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Sarah Ketterer of Causeway Capital's Answers to GuruFocus Q&A

Holly LaFon

272 followers

1. How did you get into value investing? Who influenced you the most?

My father, John Hotchkis, had the greatest influence on my education as a value investor. I also listened carefully to the late Bob Kirby of Capital Guardian Trust, a renowned value investing pragmatist.

2. Understanding business: What is your investment process like? Can you discuss your process for understanding a business? What questions do you ask yourself? For example, are there specific questions you consider about the company's consumers? Or about capital expenditures and operating leverage, etc.? What kind of companies do you avoid? What are you looking for in a company? Can you discuss your sell strategy? Do you talk to management? What questions do you ask when you talk to management? Also, value traps - How to avoid?

The Causeway investment process begins with quantitatively-derived screens that we use to narrow a 3,000 global stock universe to a subset of candidates. Those screened stocks have characteristics that make them biased to outperform their markets. Causeway research then eliminates those stocks with inadequate financial strength and poor industry outlook. We investigate the remaining stocks very thoroughly, drawing on decades of industry expertise within our team. Attractive candidates pass a series of tests, namely a review and conversations with company management, scenario analysis where we stress test our assumptions of a recovery in growth and profitability, and multiple interviews with industry experts to understand the competitive, regulatory, legal and political landscape and the business cycle. My colleagues and I like to buy stocks when the business has reached a cyclical low, the balance sheet remains rock solid and the income (via dividends) secure. We expect the cyclical stocks to pay our clients to wait for the inevitable cycle upturn. We also gravitate towards operational restructuring situations, where new management has a plan to revitalize the business. We also find opportunities in consolidating Industries, implying sustained discipline in supply and in pricing, which often sets the stage for long-lasting improvement in earnings. Value traps typically occur when investors cannot push the board to remove underperforming management. In addition, we are careful about buying “cheap” stocks where a large sovereign ownership stake makes the company’s agenda more about national service than maximizing shareholder returns.

3. What questions do you ask yourself regarding the sustainability of a competitive advantage?

Typically, the most undervalued companies do not appear to have a sustainable competitive advantage – or appear to have allowed that advantage to slip away. In times of stock market upheaval, the Causeway team buys all the sustainable competitive advantage stocks we can find. In more sane market periods, however, those stocks generally carry premium valuations.

4. Smaller amount of money: If you were managing small amounts of money what are the things you would look at? What is your valuation approach and what do you consider when forecasting earnings? What would you recommend that the investor do in order to hedge their portfolio and buy insurance at a reasonable cost and in a relatively simple way?

Define “smaller”? We manage over $31 billion. The asset management industry giants would call that small.

5. Overall market valuation: If you were managing a stand-alone hedge fund, would you manage the market exposure of the portfolio according to the general level of the market (according to the Schiller PE for example) or according to how many individual ideas you were able to find? Could you share your current opinion about the macro picture for the next five to 10 years and how you incorporate it or not into the construction of your portfolio?

We don’t have a macro forecast for more than two years. Our macro forecast comes from our banking research, where macro expectations drive valuation.

6. Do you think this market is overvalued or undervalued overall?

As a bottom up manager in the developed markets, we don’t make market forecasts. However, based on the output of our weekly value screens, we would argue that you can put the world’s equity markets on a ladder of most-to-least expensive, with the US (especially US small/mid cap) at the higher end of valuation ladder, and many of the emerging markets at the bottom.

7. Any book recommendations?

Read everything you can about the history of market booms and busts. Human behavior doesn’t change, and will likely always be prone to bouts of irrational buying and selling.

8. What do you think about the Brazilian and Chinese market? Is this an opportunity to pick up stocks like Banco Santander (BSBR), China Mobile (CHL) or Petroleo Brasileiro (PBR)? Thank you.

Yes, if you have a long-term investment horizon, buy a diversified emerging markets fund for this exposure.

9. Thank you for taking our questions. I have a two-part question: (1) How did your global portfolio position strategy change each time the Fed announced a new round of QE and (2) How would you position your global portfolio in anticipation of the eventual wind-down of QE?

1) It didn’t change, 2) Abundant monetary liquidity appears likely for the Eurozone and Japan for many quarters ahead, partially offsetting the US tapering. If the European Central Bank decides to sell euro and buy US Treasuries, then that may offset the upward pressure on US bond yields from tapering. The Fed can remove some liquidity without dampening investor enthusiasm for equities, in part due to the lingering investor concerns that bonds no longer look like a one-way bet. Always emphasize portfolio diversification, especially in the wake of a bull market.

10. I'm going to start my own investing company. I would like your kind advice: What are the most important things for the start? Thank you and best regards!

Make sure you can offer your clients the security of knowing that you can make payroll for several years after launching the business. Without the human capital, you have nothing.

11. I have a very simple (yet not simple) question. As a 24-year-old, I have a lot of time to allow for compounding. If you had to pick one or two smaller companies to buy and hold for the next five to 10 (or longer) years, what would they be?

Don’t buy individual stocks unless you have the time and expertise to conduct the level of maintenance research that you would receive from a reputable mutual fund investment staff. I suggest you find a fund or funds that hold securities that you understand, then do regular maintenance research on the fund’s advisors (the investment managers) and their ability to sustain superior track records.

12. As a contrarian investor, what are the key indicators your company looks for in stocks that have been discarded by other so-called experts and picked by you? I typically don't follow numbers or parameters and decide to invest in stocks at or near 52-weeks lows. So far I've been blessed with stocks such as Ariad Pharmaceuticals (ARIA) and OxiGene (OXGN), and I have hope in Groupon (GRPN) only because I think its business model is improving and has plenty of upside potential. In other words, I trade by gut feeling and I'd like to learn more about real signs. Thanks in advance for taking our questions.

As a value investor, I admit I don’t know much about companies with exciting growth stories and lofty valuations. I would give you this advice, however. Don’t buy individual stocks unless you have the time and expertise to conduct the level of maintenance research that you would receive from a reputable mutual fund investment staff. I suggest you find a fund or funds that hold securities that you understand, then do regular maintenance research on the fund’s advisors (the investment managers) and their ability to sustain superior track records.

13. In your case, what are the important factors to consider for building a portfolio?

The number one factor we consider is risk-adjusted return. Our team handicaps each stock with a risk score (risk baggage). The return that stock offers (based on our research) must more than compensate for the risk. The risk score measures the incremental amount of volatility that stock will likely add to our portfolio. The score helps our team build highly diversified portfolios despite the concentrated number of stocks.

14. 1) Which aspect of value investing do you place a greater emphasis on: projecting future earnings or calculating the respective company's present value if liquidated (since some of the companies are in “out-of-favor sectors” and some face “temporary setbacks”)?

We do both, depending on the industry. Highly cash-generative companies lend themselves to a discounted cash flow valuation methodology. In contrast, cyclical businesses with volatile earnings are better suited to a projection of earnings recovery and a P/E multiple valuation approach.

15. 2) Do you think that U.S. equities are reaching a saturation point/becoming significantly overvalued as Seth Klarman believes is so? If not, why?

I doubt the entire US market is overvalued. Don’t underestimate the vast size of the US equity market. Even after a prolonged bull market, our team can still find US-listed laggards and undervaluation in a variety of industries. We have to work harder to find these stocks, but that’s why we earn a fee.

16. I have two questions. The first is how do you allocate your global portfolio regarding position sizes? Do you allocate strictly from a bottom-up perspective or do you have a certain threshold for each geographic area that must be met (or limited) in terms of percentage of the portfolio?

The second question is what do you think of the prospects for Africa and the Middle East in the next 20+ years? How to you evaluate the financial statements and verify the companies are legitimate in the "questionable" geographic regions? It seems most Western investors neglect these geographic areas, but I could see tremendous value being created over the coming decades, especially in the agriculture and energy industries. I would love to hear what you have to say! Cheers and thanks again for your time.

In the developed markets, we construct our global portfolios from the bottom up, emphasizing those stocks with the greatest risk-adjusted returns. In contrast, we use a quantitative approach in the emerging markets, where we can employ both bottom up and top down tools, and capture price momentum in our stock selection. Africa remains too speculative for our emerging markets portfolio, but the Middle East does have some interesting opportunities. They key is to hold small amounts of these more speculative, nascent equity markets.

17. The banking system in the U.S. seems to be improving. As far as foreign banking investments, which would you favor, a European bank such as Commerzbank AG (CRZBY) or an emerging market bank such as Itau Unibanco Holdings SA (ITUB)? Thank you.

We hold a wide array of European and US-domiciled banks in our developed markets portfolios. Both those regions have seen the peak in bad debts, provisions, regular requirements and legal settlements. These demonstrably better capitalized banks will move into the next 5 year period with very favorable opportunities to improve profitability and return capital to shareholders.

18. Hi Sarah and colleagues. Thanks for taking our questions.

Do you still own Tesco (OTCPK:TSCDY)? If so, what are your current thoughts on valuation? It seems to be going through a challenging patch.

I will limit my comments to concept, as I cannot mention specific stocks for compliance reasons. I admit that we do not strike gold on every one of our investments; sometimes the company and its industry take a direction that we did not consider likely when we developed our investment thesis. If we believe the problems with any underperforming stock will persist, we admit we were wrong and we sell. Conversely, if we believe that our thesis remains intact, then we buy, or at least hold.

19. Who is your all-time favorite investor and why?

I have invested professionally for over 23 years, and I can state with confidence that no one investor has all the answers. Causeway has deliberately adopted a multiple portfolio manager system, giving each of our talented PMs a chance to lend his/her global industry expertise in our research and portfolio construction process. Yes, you can point to great individual investors, but imagine having the combined knowledge and market wisdom of eight of them in your portfolio.

20. Japan: Do you think (A) a new secular bull market has begun or (B) it is yet another cyclical rally that should be sold into like every other one of the last 20 years?

If (A), do you have any interesting ideas in Japan? Thanks!

I can’t see why the Japanese market should rally from here. The most promising ideas we have in the Japanese market typically include companies engaged in meaningful and increasing levels of restructuring. We look for the over diversified, low return on capital conglomerates, and occasionally find one where management has started to cut costs, remove underperforming subsidies or non-core holdings, and refocus on improving profitability. Assuming the valuation appears attractive and the financial leverage is modest, we will take that bet.

21. Thank you for taking time to respond to these questions. Regarding China and Brazil: The energy sector, in particular oil/gas, has been under a lot of pressure. Stocks like CNOOC Ltd. (CEO), Petroleo Brasileiro (PBR) and PetroChina (PTR) seem to be in oversold territory. Do you see more pain ahead with growth concerns and government intervention like with CEO or do you this as a good entry point for a long-term investor like myself? Thanks so much.

We like the intersection of China and energy very much, even assuming a modest (10-15%) decline in crude oil prices.

22. I'm a Montreal CPA title holder currently preparing for the CFA exams. As you are an experienced manager, my question would be, what are the qualities you are looking for in a new candidate? And how do you suggest a new analyst can "break into" the industry? Thank you for your time.

Intelligence, pragmatism, curiosity, humility, tireless energy and an unemotional demeanor.


Rating: 3.8/5 (6 votes)

Voters:

Comments

Washutoo
Washutoo premium member - 7 months ago

Terrific interview. The responses are filled with valuable insights on how to become a successful investor. I offer the following comment: The process of investing is rewarding in itself. You learn so much from doing it. Allocate a modest portion of your wealth to learn from being an active investor. Low cost indexing teaches nothing, but beats most active managers. Study the great investors with excellent long-term track records, low turnover and portfolios with meaningful position weightings. gurufocus is a great resource. Then study the companies and the industries in depth. Invest no more than 10% of your portfolio in any one company until you have 5-10 years experience. Resist joining fads. Remain open minded and calm. Emotion driven decisions are almost always wrong. Test your assumptions, biases and try to make a strong case for not investing in any company you think looks promising. If you can't then it will probably work out nicely. Study your mistakes (some will be winners that you sold too soon.) Remember some of your winners and losers are simply good or bad luck. A 60% batting ave. is about as good as it gets, even for the great ones. Your winners in time will trounce your losers. Looking forward to reading your interview.

Benoit
Benoit - 6 months ago

It's a very bad deal for Brazilian shareholders of BSBR.

In 2009 Banco Santander‘s Brazilian unit of Santander Spain Bank raised 14.1 billion reais ($8.05 billion) in a record initial public offering in Brazil . The bank, formally known as Banco Santander (Brasil) SA, sold 600 million units at a price of 23.5 reais each

In 2009 Grupo Santander said it will book a capital gain of 1.43 billion euros ($2.1 billion) after listing its Brazilian arm in the biggest IPO of the year.

In 2011 Banco Santander announced on Tuesday a deal to acquire the 25 percent of its Brazilian unit, Santander Brasil, that it does not already own for 4.69 billion euros, or $6.52 billion. The price offered for Santander Brasil is 15.31 reais, or $6.92, per unit

It's a real good deal for Santander Spain Bank.

In 2009 Gain of 2.1 Billions

In 2011 Gain of 3.4 Billion

Total Gain 5.5 Billions

A case teaching in school finance. How to successfully get 5.5 billions without selling anything. Amazing!

Santander gets 100% of the shares of BSBR and raises 5.5 trillion.

it's a stolen day for shareholders of Santander Brazil.

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