aren't you concerned with this side of the business? Many thanks!!!
[Mr. Yacktman]: We think News Corp is inexpensive even if you value the publishing assets at zero. Clearly they are worth more than that, especially the Dow Jones business, but there is no need to worry about that business shrinking as long as the company does not destroy significant value by investing heavily in the industry as it erodes.
[Question]: Our son is 21, just returned to school and works part-time. He has a Roth Ira worth a little over $11,000. It is currently in a Morgan Stanley Smith Barney Bank Deposit Program which earned a giant .04 last quarter and charges a $35 quarterly fee. He wants to get out asap! What would you recommend for him to invest in?
[Mr. Yacktman]: If he is a long term investor, we would recommend The Yacktman Focused Fund if he is patient and will not compare results to a benchmark in short time periods. The 3 co-portfolio managers of the mutual funds have significant personal investments in The Yacktman Focused Fund. Between the two US mutual funds we manage, we prefer the additional flexibility that The Yacktman Focused Fund offers, although we note that the expense ratio is higher for The Yacktman Focused Fund than for The Yacktman Fund.
[Question]: Do you think stock options as a form of employee incentives are acceptable? If you do not feel they are appropriate, do you ever encourage senior management of stocks that you own to quit paying them? Stock options seem to have an inverse relationship to share re-purchases to me.
[Mr. Yacktman]: We hate stock options and think they are a poor form of employee compensation. Having all upside and no downside does not put an option holder in the same position as the equity owner. We generally vote against most employee stock option plans on proxies. We far prefer having employees purchase equity at a discount to the market or receive stock grants. Additionally, we think all but the most senior executives should be compensated more with cash than shares. It is possible for Frito Lay to execute well while Pepsi’s other businesses do not, so why tie the compensation to the parent company share price for the people running Frito Lay employees? We appreciate the interest in our firm and our investment process and look forward to answering questions again in the future.
The performance data quoted for The Yacktman Fund and The Yacktman Focused Fund represents past performance. Past performance does not guarantee future results. The investment return and principal value of an investment will fluctuate so that the investor's shares, when redeemed, may be worth more or less than their original cost. The current performance may be higher or lower than the performance data quoted. The most recent month-end performance data may be obtained by calling this toll free number 1-800-525-8258.
An investor should consider the investment objectives, risks and charges and expenses of the Funds carefully before investing. The Funds' prospectus contains this and other important information about the Funds. An investor may obtain a prospectus at www.yacktman.com or by calling this toll free number 1-800-525-8258. The prospectus should be read carefully before investing.
The S&P 500© is an unmanaged but commonly used measure of common stock total return performance.
Cumulative return data calculation includes reinvestment of gross dividends.
Principal Risks of Investing in the Fund
Investors in the Fund may lose money. There are risks associated with investments in the types of securities in which the Fund invests. These risks include:
Market Risk: The prices of the securities in which the Fund invests may decline for a number of reasons. The price declines of common stocks, in particular, may be steep, sudden and/or prolonged.
Value Investing Risk: From time to time “value” investing falls out of favor with investors. When it does, there is the risk that the market will not recognize a company’s improving fundamentals as quickly as it normally would. During these periods, the Fund’s relative performance may suffer.
Non-Diversification Risk: The Fund is a non-diversified investment company. As such it will likely invest in fewer securities than diversified investment companies and its performance may be more volatile. If the securities in which the Fund invests perform poorly, the Fund could incur greater losses than it would have had it invested in a greater number of securities.
Smaller-Capitalization Companies Risk: Smaller capitalization companies typically have relatively lower revenues, limited product lines and lack of management depth, and may have a smaller share of the market for their products or services, than larger-capitalization companies. The stocks of smaller-capitalization companies tend to have less trading volume than stocks of larger-capitalization companies. Less trading volume may make it more difficult for our investment adviser to sell securities of smaller-capitalization companies at quoted market prices. Finally, there are periods when investing in smaller-capitalization stocks falls out of favor with investors and the stocks of smaller-capitalization companies underperform.
Interest Rate Risk: In general, the value of bonds and other debt securities falls when interest rates rise. Longer term obligations are usually more sensitive to interest rate changes than shorter term obligations. While bonds and other debt securities normally fluctuate less in price than common stocks, there have been extended periods of increases in interest rates that have caused significant declines in bond prices.
Credit Risk: The issuers of the bonds and other debt securities held by the Fund may not be able to make interest or principal payments. Even if these issuers are able to make interest or principal payments, they may suffer adverse changes in financial condition that would lower the credit quality of the security, leading to greater volatility in the price of the security.
Junk Bond Risk: Although junk bonds generally pay higher rates of interest than investment grade bonds, junk bonds are high risk investments that may cause income and principal losses for the Fund. The major risks of junk bond investments include: 1) Junk bonds may be issued by less creditworthy issuers. Issuers of junk bonds may have a larger amount of outstanding debt relative to their assets than issuers of investment grade bonds. In the event of an issuer’s bankruptcy, claims of other creditors may have priority over the claims of junk bond holders, leaving few or no assets available to repay junk bond holders. 2) Prices of junk bonds are subject to extreme price fluctuations. Adverse changes in an issuer’s industry and general economic conditions may have a greater impact on the price of junk bonds than on other higher rated fixed-income securities. 3) Issuers of junk bonds may be unable to meet their interest or principal payment obligations because of an economic downturn, specific issuer developments, or the unavailability of additional financing. 4) Junk bonds frequently have redemption features that permit an issuer to repurchase the security from the Fund before it matures. If the issuer redeems junk bonds, the Fund may have to invest the proceeds in bonds with lower yields, with a corresponding reduction in future income. 5) Junk bonds may be less liquid than higher rated fixed-income securities, even under normal economic conditions. There are fewer dealers in the junk bond market, and there may be significant differences in the prices quoted for junk bonds by the dealers. Because they are less liquid, judgment may play a greater role in valuing certain of the Fund’s securities than is the case with securities trading in a more liquid market. 6) The Fund may incur expenses to the extent necessary to seek recovery upon default or to negotiate new terms with a defaulting issuer. The credit rating of a high yield security does not necessarily address its market value risk. Ratings and market value may change from time to time, positively or negatively, to reflect new developments regarding the issuer.
Foreign Securities Risk: The securities of foreign issuers may be less liquid and more volatile than securities of comparable U.S. issuers. The costs associated with securities transactions are often higher in foreign countries than the U.S. The U.S. dollar value of foreign securities traded in foreign currencies (and any dividends and interest earned) held by the Fund may be affected favorably or unfavorably by changes in foreign currency exchange rates. An increase in the U.S. dollar relative to these other currencies will adversely affect the Fund. Additionally, investments in foreign securities, even those publicly traded in the United States, may involve risks which are in addition to those inherent in domestic investments. Foreign companies may not be subject to the same regulatory requirements of U.S. companies, and as a consequence, there may be less publicly available information about such companies. Also, foreign companies may not be subject to uniform accounting, auditing, and financial reporting standards and requirements comparable to those applicable to U.S. companies. Foreign governments and foreign economies often are less stable than the U.S. Government and the U.S. economy. Because of these risks the Fund is a suitable investment only for those investors who have long-term investment goals. Prospective investors who are uncomfortable with an investment that will increase and decrease in value should not invest in the Fund.