The two value funds, Equity Income (HULIX) and Small Cap Value (HUSIX), hold some of the same stocks that Hotchkis & Wiley hold, such as: Unum Provident (UNM), EDS, Tyco (TYC), Conseco (CNO), and Capital Lease Funding (LSE).
This interview is free (Joe does not give stock picks in this interview).
Q. What do think of subprime?
A. In general, I’m a contrarian investor. So when everyone is thinking one way, I’m thinking, why not the other way? In the case of what is going on with the subprime market right now, this is one of those rare instances when I feel there should be some fear and skepticism in the marketplace. We’ve gone through a very long period of very weak credit quality that has been out there. It’s just starting to come to fruition. The problem is that banks are very leveraged. So when the problems hit, it magnifies the problems in their businesses.
It took Morgan Stanley 150 years to get $500 million of assets on their balance sheets. It took them three years to triple that amount. The equity that is underlying that business certainly hasn’t tripled. Also, if you look at off balance sheet liabilities in terms of lines of credit and other types of things they have, they have a lot more risk on their balance sheet.
It goes deeper than just the subprime market. In reality, there are a lot of prime lines out there that don’t really have the credit backing using traditional metrics.
Q. What is your process for buying undervalued companies? Do you look at free cash flow and price to book?
A. We look at more of a replacement cost for assets than a price to book. I think book, the way U.S. GAAP is set up, misstates the true underlying value of the assets materially. So we look at the replacement cost as downside. How much would it cost to reinvent this company from scratch?
We also look at normalized free cash flow. GAAP tends to misstate what earnings are in terms of giving capital back to shareholders.
Q. What do think of homebuilders as an industry?
A. We think that the stocks right now have overdiscounted the worst that is out there. For example, you can buy the best homebuilders right now for less than the working capital on their balance sheets. They own dozens of years of land. You get the business and the land for free.
Q. What is your biggest concern with the American economy?
A. My largest worry tends to be the amount of off balance sheet leverage at many of the large investment banks. I think the amount of off balance sheet leverage is enormous right now and the capital against it is very low. The assets that were historically perceived to be not very risky are now proven to be risky assets. You don’t have a lot of flexibility on the balance sheets of a Morgan Stanley, Lehman Brothers, Deutsche Bank, or Bear Stearns. If one of those companies goes under, you could have a domino effect.
Hear the interview in its entirety for free at www.stockroyalty.com