20 Questions With David Rolfe - Part II

Read Part I of GuruFocus' interview with David Rolfe here.

10. So basically you have a shortlist and the way you get this is, as I understand, is doing research on your clients’ requirements, even to get into the list?

The number one thing is they have to generate very high levels of profitability. We don’t want to waste our time with mediocre companies. Now, if a company generates high returns on capital, high returns on equity, high returns on assets, whatever measure that best fits the company, it’s our job to determine if they can continue to generate high returns in the future because as that money is ploughed back into the company, that’s the seed for future growth and that’s our best definition of a growth component. To see what it’s going to do over the next couple quarters or the next three, five, or ten years.

It’s a very difficult challenge for a company that’s only returning 10%. If we could find companies that are doing 20% at reasonable valuations, why should we waste our time with mediocre companies? That’s the first step. Just that alone eliminates so many other stocks, so our list is very narrow to begin with.

11. So you are talking about high return ratios, right?

Yes, high returns investment capital. In fact, here’s an interesting stat: Morning Star did an article about three or four weeks ago and it was entitled, “Finding Value Within the 100 Medalist Ranked Mutual Funds.” In the larger cap funds, they have ranked or awarded about 100 mutual funds their medalist ranking. Our fund is one of them. Anyway, they ranked the funds -- again, growth, blend and value -- out of the 100 they like, they rank them by portfolio return on invested capital. Right now, ours is number one. It’s 19.7%, so we’ve built a portfolio of very high return companies.

Mathematically, if a company can retain earnings and take that marginal dollar and get 20%, it’s going to compound. Earnings are going to go up. However, if we buy that stock at a P/E of 35, that stock might be flat for years to catch up.

So we’re very demanding. We’re not looking for growth for growth’s sake. We’re looking for profitability first.

Do we think the company is going to have competitive advantages five or ten years from now? Yes, check. Do we think the total addressable market for this company to grow will propel and reach double digit earnings growth? Check. Now, is it cheap enough? And all of these hurdles slow us down. We’ve only bought five little stocks in the last two and a half years and that’s it. In today’s market, we’re finding plenty of companies we want to own, but their stocks are too high and that’s part of the disadvantage.

12. Do you have a true checklist that you use?

Yes, it’s mental.There were five big check marks and three big ones are, is this a company that we want to own? Is the price right to own today? Lastly, is there not a like-business that’s already in our portfolio?

So we own Visa (V, Financial). We wouldn’t own MasterCard (MA, Financial). We own Google (GOOG, Financial). We won’t own Facebook (FB, Financial) at the same time.

These are the three things: fundamentals, valuations, portfolio management.

13. What is the reason for that?

We only invest in 20 companies, so it wouldn’t make sense for us to own three railroad companies, or three casinos or three Hepatitis C drug companies. If we make a mistake, we don’t want penny action in the portfolio. If we made a mistake on investing in a casino and we have a couple extra casino stocks in the portfolio, well, we’re probably wrong on those, too. We believe that 20 different business models is all you need to get plenty of diversification. Just get the one that will get you the most return from that industry.

And all the things I am talking about slow us down by design. So, we currently have 21 stocks in the portfolio. Typically, it’s 19 or 22, or 20. In the last 27 years, we’ve only owned about 80 or 85 others. That’s it. We want to embrace a different behavior set than our competitors.

14. Do you talk to management for your resources?

Sure, all the time. It’s probably just as important to tell you what we don’t ask. We have found that the managements in which we invest in will talk for a long time, as long as we’re not trying to ask questions about what the next quarter is going to be like. But if we ask them questions on business strategy, or a new product line, they’ll talk forever because they’re proud of that.

We tell them how important their stock is to us and that we’re often one of the largest shareholders of their company, like with Apple or Google.

Now, it’s not the shares we have. It’s the percentage in the portfolio. When they find out how important they are to us, they are all ears. When we tell them we have invested, they’re all ears and when we tell them, “Yes, we have invested with you over the past four years and we have a reason to reach out to you today. We have a couple of questions,” they’re happy to talk to us and once they figure out we have no intentions of trying to ask some sleek questions about what the next quarter is going to look like, they talk about that. We approach them on the same side of the table. We’re in it for the long term like them. We’re not just traders, we are true investors in the company.

15. So what do you look for in them when you talk to them?

It can be a myriad of things. Again, if a company makes that decision, maybe it stumbled a quarter or two, or maybe it’s the international division that’s not working out, well, that’s what we all ask questions about. And typically what we’re asking is the company’s long term strategy of that particular division or product line or service.

16. What kind of CEOs would you avoid?

The ones that are stock promoters. The ones that tend to not be good stewards of shareholder capital. The CEO’s that back up their truck and buy their stock in the 5th year or 6th year of a bull market. When you go back to late ‘08 or ‘09, they weren’t buying anything because they were just afraid of anything else.

We want to invest in high conviction CEO’s. If we were in their shoes, what would be the attributes that we were born to do, to emulate and vice versa. So we like to invest in CEO’s that mirror our culture of investing.

17.In your portfolio, I see your largest holding is Qualcomm Inc (QCOM, Financial), right?

It’s been a lousy stock and that’s the reason why it’s so cheap because the business has been a lousy business over the last year or so. The growth rate has slowed down and we’ve had issues in China. The chip division is almost becoming commoditized and Wall Street has thrown in the towel. We’ve owned this stock since 2005 and in this current environment, we don’t have a lot of really great, compelling ideas. Qualcomm is our most compelling right now. We recently made it our largest holding in the first quarter. The stock is selling a little more than 10 or 11 times.

Next year’s earnings, if you took the cash off of the balance sheet, it’s a high return business. Its growth rate is lumpy, which we’re okay with and that’s the reason why it’s number one.

18. Warren Buffett (Trades, Portfolio) would never invest in a company like that because it’s too hi-tech?

There are some things that Buffett wouldn’t touch that we will touch, and we think that the company’s intellectual products and IP portfolio is second to none. And almost without exception, when somebody buys a smartphone, they’re going to get a piece of that phone because some of their technology is largely embedded in that phone. They’re kind of like a non-regulated toll booth on the growth of smartphones.

Their royalty business throws off almost 90% margins. It’s a cash machine, but the chipset business is the one that’s been the black sheep of the family.

19. So even after five years or 10 years, you think this will still be a good position?

Yes, but it won’t grow as fast as it once did, but the valuation is quite undemanding and I would argue that the current valuation has priced in the market expectations at current valuations that its growth rate will be zero over the next five years. We think that’s far too pessimistic.

20.Do you think your second largest holding, Berkshire Hathaway (BRK.B, Financial), is still undervalued?

I think it’s more close to a reasonable value. It’s still attractive enough to own in size. We recently trimmed it back earlier in the year. It was our largest owning then. It’s not a screaming bargain, but it’s reasonable and we own B shares. So the B shares are around $141. Fair value is probably $165. If we got the $165, quick or soon, we would probably be trimming back more. Lets just say over the next couple of months it rallied to $175 or $180. We probably would own 3% or 4%, not 7%.

21.And your third largest holding is Apple, right? You were certainly right about it in 2013 when it was trading at $70 or $65 and has doubled since. Congratulations on that. Do you still think it is undervalued?

Thanks, thanks. Apple is a unique story because they still have some arils in their quiver to the fire, to drive that stock price. So the Apple Watch is just starting up. We’re just in the first inning of the Apple Watch. The company is still generating $50-60 billion of free cash-flow a year. It could buy back a ton of stock, which is free earnings if they buy cheap enough. The iPhone has a remarkable quarter. Apple’s ecosystem--depending on how you want to add it up--is $600-700 million. By the end of the year, the company will be getting close to 1 billion users that use some type of Apple product in their ecosystem.

We don’t view it as a technology company. We view it as a consumer defensive stock--a consumer product company. I can tell you firsthand that to my dear children, asparagus and broccoli is consumer discretionary. Their iPhone are not. They have them next to their beds at night.

I think Wall Street gets too caught up in labels sometimes. Like, it’s a technology company and a technology company has never done this before. Okay, well, what does that mean? That doesn’t mean that whatever Andy Carnegie did wasn’t ever done before or whatever John Rockerfeller was never done, Walt Disney was never done and Alfred Sloan and GM and George Eastman and Eastman Kodak and from time to time, Warren Buffett (Trades, Portfolio). From time to time, there are trailblazers and I think Apple is one.

22. I feel it’s a very hi-tech and compact business. The company is similar to Blackberry (BBBY, Financial) several years ago. Everyone had a Blackberry phone.

Yes, they did. I think the big thing those companies did have and today Samsung (XKRX:000830, Financial) does not have is they don’t have an ecosystem and the switching costs, as we’ve come to find out, the switching cost for a Blackberry, Samsung or Android phone are rather easy. Switching costs for an iPhone user maybe not so much because then you have to think about ‘What am I going to do with all of my music, all of my photos? This device is so easy to use.’ Maybe that next Samsung phone or that next Android phone, maybe it runs a little faster or maybe it’s a little bit bigger screen, but it’s not good enough.

Also, to the take the other side of the argument, Apple has literally the Fort Knocks of capital to keep their competitors at bay. If they’re generating $200 billion in sales and they’re going to spend 5% of that on R&D, I mean that’s $10 billion. That’s enormous. They’re sitting on a war chest. Think about their competitive advantage with the roll of the Apple Watch. So, we’ve got this new product and it’s pretty cutting edge. It’s just the first iteration, first inning with all these watches that are in stores, and the company has stores all over the globe. If someone wants to look at one, he can just go into one of the stores and put it on.

If someone wanted to put on a Samsung phone or a Dell phone, where do you go, right? Think of the resources behind that launch of that watch. They bring resources to bear on any other product at a multiple; 5, 10, 20, 50 times their competitors. So one of these days, they are going to fail. One of these days, they are going to be so big, but we don’t think that’s the case right now and I would agree with Icon. Their stock is not expensive.

If you look at the valuation and you take the cash out and look at the enterprise value, they could average $50 billion in cash-flow for the next 10 years. They’ll probably take 50-60% of their shares and retire them.

23. I still want to go back to the iWatch and iPhone. With the iPhone, everyone will need a phone, right? But for the iWatch, I don’t see the demand for it.

Well, think about when the iPhone was launched. We didn't necessarily need a new smartphone. We had Trios and Blackberries and they did a pretty good job. The Google phone looked a lot different after the iPhone was launched. Think about the iPod. We didn’t necessarily need a new MP3 player. With the iPad, I don’t think we necessarily needed a new tablet, or the Mac. We don’t need it, but it’s still interesting. If the iPhone was an easy decision to buy right now, that would mean that people are familiar with it. People were familiar with the hardware and software integration, which would mean someone else is already doing it, so that would truly be a need-to product. There’s a learning curve here. I know he was biased, but during the launch of the iPhone, Steve Ballmer said, “Why would anyone want to own a $500 phone?” Well guess what? It wasn’t just a phone. It was a computer in your pocket. Now the first Apple iPhone couldn’t be any different than the current one. So if you think that Apple has not launched a revolutionary product until maybe the Watch, I would have to disagree with that. The first iteration of the iPhone was revolutionary to the second.

If you look at the first iPhone in 2007-08 to the iPhone now, that art: revolutionary. Same thing for the iPad and same thing for the Mac over a long period of time. Again, it gets back to what we talked about earlier. If we think in quarters, the Watch is no big deal. If we think in terms of years, the Watch could be huge.

24. So you’re saying over time, maybe five years from today, the watch market will be as big as the phone market?

Absolutely. And if you think in terms of price, I mean it’s called a watch. the iPhone was called a phone. It’s not a phone, it’s a computer in your pocket that happens to make phone calls. It’s not a watch, it’s a computer on your wrist that tells time, but it does all this other functionality. So when people are looking at the watch, I think they are looking through the lense of what the iPad does today and what the iPhone does today.

With just my son in the past 24 hours, I cannot tell you how many times we have taken our phones out of our pockets. If [the iWatch] can help me exercise a bit more and I don’t have to take my phone out of my pocket as much, it’s worth it to me to spend $500 on that. Again, we’ll see. We’re just the first step in.

25. What are your most recent new buys?

Core Laboratories (CLB), which we started buying late last year. We’ve been nibbling at it and now we’re done buying. The stock got hammered and it’s come back nicely, but that’s one of the three oil service companies that we own, but Foraco (FAR) and Core Labs are very different businesses.

Last July, the stock hit a high of $221 and it would fall by mid January to $87 and I would expect it to go back up to $131 or $132. It’s undervalued, but it was recently under $95 or $90.

26. Do you find it difficult to find bargains in the overall market?

It’s very difficult. If you think about where we are now, the market has gone up nonstop for the past two years, almost three years. I think this raw market is different than 1999/2000 or 2006/2007 in that there’s very little to do today, but even in the back of those bull markets, there were all kinds of things to do--if you didn’t own Tech n’ Telecom. If you were investing in Tec n’ Tell in 1998-99, you under-performed.

If you were buying cyclical stocks, credit sensitive stocks in 2006-07, you under-performed and if you are not buying yield and biotech and consumer defensive, then you under-performed like we have. This is a very challenging environment. There are plenty of businesses we’d like to own but not too many with a valuation space sense.

27. Do you feel that the market morphed homogeneously and is overvalued?

I think so. If you look at the large cap stocks, mid-cap stocks, small-cap stocks, value growth, every industry sector--almost all industries are at all-time highs.

We never let our cash level exceed 10. We have been averaging about 7-8% for almost the past two years. Our clients are happy with that. We have told them [that we are waiting for better], but we’re patient and they’re like, “swing your bat, you bums. Come on! The market is going up every month, every quarter. Why are you holding a nickel of cash?” That’s part of the discipline.

28.How do you look at the economy or business?

The growth of the economy is really slow, but we don’t spend a lot of time thinking about the economy. If I were fortunate enough five years from now to talk to you and the markets were exactly the same, I wouldn’t be surprised at all. If the market were down 30-40% two or three years from now, I wouldn’t be surprised at all, either. We have bull markets, we have bear markets and nobody has repealed that, despite what the central banks may be trying to do. They haven’t been able to meet the business cycle so much so that investors fear and agree that we won’t have a fair market anymore. So it’s a tough environment for a valuation sense investor.

29.So what do you do at this point?

Nothing. We have 20 stocks. We have our 7% cash and we wait patiently. Now is the time for studying and new ideas as well as what’s in the portfolio. But now is the time to plant the seeds of new ideas. So that if we ever have a market pull back, the harvest, the torture, that metaphor, the harvest could come like that. We make very fast decisions that are born of years of study. So if I’m looking at ABC company today and it’s a P/E o 25 and I want to own it at a P/E of 15, i we get into a bear market and it hits 15, great, assuming we’re following the company.

”‹30. So you have done all the research you need, you are just waiting for the valuation level to drop?

Yes, there are four of us on the investment team and we’re all studying together. It’s a team effort, it’s not just me. Now is a good time to get caught up on reading.

31.What books are you reading?

Too many that I can’t finish. A little bit of everything. Most of the reading we are doing is company transcripts and reports.

32.Any advice to young people who want to get into the business?

Be a sponge. Soak it in and once you get the bug, nobody has to tell you that. I study other great investors and learn and try to be humble. Even if we have a couple good years of performances, who cares? You’re not as smart as you think you are and hopefully we’re not as dumb as we think we are here. Our clients think we are of late. But I find in this business, if it really is work, it’s tough. It’s a tough avocation or vocation.

However, if you’re enjoying it, if you pick up a book or report at 7:00 and the next thing you know it’s 9:00 at night, this business can be a breeze. And I mean that in all sincerity. If this business becomes a passion--you can’t wait to do it. It doesn’t mean you’re always right, but it doesn’t feel like work and that’s probably the number one thing that I’ve been blessed with in this industry is that rarely, if ever, does it seem like work to me. And that is everything to me.

Read part I here