GuruFocus Interview with Wedgewood's David Rolfe at the Omaha Value Investing Conference
Holly LaFon: How did you get started in investing?
David Rolfe: I got started a long, long time ago. And I was really fortunate that I got started in college. I’m going to date myself here – I got hooked in 1984. I was 21, 22. My first investment professor, turned out he was a stock market junky. I was like, this is great. We rarely talked about the book. He talked about the markets. Hooked. Long story short, myself and another student with the professor started the student investment club at the University of Missouri St. Louis. It’s still up and running. They have like $180,000 in money. But he was instrumental in pointing me in the direction of reading about the gurus. So, it was non-academic books. He said here are a couple of books if you like it, buy these books, build your library. And, hook, line and sinker. So that was my first in ‘84, that was my first exposure to Buffett and T. Rowe Price and Templeton.
HL: What was your first stock?
DR: When I graduated in '85, the easiest way for me to get into the business was to become a stock broker. So, I was at a tiny little company that is not even in business anymore. But then I went over to Pain Weber once I got licensed. And I was only there for about a year and a half. But I’ll never forget, my first stock was Walmart (NYSE:WMT). It was March 15th or 16th, 1986. I bought it for my first client. I paid $48 and 7/8, and I the reason I remember that is because it was for my mother in law. So when I went over to my girlfriend, now my wife’s house, and I talked to my future mother in law, I said hey I bought the 100 shares of Walmart. And she said, what price? And I said, $48 and 7/8. And she said, well where did it close? And I said, $48 and ¾. And she said, well why was it down? And I thought, do I really want to be in this business?
But that 100 shares would eventually turn into 1,600, and that $5,000 investment went up huge. And it’s actually providing for her retirement care now.
HL: Great background. About your Geico presentation, "The 'Growth Company' That Made the 'Value Investing' Careers of Both Warren Buffett and Ben Graham" – I know it’s interesting because of Buffett, but does it tie into your investment philosophy in any way?
DR: Yeah, it does. At Wedgewood what we’re trying to do is both growth and value. Twenty stocks, best of breed, wait patiently for the valuation to make sense. And I’ve been questioned over all the years and so have my partners, that, we get pigeonholed in this business, where you’re growth or you’re value, or you’re large, etc. And one of the questions is, it seems like a lot of times when you’re buying stuff that there’s a real strict discipline on valuation. There is! The story of Geico is one of both tremendous growth, and then they got into some tough times, and then of great value.
So, I think with Geico, there are lessons to the growth and value. You know the classic coin of the realm – two sides to the same investment coin? I think investors can learn a lot by the study of Geico from the growth and value.
HL: Is that one reason you like Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) because they own Geico? It’s not a huge growth company, and it’s your second largest holding.
DR: It doesn’t move the needle as much as it once did. But actually, the study of any of the masters has to include Buffett. So I tried to read everything that he ever wrote, back in college. It’s been a lifelong study of him. We’ve actually for our clients been investors in Berkshire Hathaway since 1998. So, I sit at the feet of the masters, I stand on their shoulders and try to learn, and obviously Buffett is in that pantheon.
HL: What do you think about market valuations right now?
DR: I tell you what, it’s interesting. We’re entering the fifth year of a bull market right now. So certainly it’s not late 2008, early 2009. A lot of stocks have gone up tremendously. We’ve had a decent earnings recovery but earnings haven’t been that great of late. We have incredibly low interest rates to where that marginal dollar is seeking something else. And I think it’s starting to feed into the stock market, particularly when you look at the market leaders thus far this year. They are these utilities. They’re bond-like alternatives. High-dividend yielding stocks that include consumer staples, health care related, pharmaceuticals and utilities. But it’s interesting, when you consider that these companies are five, six, seven percent growers and they’re at P/Es of 21, 22, valuations are getting up there. So, what’s interesting is that over the past year, the most significant part of the gain in the market averages has come from a change in valuation, not earnings growth, and I think we’re starting to get excessive here.
HL: You think earnings are going to slow down?
DR: Yeah. I think it’s been a tough environment for the past few quarters of earnings.
HL: I read many quarterly reports and it seems that for a while it was very impressive: Wow, look at these high profit margins, but oh, they cut thousands of workers and had to squeeze out so much to make them. I don’t know how they can keep doing it.
DR: Corporate profit margins are at 50-year highs. So you could say there’s a surplus of profitability out there that’s going to find its way into the public sector. One person’s surplus is another person’s deficit, and when you look at – exactly to your point – the good news about corporate America is it’s lean and mean; the bad news about corporate America is it’s lean and mean – the productivity, technology. But when you see how much of the pie of earnings out there that is going towards the labor force versus going to the corporation’s bottom line, we’ve rarely had a bigger divide. So you have to ask yourself the question, if corporate margins are at all-time highs, how do you get double-digit growth? It has to be through revenue. I don’t know how much more you can cut before you start cutting bone and muscle. I don’t think we’re in a global economic environment much less the United States that would support wide-based double-digit revenue growth.
So, I think that margins are as good as they can get, and let’s face it, our economy’s at little more than stall speed. I think corporate earnings are going to disappoint to the foreseeable future. That’s just one person’s thought.
HL: Doesn’t that usually weigh on the markets though?
DR: Well that’s the $64,000 question. And I’m reminded, the correlation of corporate earnings and movements in the market is not as tight as a lot of people think. The market is a discounting mechanism. Now certainly, a lot of what I think we’ve seen in the past year of gains in the market is looking a year or two out. Now if it disappoints the market’s going to be set up for a correction. We haven’t had a meaningful correction in a long time. I mean, it just doesn’t go straight up.
HL: Well that’s why you’ve got your solid 20 companies right? They’ll be impervious.
DR: That’s right, that’s it. That’s all the bandwidth we have at Wedgewood – 20 companies.
HL: [Laughter] Tying into that, does the recent report of profit margin decline at Apple change your valuation on the company?
DR: Yes, it does, but the stock was at $705, and it fell to $380. Now it’s back to $445. We are modeling and expect lower margins going forward. In this case, let’s talk about gross margin. We believe the company over the next few years will have a range between 35 and 40, maybe 36 to 39 if you want to get pretty specific. The margins a year ago, when the iPhone 4S was at the best part of its cost curve, they were booming China. In the previous recession, Tim Cook was able to secure incredible quantities of components at really cheap prices. Perfect environment – corporate margins were like 47. Those were not sustainable. However, in our view, we believe that the current price, the market-implied margin assumptions at current is lower than where we think they’re going to be. We think the market has overshot the price. Lack of growth, concerns of margins. We don’t believe that the ultimate margin range is going to be as bad as, I think, the bear case. So now we have an argument, now we have a debate. But we are not modeling a return anywhere close to where margins were about a year ago.
HL: And what if they don’t come up with a new product, or does that matter to you, without Steve Jobs?
DR: Well, certainly, there’s going to come a time when they’re going to miss Steve Jobs, if they haven’t missed him already. But we know that he’s had his fingerprint and input on a lot of what’s in the pipeline. Here’s our take on this whole product stuff: As long as they continue to deliver evolutionary upgrades that are still best in class – they just won the JP Power Award how many years in a row for the iPhone? The iPad usability, favorability ratings are off the charts. As long as the products are good enough to support ecosystem growth, we’re not going to be concerned. If Apple (NASDAQ:AAPL) starts to do cheap, poor quality products, we’re going to be worried.
HL: You’re going to keep it as your top holding?
DR: Well, it’s our largest holding right now, and our last move on it was when we added it at right about these levels.
HL: Are you still finding bargains in the market with valuations so high?
DR: Few and far between. And generally speaking it’s interesting, the worst performing sector so far this year has been technology stocks. Technology-related stocks. I’m not crazy about the term “tech stocks” because Google’s a tech stock, but really is it? Cognizant technology is business services. But when you say tech stocks, people think hardware or specific software. But tech related have been poor performers and our last three purchases in our portfolio have all been technology stocks. Because we think the valuations are too cheap.
So, we’re seeing limited opportunity and where we are finding it is in those areas that have been some of the bigger disappointments or laggards thus far this year. And that’s our playbook. We like to buy stuff when it’s out of favor.
HL: So you go for sectors or?
DR: It’s bottom up. But we’ve always had a pretty good weighting in technology, financial, health care, kind of soft consumer discretionary, consumer durables, we’ve always had a pretty good weighting in those types of names. We tend to avoid the deep cyclical stocks.
HL: I think I read you keep a list of things you like to own if the valuations were better –
DR: To give you an idea how little we do by design, we have 22 stocks in our portfolio – over the last 25 years, we’ve owned little more than 75 or 80 others. That’s it. So typically we have a list of about 30 to 40 companies that we want to own. We love the business, we want to own them. Only about 20 make the cut into our portfolio. So let’s just say we had a list of those 35, 40 – the 20 that we thought were the best bargains, that’s the portfolio, and then we weighed them, best to worst, that type of thing. And then we’re very, very careful at the portfolio level, not to have companies that are largely competing with other companies in the portfolio. We don’t think you need 50 stocks to be prudently diversified. We think a dozen and a half or two dozen are plenty, as long as you don’t own three railroads, three money center banks.
HL: A 30-year-old investment manager with $8 million in assets under management who is an investing student, level 1 in the CFA program, and operates an IRA by himself wants to know if you have any advice?
DR: First and foremost, all your interests have to be aligned to generating the best experience for your clients. What’s on your desk in front of you right now is a priority. Take care of that first. In the investment business, we can’t control our returns. We can do our best. We have bull markets and bear markets and everything in between. So if you have a sound philosophy that you can have the discipline to repeat, wonderful. On the client service side, expectations are always going to be high. And there’s little room for error. So in your practice in your profession, on the client service side, literally, zero mistakes. Take care of that client like it’s your mother. And then on the investment side, you have to have the discipline to stick to your philosophy because there’s going to be times when it’s dramatically out of favor, and that’s the test.
HL: Do you think value investing is in favor or out of favor right now?
DR: We don’t think value investing ever goes out of favor, but certainly the types of companies that we favor are out of favor right now. We typically don’t own the big dividend yielders. Back in 06 and 07, we were really out of favor. That’s when cyclical stocks were booming – cheap and easy credit. You know, that whole environment back then. That’s the hardest part of this business is sticking to your philosophical guns when you’re underperforming. Because in this day and age, 24/7, your clients know what the portfolio’s doing by the second.
HL: Right, why did it go down today?
DR: Exactly. But if you want to own something that you think you want to own for the next five to 10 years, don’t get caught in the trap of instantaneous success and affirmation of the success of your investments. When you buy a stock, if it goes up the next day, it doesn’t mean you’re right. If it falls it doesn’t mean you’re wrong either. That’s tough. I think it’s the behavior and temperament is the rare quality in this business. Everyone has a high IQ otherwise they probably wouldn’t be in the business at a certain level.
HL: So do you have the shareholders, like Bruce Berkowitz, who feels like he’s found his core, who will stick with him through thick and thin?
DR: Absolutely. Absolutely. We are, and at the risk of making this sound like a commercial, I don’t want it to come across that way, but one of the big databases – our mutual fund’s only two years old, but it’s managed identical to our separate accounts. In the separate account space, one of the big databases that ranks money managers is PSN, if you’re familiar with them – part of Mobius, e-investment alliance. We just got our rankings for the period ended end of March, and for the five, 10, 15 and 20-year, in large-cap growth, we were top 1%, top 5, top 1, top 1. Year to date, we’re stinking it up. We’re behind 6 or 700 basis points. But that has to be the understanding. If a manager is going to have a philosophy and process that can give them a chance of outsized returns, you’re going to have to accept the fact that there are going to be times when you’re really out of favor. So having clients understand that is imperative. It’s very important.
HL: Going back to Geico, do you want to talk a little bit about your Geico presentation you’re giving here at the Value Investor Conference?
DR: When you step back and you look at the sweep of Geico – just a couple of things – this has been one phenomenal success, and it’s growing nicely even today. It’s on the verge of becoming the nation’s second largest auto insurer. It’s amazing. So just in and of itself the history of Geico is I think interesting to any student of business as the study of a unique business with a unique business proposition that has executed it nearly flawlessly for its entire corporate history. Now there’ve been times where they’ve kind of gone off the straight and narrow, and that’s given value investors an opportunity to swoop in and buy this great business at literally give-away prices. So I think there’s a couple of lessons in the Geico story.
HL: So when you’ve just found a good company that’s just fallen on a hard time, it’s still the foundation of the company that you want to look at and invest in that?
DR: Yeah, that’s more than half way. There’s an old adage or saw in this business that a stock bought right, is half sold right. And that means valuation. If you bought it right, if you’re getting it at cheap enough price, even if you make a mistake on it, your losses shouldn’t be fatal. And if it turns out that the company’s still going to do fine over the year, then, well, you’re off to the races.
HL: Right. Do you invest in other insurance companies?
DR: No, no. This has been our one and only insurance investment has been through Berkshire.
HL: Reading the presentation, I didn’t really understand the key thing that made them say, yes, let’s put a lot of money into this company. It seemed like a good idea, but what made Warren Buffett say –
DR: Well, that happened twice. I mean, go back to Benjamin Graham. His family gets wiped out in the panic of 1907. As a young adult, he made a lot of money on Wall Street in the ‘20s, he was on margin, he got wiped out. That experience obviously seared him for that first edition of Security Analysis which came out in 1934. So it was, diversify, own a little bit of a lot, and buy businesses that are very statistically cheap. When he bought half of Geico for his Graham Newman partnership in 1948, he bought half of the company and it was 25% of his firm’s assets, and it was a private company – it wasn’t even a publicly traded stock. And it just was kind of a fluke that the SEC allowed the purchase if they would make it a public company – distribute the shares and create an over the counter – so again, to coin a phrase that I used in there – you can tell which show I’m trying to catch up watching – Benjamin Graham broke bad. That’s his breaking bad, if you will. When he decided to break the rules. Now, Buffett on the other hand, even from the youngest age, he wouldn’t have put all his eggs in one basket and watched that basket. At a very, very young age he had such confidence in his own ability that he thought why do I need to find my 20th best idea, when I have two or three ones that I feel like they can’t miss. So he didn’t feel any compunction at all to invest a bunch of money in the stock.
And as the story goes, when he was studying under Graham, he found out that Graham was the director. He put half of his net worth at the time – he looked at the business, and he got the understandings of these powerful economics and he goes, this thing can’t miss. And he put half of his personal money in that. And then when Geico fell on hard times in the early ‘70s, he had an opportunity to buy about a third of the company.
It’s interesting if you fast forward from 1976 to 1987, in his 1987 chairman’s letter, for the first time, Buffett talked about permanent holdings. He only had three stocks: Washington Post (WPO), ABC Cap Cities and Geico. And he said, all of these are permanent. And next year he would buy Coca-Cola (NYSE:KO) and Coca-Cola would become a permanent holding.
It’s really interesting when I go to all of these institutional investors and they say, “Eh, Rolfe, Wedgewood, kind of an interesting story you guys have, but, just 20 stocks?”And in my head I say, “I just wish we owned 10!” But you can’t build a business with 10 stocks. You just can’t. Unless you’re someone like Buffett and has a partnership and gets this following, you can do whatever you want.
Interestingly, when he started his partnership, one of the ground rules was, I’m not going to tell you what I’m doing. I’m only going to report to you at year-end, and even then, I’m not going to tell you what’s in the portfolio. Now, it was relatives, neighbors, friends of friends, who trusted him, but, can you imagine? Even in hedge funds that have to show their holdings at a certain time, four times a year. But can you imagine, having a business where, give me your money, I’m not going to tell you what I’m doing?
HL: So, what are you going to buy?
DR: I don’t even tell myself what I’m going to buy.
I gotta tell you, when you read about the greats, and you get a sense of, at a certain point, if you’re hooked enough on the business, and you’re doing all the reading, you just slowly building that confidence that I think this is going to be a good investment, and if it’s wrong, it’s not going to be the end of the world.
And one last thought – when I first got into this business, Peter Lynch just wrote his book, “One Up on Wall Street.” To me it was like Martin Luther nailing something on the church door. When Peter Lynch retired, he had only compounded money at like 29% from ‘77 to ’88 or ’91 or ’92, or whenever he stepped down. He said two things that for me, it was an enlightening thought. He said, the worst thing that could happen in the stock market is the stock goes to zero. Now, if you have too many of those, you know, you have to go – but the good news is, a stock may double, or triple, or quadruple, or go up 10-fold. All it takes is one mini-Geico from the lay-investor’s perspective to make all the difference in the world. And that was like, hey, you know what, you get one or two of those over your career, all your mistakes might be rounding errors.
And then the second thing he said was, at the height of my ability, half the stuff never worked out as I had hoped. To me that was an amazing admission that the best of the best was saying, at best he hit 50%.
HL: Babe Ruth.
DR: Yeah. So again, to kind of torture the baseball analogy, if you can get a hit out of every three at bats, you’re on your way to the hall of fame. And I think in this business, it’s very similar. If you can bat 300 in the investment business and your losses aren’t fatal, over time, the odds are in your favor that you should be a successful investor.
Read David Rolfe's Geico presentation he gave at the 10th Annual Value Investor Conference (referenced in the interview) here. See his portfolio here.
Also check out the Undervalued Stocks, Top Growth Companies and High Yield stocks of David Rolfe.