Mr. Stephen Yacktman is Senior Vice President, Chief Investment Officer, and Portfolio Manager of Yacktman Asset Management. He conducts extensive research for the Yacktman Fund. He joined Yacktman Asset Management in April, 1993 from Brigham Young University where he earned his B.S. in economics with a minor in math and an MBA.
Mr. Jason Subotky is Senior Vice President and Portfolio Manager of Yacktman Asset Management. He joined the firm in August, 2001, having previously worked as a General Partner at Peterschmidt Ventures and as a Vice President at Goldman Sachs. Mr. Subotky received a BMusic from the University of Southern California and an MBA from Brigham Young University.
Here are their answers to our investing questions.
1.The Yacktman Funds seem to contain a lot of “wonderful businesses” as opposed to classic Ben Graham net-net cheap businesses? Is it because of the size of the fund or is it because you think buying wonderful businesses provide you with a better margin of safety?
A: Our current holdings in the portfolio are mostly high quality businesses. We think some of the best deals in the current environment are wonderful businesses. If we go back to 2007, we were mostly holding the types of businesses that we are holding today (large cap high quality). However, in 2008 and 2009, we shifted a large portion of the portfolio into businesses with somewhat more volatility as the shares in those companies declined disproportionally.
2. Buffett said it is far better to buy a wonderful business at a fair price? What is your interpretation of fair price at the Yacktman Fund? Could you walk us through an example?
A: What we do at our firm is look at what the best businesses trade for. We’d rather own the triple-A type of businesses than something riskier unless we are getting paid sufficiently for the reduction in quality. Generally speaking, today you are not getting paid enough to buy riskier businesses. One of our largest holdings is Pepsi. Pepsi is a great business. They have a variety of great brands such as Frito Lay, Gatorade and Pepsi. They basically control one of the supermarket aisles with their salty snack business. Pepsi is very predictable and a lot of the earnings can be paid out in free cash. It is not dirt cheap but should give us a satisfactory rate of return with consistency and lower risk.
3. Warren Buffett bought Exxon Mobil in the latest quarter and Exxon Mobil is also one of Yacktman Fund’s largest holdings? What is your thesis on Exxon Mobil?
A: We own Exxon Mobil because historically it has had much higher return on capital than other major oil companies such as Chevron, BP and ConocoPhillips. Chevron has historically taken on debt to repurchase shares and pay dividends while Exxon Mobile has used cash generated by operating activities to give cash back to the shareholder.
4. Can you walk us through the investment process at the Yacktman Fund? Hypothetically, if you are interested in Target or Oracle, where do you start with the research process and how do you go about allocating research effort among all dimensions? Where do you spend the majority of the time on during the research process?
A: A good amount of the time is spent finding the ideas. You can quickly filter a lot of things out. Once we’ve sifted through the ideas, generally the first thing we do is to read the annual reports and the proxy statements. We try to first get an understanding of the business so the business description section of the 10K is a great place to start. Then we move on to the risk disclosure section. Those are put together by management and lawyers sitting in a room trying to figure out what can go wrong with the business. These people are worried about getting sued so they’ll include the things that keep them up at night or keep them nervous in the disclosure in case something goes wrong.
I read the business description and risk disclosures first and then move on to financial statements and footnotes. We also use sell side research reports for industries we are not familiar with to help us get up to the speed. We also read trade articles or other publications that are relevant to the business. Typically, the last place we go is to the management team because management is usually there to sell you on why to own the stock. It’s much better to analyze what they have done than have them tell you what they are going to do.
Our core focus is the large cap U.S domestic based companies and we have been following much of our potential investment universe for a long time. Oracle is a good example because we studied it for years. It finally went into our portfolios during the second quarter after it gapped down due to disappointing earnings. A lot of the idea generation come from studying the core large cap U.S-based businesses we’d like to own at some point. We keep doing the homework and keep up with the quarterly earnings so when the valuation is right, we are able to act quickly.
We also try to get an understanding of how the businesses have performed historically. For instance, last night we were looking at the operating margins of consumer companies the 1960s and 1950s. We like history a lot because it gives you a great perspective on what might happen in the future.
5. What is Yacktman Fund’s process in terms of the initial purchase of shares? If preliminary research is promising, would you initiate a small position first or does every idea have to be fully researched before a position is established?
A: We like to say “It’s almost all about the price.” We often start with smaller positions, but when a stock gaps down, like Oracle did, we can build a bigger position quickly.
6. Once you decide to purchase the stocks of a company, how do you go about the timing and the price of buying? How do you establish a full position? For example, if you decide to buy Microsoft when it is traded at $25 and Microsoft jumps 3% within days, would you buy the shares on the way up or would you wait for a better entry point?
A: It all depends. We usually buy and sell gradually. For the most part, we are slow in and slow out. Again, we don’t set a price target. Instead, what we do is we’ll make the stock 2% of the portfolio at this price and 3% if it drops further. However, in 2002, Tyco’s stock gapped down from our initial purchase at to around $7 within a fairly short period of time due to a lot of bad news. In that case it quickly went from a half percent in our portfolio to an eight or nine percent position. Unless there is a dramatic price movement, we try to build our positions slowly. Everything is price-driven or forward return-driven.
Every period is unique. In 2008 and 2009, we are looking at investment that we thought could that double quickly and if they couldn’t, why did we own them? Today it’s not even remotely the case, so we are more heavily weighted to companies we think have high quality and consistency. We think we have the ability to be patient or move quickly when we see bargains.
7.When you value the equity interest of a business, do you use a Total Enterprise Value based approach (such as EV/EBITDA, EV/Sales) and subtract net debt to arrive at equity value, or do you use price based approach (P/E, P/S, P/B, P/CF)? If it is dependent on the business, under what circumstances is EV based approach more appropriate?
A: P/S and P/E ratios may help you if you are looking at an industry and comparing the ratios within the same industries. But if you are cross comparing businesses from different industries, there will be a variety of cash flow characteristics. For example, a lot of consumer product businesses such as Procter and Gamble have been able to pay out almost 100% of their net income whereas an average company in the S&P 500 may only pay out 45-50% of net income. Comparing companies of different industries using P/E or P/S ratio does not help you when you have a business that to earns a dollar and pays out a dollar and another business that earns a dollar and puts 50 cents back to keep up with competition. So when we are valuing a business, we’d like to focus on the forward rate of return. By that I mean if I buy a stock today at this price, what is my anticipation of the return I am going to get in the future? This forward rate of return includes free cash flow yields and anticipated growth rate. At Yacktman Funds, we don’t set a price target, instead, we ask ourselves at this price, what types of return are we going to get and we compare that across industries. If it’s a less consistent business that is growing at the same rate as the other business which is more consistent, we will demand a higher premium for the less consistent business. Therefore, our current default positions end up with those consumer product companies because if we are not getting paid for a premium, we might as well go with something less risky.
It’s also important to look at all the businesses from a bottom up standpoint and try to understand as much as you can about a business if you are using a price to sale multiple. For example, News Corp had a lot of sales in businesses that were not profitable such as newspapers. Now the newspaper business is gone. Similarly, when Coke Cola bought their bottling business, the sales mix effectively shifted. So it is very important to look at the business from every aspect instead of just using one metric.
Furthermore, we will look at historical data and get an idea of how the business has been doing over the past 10 years. What percentage of earnings did they get to keep? We are trying to get a general idea for the future but we are not forecasting. If you are forecasting whether the business is growing at 7% or 8% in the future, you’ve already got a problem. We look at what the mean case scenario is and what the likely distribution of scenarios around the mean case scenario is. If you look at Procter and Gamble, in 20 years they will probably still own Tide, they are probably still going to be in hair and shampoo and they are still probably going to be dominating. You can pretty much forecast to a certain degree of certainty what is it going to be like in 20 years. But you can’t tell what Microsoft or Intel are going to look like in 20 years.
The lower the ability to forecast the future, the lower the valuation should be. We’ll pay less because there is more volatility associated with it.
And risk to us is not the risk of the stock price, it is the risk that the business is not performing as we expected. You can have a business that has been doing very well for the past 10 or 20 years but they may not be doing as well in the future. The newspaper business is a good example of this. We had looked at Gannett in the past. In 2004, at the multiple it was trading, you could expect to earn about 8.5 to 9 percent if they can repeat what they have achieved during the past 10 years. At the end of 2004, we were asking what are the odds that this newspaper company is going to keep earning 8-9% in the next 10 years and it was pretty obvious that the business model of the newspaper business is deteriorating and we did not think it was going to earn 8-9% in the future, we quickly threw the idea away.
8. What is the mistake you remember the most and what did you learn from that? When you find out that you have made a mistake in your investment analysis, how do you go about exiting the position? Do you sell it right away?
A: We bought Tupperware back in the late 90s. It was just spun off from Premark International. As we gathered historical data from the new management team we did not feel confident in so we sold the position. If you think you’ve made a mistake, you should sell right away. Why hold something you are not comfortable with?
9.How are decisions made within Yacktman Funds? Does each portfolio manager have discretion in make his or her own investment decisions for the fund or does someone else have to approve the decision?
A: There are three co-managers of the funds. We work as a team, and no one portfolio manager can make the investment decision or have veto power. If you look at our portfolio today, you will see we have small positions and large positions. Where you see positions are very large, it is usually because we have a uniform consensus from the portfolio managers. Very often it is a relatively cheap low risk, high quality stock.
10. How many ideas have you researched this year and how many of them have you acted on ultimately? What are the most common reasons that you pass on the idea? Is there an idea that you almost acted on but in the end did not?
A: We don’t keep a scorecard of the ideas that we have researched. We manage approximately $30 billion in assets, so the universe of stocks that we can invest in is about 500 companies. We are constantly looking for new ideas.
Price is critically important. Coke is a large position for us today and we added to our position in the most recent quarter. But if you go back to 1998, Coke’s stock price was higher than it is today and the earnings were about a third the current level -- and of lower quality. So if you had bought Coke in 1998 and held it until today, you did not make much money other than the dividends. We like to say that it is almost all about the price because that is what truly gets you excited about a holding. We have a preference for higher quality businesses, but we are willing to sacrifice the quality a little bit if the price is right.
11. Why do you choose to operate as a mutual fund as opposed to a hedge fund?
A: It’s legacy. Don Yacktman previously ran another mutual fund, so when he started the firm he launched in the mutual fund format.
12. What do you think about portfolio hedging? Some investors such as Seth Klarman and Prem Watsa bought put options on general indexes. Some other renowned investors just increase the proportion of cash in their portfolios. One of the recent discussions on gurufocus is about buying index funds versus cash in a rising market. What is your suggestion to small investors?
A: The Yacktman Fund has no ability to hedge, while Yacktman Focused has the ability to purchase and sell options. Since 2000, we’ve had an average cash position in the funds of about 18%. Of course whenever we find compelling ideas we’ll use cash and if we can’t find enough good investments, we will wait. During 2002 and 2008, we were pretty much fully invested.
Hedging can be very expensive. You are also timing the market, which wejust don’t try to do. A lot of investors have the concern that if you have cash in the raging market, you will not be able to keep up with the market. Sometimes it is better to hold cash that to own fully or over-priced stocks.
As far as owning index fund versus cash, we don’t think the index fund will deliver good returns over the next few years. One mistake that a lot of investors make is that they or their clients judge themselves against a benchmark over a short time period. The time to panic buy is not at the top, the time to panic buy is when everybody is fleeing such as during 2008 and 2009. We were pushing ourselves during that period to buy stocks that have a lot of upside.
Most of our investors understand what we are trying to achieve and they appreciate the fact that we are willing to potentially sacrifice some short term returns to thoughtfully manage risk.
13.There have been a lot of discussions about JC Penney recently and quite a few big funds bought JC Penney’s equity during the past 2 quarters. What are your thoughts on JC Penney and its equity dilution?
A: We actually looked at JC Penney’s debt and we did not invest in it. It will be very hard to get interested in the equity if we passed on the debt. I think the problem is that JC Penney is a retailer and there is a long list of retailers that have gone bankrupt even though they had been in business for more than 100 years. This is in the too hard pile for us because the future is too uncertain. If things go poorly on JC Penney, you will be lucky to cover your money on the debt.
14.Under what circumstances do you think secondary equity offering is beneficial to equity holders?
A: Equity offering is good to stockholders when the stock is overpriced. But you wouldn’t hold a stock you think the stock is overpriced.
15.Could you talk about some characteristics that would make for an enticing, yet in reality, a risky investment? What advice would you give amateur investors with regard to suppressing the excitement and urge to act?
A: Some of the biggest investment risks come from valuation and businesses that are in highly competitive, rapidly changing markets. We would recommend sizing positions to manage the risk or uncertainty.
16. For small and amateur investors, which approach do you think is better? Cigar Butts or Wide Moat?
A: That really depends on price. What’s better? What’s cheaper? It is easy to find the moat and stick with it and the problem with cigar butts is that very often there is no value to begin with because management is burning the money. Margin of safety is just a function of the price you pay. At the right price, either approach will work. My advice for investors is to be open to all kinds of opportunities and focus on what the return on the investment.
17. What is the most important quality to success in managing a big mutual fund?
A: Don’t overpay for your investments. If you can be patient, objective and diligent, things should work out pretty well over the long term.
18. Any book recommendations?
A: My suggestion is to go to sec.gov and read as many 10Ks as you can. You can learn so much about businesses by just reading lots of 10Ks.
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