(GuruFocus, October 22, 2009)Last month, we were very delighted toannounce that Investment Guru Donald Yacktman and his son Brian Yacktman agreed to answer the questions for GuruFocus users.
Although they are father and son, Donald and Brian actually have different practices:
After the announcement, we gathered many questions and we dutifully sent to Don and Brian. We want to thank the GuruFocus community for the questions.
Today, we are very happy because we have received the answers back from Don and Brian.
Thank you, Don and Brian.
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Answers from Don and Brian Yacktman
Question 1. In a recent interview Don mentioned that the spreads of low quality companies was high in March, now it shrank and you are investing in high quality companies. How do you measure the spread? The spread between price and value?
Don: While we buy equities, we value them like long term bonds. We put a forward long term rate of return on an individual stock and look at the quality (or predictability) of that return. A bond buyer looks at the yield spread between bonds with different ratings. Equity investors can do the same thing although not with the same exactness.
Brian: To elaborate a little further, what we’re essentially doing is flipping the “Gordon Growth” formula. Rather than come up with some arbitrary discount rate (meaning utilizing CAPM, betas, etc.) and come up with a stock price value, we prefer to figure out what is the implied expected return if we were to buy the equity at the current price. In short, this is calculated by looking at the cash yield plus the growth rate (for more detail, see my website at www.yacktmancapitalgroup.com). Thus, the focus is on coming up with a decent estimate of cash flow. Stated EPS numbers aren’t an accurate representation of the cash flow shareholders actually get to keep. Adjustments need to be made for option issuance, for pensions, for capital expenditures that will reabsorb the cash generated (often overlooked), etc. But even coming up with a good cash flow number isn’t always exact science – as we like to say, we’d rather be right than wrong to the fifth decimal. For example, in 2002 when Tyco (TYC) was purchased at less than $10, it was estimated it was generating somewhere around $2/sh in cash. At that high of a cash yield, who really cares if it’s $1.5 or $2.5, or what the growth rate is for that matter, as long as you’re confident that the cash flow won’t disappear. So, coming back to your question about spread, we look at the forward expected returns on individual stocks and compare them to each other, giving consideration to their quality rating. Quality is more of a subjective call based on competitive advantages (think Porter’s 5 forces, or Buffett’s “moat around the castle”) and stability/predictability of cash flows. Today, we’re seeing few “good businesses at great prices”, but we are seeing “great businesses at good prices.” If you have nearly the same forward expected return among high and low quality, obviously we’d rather take the higher quality.
Question 2. How do you value a low quality companies? How do you measure the quality of companies?
See answers to #1
Question 3. You mentioned that P&G is high quality, that is understandable. How do you think about USG? To you is it a high quality or low quality company? how do you value USG?
Don: USG has a strong market position but its revenue is very cyclical because it has a strong correlation to housing so its quality is lower than P & G but not as low as a home builder (as an example).
Question 4. At this level of market valuation, how do you think the market will do in the next few years?
Don: We don’t predict the market. Frankly I think that most of the time it is a waste of time. Looking at individual businesses and buying them at good value is a much better use of time. If someone correctly predicted the market 10 years ago, they would have been in cash and not our funds. Who is better off?
Brian: My father’s comment reminds me of Peter Lynch saying, “If you spend 13 minutes a year on economics, you've wasted 10 minutes.” While I agree that there’s no need to spend gobs of time pouring over economic data, I also believe that taking a moment out to assess the macroeconomic climate can be useful in providing a relative frame of reference. So, I’ll throw in my two cents.
As Ben Graham used to say, “In the short run, stock prices are a voting machine. In the long-run, they are a weighing machine.” So, rather than answer what direction I think the market is headed over the next few years (trying to predict the voting machine), let me tell you what I believe the forward looking rate of return is on the S&P 500 from these market levels (the weighing machine). Note, because we go through periods of multiple expansion and contraction, the following demonstration will become more accurate as business cycles are stripped out over time.
Hopefully, going through this exercise will also help better explain our answers to question #1. You can view the S&P 500 as if it were a company. Operating margins had been 40% above the norm, and now they’ve been slashed, particularly due to financials. If you were to estimate normalized earnings on the S&P, it’s probably somewhere between $55-60 (after taking into consideration options, pensions, and what I affectionately call recurring non-recurring charges). Of that, shareholders probably see about half. Growth has historically been about 1.1% from population growth, 2.2% from technological growth, and the S&P captures about two-thirds of that sum. With the S&P trading near $1100, that would be a cash yield of 2.6% and growth of 2.2%. Thus, if you buy the S&P at today’s prices, you’ll get about 4.8% + inflation. I run through this exercise in more detail in my Q2 2008 client letter found here. Note, even though I penned it, this lengthy letter will give you a lot of insight into what my father and I feel about the economy in general.
Now, if you were to force me to give you an opinion about the next few years, despite popular consensus, I’m not convinced we’re out of the woods. My biggest concern is leverage – General Motors would be a great metaphor for the U.S. My second biggest concern is unemployment – getting out of debt won’t happen if we’re not employed, and I don’t believe employment will be a lagging indicator this time (I plan to touch on this topic in my year-end letter). Thus, the combination of these two suggest consumer spending (which is 2/3+ of GDP) will continue to hurt and that more mortgage defaults are on their way. My third biggest concern is future inflation. We have a government who is leveraging us further, and the only way out will be increased taxes, whether directly or indirectly. As Milton Friedman put it, “Inflation is taxation without legislation.” If I had to guess, it’ll be 2014 before this “famine” is completely over.
If you read through all my client letters, I think you’ll gleam the detailed insight that you may be seeking. I’d also suggest reading some blogs from my site. A couple you might get started on include: The National Debt Trip, Fed Says Recession Near End
Funny, coming back full circle, I’ve ironically spent more than 13 minutes writing this – ha! In the end, I think my father has a good point – their mutual funds acted nothing like the market. Their funds have compounded money at roughly 11-12% annually while the market has gone nowhere. So, regardless of your assessment of the market, in the end, your returns come down to the individual businesses you own.
Question 5. What valuation parameter do you use, P/E, P/CF, DCF etc? An example will be greatly appreciated.
Don: All of those measures assume exactness that is simply too difficult to justify. Valuations basically come from cash generated by the business plus an estimated growth of cash (looking at revenue and margins) plus inflation.
Brian: I look at adjusted P/E’s and P/CF’s (by adjusted, I mean to say that the published earnings aren’t necessarily “true earnings,” and so you need to look at normalized earnings while taking into account options, pensions, maintenance capx, etc.). But you also need to take into account leverage, so my favorite ratio is Enterprise Value divided by adjusted EBIT. You might be asking why I use EBIT instead of EBITDA. The reason is this makes it apples to apples across companies and industries. While it’s true that depreciation is a non-cash charge, when looking at a snap shot ratio such as this, you need to account for capital expenditures. Depreciation obviously is estimating capx. To look at EBITDA’s can give you a very misleading picture.
I think the point I’m trying to make is even if I get something cheap, next I want to know where the ROE is coming from (think of DuPont formula – is it high margins, low capital intensity, or high leverage). I prefer the first two. I’ll give a little on the third component if cash flow is extremely predictable. But the worst is when you get cyclicality combined with high capital intensity and high leverage (think of Autos, Airlines, Amusement Parks). That explains why even though the airline industry has been one of the fastest growing industries on the top line over the past century, it hasn’t made a dime since Kitty Hawk – every dollar it makes goes back into the business to survive, so it never prospers. While not a valuation parameter, for what it’s worth, a good measure of capital intensity is to look at EBIT divided by PP&E + Inventory + Working Capital, i.e., the return on tangible assets.
With the exception of when I was in MBA school, I have never built a DCF model. I believe it was Charlie Munger who said he’s never seen Warren Buffett do a DCF calculation. Buffett’s response was something like, “If I feel like I have to do one of those, it’s not cheap enough.” But on the other hand, Buffett has said he’s made high dollar investments from doing analysis on the back of a napkin.
As far as your desire for examples on valuation ratios, see the prior questions (#1 and #4) where we discussed looking at cash yields (which is essentially the inverse of the aforementioned valuation ratios).
Question 6. An advice to a young man without finance background who wants to get into investment business?
Don: Today’s investment business requires an MBA so he needs to get one. Many firms also like to hire someone with a CFA. Reading books like “The Snowball” or “The Real Warren Buffett” about Warren Buffett or books written by Ben Graham should also help him.
Brian: Get educated, network, and start investing. I would suggest getting an undergrad with a dual major in first, Economics (the theory), and second, Accounting (the language). Then, go get an MBA. You may or may not need a CFA – it’s simply a signal to the market that you’re competent so you can be considered in getting a job. But that’s why I emphasize networking. I’ve heard 66% of jobs come through networking…although, I’ve also heard that 30% of all statistics are inaccurate.
It’s critical you do some reading on your own, because academia will probably having you thinking of things backwards. To learn the basic principles of value investing, there are of course the classics that Warren Buffett has mentioned like “Security Analysis” by Graham and Dodd, “Common Stocks and Uncommon Profits” by Fisher, and “The Intelligent Investor” by Graham (I agree with Buffett that the Mr. Market chapter and the Margin of Safety chapter are the most critical). But to speed you up, I would recommend reading “The Warren Buffett Way” by Hagstrom. The first few chapters give you a synopsis of those aforementioned books, and then the rest of the book is made up of individual case studies. I’d also recommend “Essays of Warren Buffett” by Lawrence Cunningham which is a compilation of Buffett’s shareholder letters organized by topic. I also really enjoyed Poor Charlie’s Almanack. If you’re looking for a technical book, I’d go with “Valuation: Measuring and Managing the Value of Companies” by Copeland, Koller, and Murrin. Then, get investing! And if you don’t have money to invest, you can start getting experience by going to a website such as www.stocksquest.com. You need to start pulling the trigger sometime.
Question 7. What are some typical options strategies you have found profitable over the last year?
Brian: This will come as a surprise to you given we’ve gone through the biggest market crash since the Great Depression – but a profitable strategy has been cash secured put options. Some history will help that make sense. I’ve been feeling uncomfortable with the market’s valuation for years. In 2002, it bottomed at levels that have been prior market peaks! By 2005, I was getting really uncomfortable, and yet I looked really dumb because I was building cash and the market just kept on climbing. I got more uneasy the further it went. In the middle of 2007, I met with some investment friends about forming our new company. I told them that with mortgage resets coming due that I felt by the end of the year, or at least by early next year, I thought we were ready to peak out. I’ll chalk it up to luck – but sure enough, the market peaked in October 2007. All of this is to explain that because I had a hard time finding buying opportunities, most clients were 30-50% cash at the market peak. Then, the market made its gradual decline. I patiently waited until October 2008 when it fell off a cliff. At that point, the market reached what I felt was fairly valued (around $900-1000). I wanted to jump right in because I was so value starved and I was finally seeing stuff, but I also knew history has shown markets tend to overshoot to the downside. So, I began writing put options like crazy. I figured if the market took off again, at least I would pick up some premium. But if the market dropped some more, the premiums would buffer my mistake of pulling the trigger too early – which it did (thus under the assumption I would have bought, it was profitable because the alternative was I was going to make outright buys). The market kept heading down, and I kept writing more put options all the way down. Through these options, I finally became fully invested. In some cases, because implied volatility was so high, I ended up owning some stocks at prices that were below what prevailed in the market place even at the market bottom in March! Now, the market has swung back around and is about right back where we were a year ago. While there are still some places I’m writing puts, I’ve found myself doing a lot of covered calls as of late.
Question 8. The Yacktman Fund (YACKX) and the Yacktman Focused Fund (YAFFX) both seek long-term capital appreciation and, to a lesser extent, current income. Over the next decade, which fund do you expect to offer the best rate of return and why?
Don: I feel The Yacktman Focused Fund will do better because it is a concentration of our best ideas. All of my SEP-IRA money is in it.
Question 9. In your view, does USG have competitive advantages; If so, what are they ?
Don: USG has a huge market share of the wallboard business. Normally a company that has a 40% share of a market will make four times (not double) as much money as a company that has a 20% share.
Question 10. What do you find attractive about COP? What do you think COP can do to improve upon its current strategy and execution?
Brian: Turns out both my dad and I own this, so I’ll pipe in – no pun intended. My fear in buying oil companies is that my returns are dependent upon oil prices and their supply/demand factors. For that same reason I don’t like owning gold. So, I liked to see that COP is more diversified (50% of production is natural gas and they have other businesses such as chemicals that aren’t directly linked to crude and natural gas prices). But in the end, the merits of an investment come down to price. I looked at the other diversified majors (XOM and CVX), but COP was the cheapest. I estimated what I thought was a reasonable bad scenario with oil priced at $50 and natural gas at $5, and in that bad scenario I felt COP is likely worth around $65, and I was purchasing it at a 30% margin of safety on top of that. I also flipped it around and said, “Well, what prices must the market be assuming to price COP shares this low?” and it seemed as though they were expecting oil prices to be below $30…forever! I disagreed. I am concerned about management behavior – they overpaid for acquisitions in years past, and now it looks like they’ll likely be selling off undervalued assets. But I suppose kudos to them for using their times of prosperity to pay down their heavy debt burdens. Another company I like (well, less so now that they’ve performed well) is PTEN, and given they are very cyclical, I especially like that they have no debt, unlike their peers.
Question 11. What do you do to stress test the companies you pick either qualitatively or quantitatively?
Don: The best predictor of a company’s future is its past but it is very important to understand the company and how it is likely to behave in all types of economic environments.
Question 12. Not specifically asking for numbers here but at what level do you reevaluate an investment thesis and what kinds of factors commonly come up that have forced you to reevaluate a stock pick? (ie. valuation miscalculation, not understanding business fully, overweighting wrong factors, etc.)
Don: As an investment is made and monitored over time an investor develops greater understanding of the business and builds an internal data base of the strengths and weaknesses of the business and its management. It is important to be both patient and objective and as they say on “CSI” “see where the evidence leads you.”
Brian: That’s a good question – I can guarantee we’ll make mistakes and it’d be good to identify a common theme. But truthfully, I think it depends in each scenario. The primary factors I look at are 1. Is the price right given the predictability of cash flows?, 2. Is it a profitable/growing business?, and 3. Is management shareholder-oriented, making decisions as we would if we were in their shoes? Typically, you can analyze number one and two great, but normally, when an investment goes bad, usually it’s because management did something to mess things up.
Question 13. How long did it take you to hone your investment process?
Don: It took me several years to have the major pieces fall in place and I made plenty of mistakes along the way. In this business, we are almost always wrong because no one buys everything at the bottom or sells everything at the top. Hopefully people who read about good investors and can truly understand how to value businesses will not “wander in the wilderness” as long as I feel I did.
Brian: Still honing…and will always be honing. But I’m grateful for my father who did indeed prevent me from “wandering in the wilderness” and placed me on the proper path. I think that likely those who subscribe to gurufocus are on the right path because they are probably believers in the true principles of so-called “value investing.” I say “so-called” because I really dislike that terminology. I’ve never heard an investor say their strategy is buying overpriced stocks!
Question 14. How hard is it to admit a mistake on an investment thesis and what do you do to not repeat the mistake?
Don: It is important to be objective and not let our ego get in the way. As Will Rogers said, “Good judgment comes from experience and a lot of that comes from bad judgment”.
Brian: I agree. In addition, we can’t let our emotions get in the way. When a mistake has been made, you can’t cross your fingers and hope to recoup your losses. You have to ask yourself, where do I go from here? On this day, what are my best options, where are my highest yielding assets? Where would this capital best be allocated now? Once you’ve experienced a permanent loss of capital, there’s only one gear from here and that’s forward. But the key in this business is to avoid the permanent losses. And as my father has often said, “A low purchase price covers a lot of sins.”
Question 15. How long does it take you to understand the business of a company (not just what it does) where you become comfortable with the unpredictable but knowable risks?
Don: By now I can understand the basics of a business very quickly because my internal database is large. What is history to many others is a current event to me.
Brian: Ha! – and his gray hairs prove it (we like to tease each other). Over time you build a database of individual businesses you have already researched, and also, you become familiar with businesses in general and how they make money. In other words, you start to group businesses into categories, even if they’re in completely different industries. For example, banks, retail, and pharmaceutical distributors are all “conduit” businesses – the same thing that comes in goes back out. Thus, these will all be thinner margin businesses. Then, you can build a comfort level in the different types of businesses.
Question 16. Although your focus (both) is stock-picking, do you occasionally get caught up with big pictures issues that distract you from your main goal of picking great stocks? How do you deal with it and why do you think it can happen to investors?
Don: I don’t get distracted by big picture issues but I think many others do. I think most people have trouble buying stocks that are in price decline either because of lack of knowledge, a short time horizon, or emotion. It is important to be objective.
Brian: Well said. I think this age of information has created a second by second mentality. We are constantly barraged by data, opinions, and flickering computer screens that nearly suffocate us. Rather than allow this stream of information be like a leash, sometimes investors just need to shut off the world. We need to find a quiet place and sift and focus in on the most important information. Reminds me of the poet T.S. Eliot who wrote, “Where is the knowledge we have lost in information?” Mind you, that was written in 1930…who knows what he would’ve written about our day! Investing is a business of patience – just like individual investments, it can take years to grow a tree, but if you’re patient, eventually it’ll produce a lot of fruit and shade.
Question 17. What other investors (not Buffett and Munger of course) do you admire that some of us here may not know of?
Don: Good investors stand on their own two feet and have excellent 10 year or longer track records. Actually I think the best time frame to evaluate managers is from peak to peak. Many who have good records are on the GuruFocus list. Some not on the list could include Jeff Auxier, Roy Papp, Lou Simpson (although tied to Buffett) and Dick Weiss.
Brian: Truthfully, I’d like to bring up my brother Steve, because I don’t think most people are aware of him. My father is always in the spotlight, and so he is overlooked. But I can honestly say he’s the most intelligent investor I am aware of. I think two others that have proven to protect the downside and be successful over long periods of time with concentrated portfolios are Bruce Berkowitz of Fairholme, and Robert Rodriguez of FPA, although he’s gone on sabbatical.
Question 18. How would recommend a person who is greatly interested in value investing, but is currently working in a completely unrelated field, break into this field? More specifically, is there certain positions that would stand out or completely eliminate a candidate? Your take on this question is much appreciated as Seth Klarman has stated that the trading program at Goldan Sachs is excellent while Andrew Weiss has stated that he would never ever hire someone who has worked at a big investment bank because "they will have learnt the wrong things".
Don: Covered in #6.
Brian: I, too, refer you to my response in #6. I see what Andrew Weiss is saying. But I think working at Goldman Sachs or Morgan Stanley is part of building the network I was referring to. I think if you read the books I recommended, you’ll be thinking about things from the proper perspective, and working at an investment bank (can we still call it that?) won’t do any harm, but could potentially build your network. Breaking into the “buy-side” usually requires somebody else pulling you through the door.
Although they are father and son, Donald and Brian actually have different practices:
Donald Yacktman had been managing money for 15 years when he took over Selected American Shares in 1983. When he left at the end of 1991, over that time frame it was the 5 th best performing mutual fund in the country. He was named Morningstar manager of the year and in 1992 he opened The Yacktman Fund (YACKX). During the late 90’s he resisted the temptation to jump on the tech band-wagon and thrived in the 2000-2002 bear market and 2003 recovery. At the peak of the market in October 2007, with 30% in cash and low exposure to financials, he was prepared for the market crash – over the last year his Focused Fund (YAFFX) is up 22% (through the middle of September, 2009), nearly 32% ahead of the S&P 500 which puts his funds in the small category of funds that have actually made money since October 2007. Over any 10-yr. rolling period he has beaten the S&P 500 index.
Brian Yacktman started out working with Donald but left Yacktman Asset Management to begin his own new venture, founding Yacktman Capital Group, LLC(YCG), a registered investment advisory firm that manages separate accounts. Brian believed in the time-tested investment philosophy of his father and desired to enhance the process through the use of options and active hedging. He has been managing money for over a decade and since establishing the firm back in December 2007, his separate account strategies have performed very well despite the recent turbulent market – year-to-date (throught August 31, 2009) his concentrated option-enhanced portfolio is 20% ahead of the S&P 500. We wish Brian and his firm continued success in his new venture.
After the announcement, we gathered many questions and we dutifully sent to Don and Brian. We want to thank the GuruFocus community for the questions.
Today, we are very happy because we have received the answers back from Don and Brian.
Thank you, Don and Brian.
Question 1. In a recent interview Don mentioned that the spreads of low quality companies was high in March, now it shrank and you are investing in high quality companies. How do you measure the spread? The spread between price and value?
Don: While we buy equities, we value them like long term bonds. We put a forward long term rate of return on an individual stock and look at the quality (or predictability) of that return. A bond buyer looks at the yield spread between bonds with different ratings. Equity investors can do the same thing although not with the same exactness.
Brian: To elaborate a little further, what we’re essentially doing is flipping the “Gordon Growth” formula. Rather than come up with some arbitrary discount rate (meaning utilizing CAPM, betas, etc.) and come up with a stock price value, we prefer to figure out what is the implied expected return if we were to buy the equity at the current price. In short, this is calculated by looking at the cash yield plus the growth rate (for more detail, see my website at www.yacktmancapitalgroup.com). Thus, the focus is on coming up with a decent estimate of cash flow. Stated EPS numbers aren’t an accurate representation of the cash flow shareholders actually get to keep. Adjustments need to be made for option issuance, for pensions, for capital expenditures that will reabsorb the cash generated (often overlooked), etc. But even coming up with a good cash flow number isn’t always exact science – as we like to say, we’d rather be right than wrong to the fifth decimal. For example, in 2002 when Tyco (TYC) was purchased at less than $10, it was estimated it was generating somewhere around $2/sh in cash. At that high of a cash yield, who really cares if it’s $1.5 or $2.5, or what the growth rate is for that matter, as long as you’re confident that the cash flow won’t disappear. So, coming back to your question about spread, we look at the forward expected returns on individual stocks and compare them to each other, giving consideration to their quality rating. Quality is more of a subjective call based on competitive advantages (think Porter’s 5 forces, or Buffett’s “moat around the castle”) and stability/predictability of cash flows. Today, we’re seeing few “good businesses at great prices”, but we are seeing “great businesses at good prices.” If you have nearly the same forward expected return among high and low quality, obviously we’d rather take the higher quality.
Question 2. How do you value a low quality companies? How do you measure the quality of companies?
See answers to #1
Question 3. You mentioned that P&G is high quality, that is understandable. How do you think about USG? To you is it a high quality or low quality company? how do you value USG?
Don: USG has a strong market position but its revenue is very cyclical because it has a strong correlation to housing so its quality is lower than P & G but not as low as a home builder (as an example).
Question 4. At this level of market valuation, how do you think the market will do in the next few years?
Don: We don’t predict the market. Frankly I think that most of the time it is a waste of time. Looking at individual businesses and buying them at good value is a much better use of time. If someone correctly predicted the market 10 years ago, they would have been in cash and not our funds. Who is better off?
Brian: My father’s comment reminds me of Peter Lynch saying, “If you spend 13 minutes a year on economics, you've wasted 10 minutes.” While I agree that there’s no need to spend gobs of time pouring over economic data, I also believe that taking a moment out to assess the macroeconomic climate can be useful in providing a relative frame of reference. So, I’ll throw in my two cents.
As Ben Graham used to say, “In the short run, stock prices are a voting machine. In the long-run, they are a weighing machine.” So, rather than answer what direction I think the market is headed over the next few years (trying to predict the voting machine), let me tell you what I believe the forward looking rate of return is on the S&P 500 from these market levels (the weighing machine). Note, because we go through periods of multiple expansion and contraction, the following demonstration will become more accurate as business cycles are stripped out over time.
Hopefully, going through this exercise will also help better explain our answers to question #1. You can view the S&P 500 as if it were a company. Operating margins had been 40% above the norm, and now they’ve been slashed, particularly due to financials. If you were to estimate normalized earnings on the S&P, it’s probably somewhere between $55-60 (after taking into consideration options, pensions, and what I affectionately call recurring non-recurring charges). Of that, shareholders probably see about half. Growth has historically been about 1.1% from population growth, 2.2% from technological growth, and the S&P captures about two-thirds of that sum. With the S&P trading near $1100, that would be a cash yield of 2.6% and growth of 2.2%. Thus, if you buy the S&P at today’s prices, you’ll get about 4.8% + inflation. I run through this exercise in more detail in my Q2 2008 client letter found here. Note, even though I penned it, this lengthy letter will give you a lot of insight into what my father and I feel about the economy in general.
Now, if you were to force me to give you an opinion about the next few years, despite popular consensus, I’m not convinced we’re out of the woods. My biggest concern is leverage – General Motors would be a great metaphor for the U.S. My second biggest concern is unemployment – getting out of debt won’t happen if we’re not employed, and I don’t believe employment will be a lagging indicator this time (I plan to touch on this topic in my year-end letter). Thus, the combination of these two suggest consumer spending (which is 2/3+ of GDP) will continue to hurt and that more mortgage defaults are on their way. My third biggest concern is future inflation. We have a government who is leveraging us further, and the only way out will be increased taxes, whether directly or indirectly. As Milton Friedman put it, “Inflation is taxation without legislation.” If I had to guess, it’ll be 2014 before this “famine” is completely over.
If you read through all my client letters, I think you’ll gleam the detailed insight that you may be seeking. I’d also suggest reading some blogs from my site. A couple you might get started on include: The National Debt Trip, Fed Says Recession Near End
Funny, coming back full circle, I’ve ironically spent more than 13 minutes writing this – ha! In the end, I think my father has a good point – their mutual funds acted nothing like the market. Their funds have compounded money at roughly 11-12% annually while the market has gone nowhere. So, regardless of your assessment of the market, in the end, your returns come down to the individual businesses you own.
Question 5. What valuation parameter do you use, P/E, P/CF, DCF etc? An example will be greatly appreciated.
Don: All of those measures assume exactness that is simply too difficult to justify. Valuations basically come from cash generated by the business plus an estimated growth of cash (looking at revenue and margins) plus inflation.
Brian: I look at adjusted P/E’s and P/CF’s (by adjusted, I mean to say that the published earnings aren’t necessarily “true earnings,” and so you need to look at normalized earnings while taking into account options, pensions, maintenance capx, etc.). But you also need to take into account leverage, so my favorite ratio is Enterprise Value divided by adjusted EBIT. You might be asking why I use EBIT instead of EBITDA. The reason is this makes it apples to apples across companies and industries. While it’s true that depreciation is a non-cash charge, when looking at a snap shot ratio such as this, you need to account for capital expenditures. Depreciation obviously is estimating capx. To look at EBITDA’s can give you a very misleading picture.
I think the point I’m trying to make is even if I get something cheap, next I want to know where the ROE is coming from (think of DuPont formula – is it high margins, low capital intensity, or high leverage). I prefer the first two. I’ll give a little on the third component if cash flow is extremely predictable. But the worst is when you get cyclicality combined with high capital intensity and high leverage (think of Autos, Airlines, Amusement Parks). That explains why even though the airline industry has been one of the fastest growing industries on the top line over the past century, it hasn’t made a dime since Kitty Hawk – every dollar it makes goes back into the business to survive, so it never prospers. While not a valuation parameter, for what it’s worth, a good measure of capital intensity is to look at EBIT divided by PP&E + Inventory + Working Capital, i.e., the return on tangible assets.
With the exception of when I was in MBA school, I have never built a DCF model. I believe it was Charlie Munger who said he’s never seen Warren Buffett do a DCF calculation. Buffett’s response was something like, “If I feel like I have to do one of those, it’s not cheap enough.” But on the other hand, Buffett has said he’s made high dollar investments from doing analysis on the back of a napkin.
As far as your desire for examples on valuation ratios, see the prior questions (#1 and #4) where we discussed looking at cash yields (which is essentially the inverse of the aforementioned valuation ratios).
Question 6. An advice to a young man without finance background who wants to get into investment business?
Don: Today’s investment business requires an MBA so he needs to get one. Many firms also like to hire someone with a CFA. Reading books like “The Snowball” or “The Real Warren Buffett” about Warren Buffett or books written by Ben Graham should also help him.
Brian: Get educated, network, and start investing. I would suggest getting an undergrad with a dual major in first, Economics (the theory), and second, Accounting (the language). Then, go get an MBA. You may or may not need a CFA – it’s simply a signal to the market that you’re competent so you can be considered in getting a job. But that’s why I emphasize networking. I’ve heard 66% of jobs come through networking…although, I’ve also heard that 30% of all statistics are inaccurate.
It’s critical you do some reading on your own, because academia will probably having you thinking of things backwards. To learn the basic principles of value investing, there are of course the classics that Warren Buffett has mentioned like “Security Analysis” by Graham and Dodd, “Common Stocks and Uncommon Profits” by Fisher, and “The Intelligent Investor” by Graham (I agree with Buffett that the Mr. Market chapter and the Margin of Safety chapter are the most critical). But to speed you up, I would recommend reading “The Warren Buffett Way” by Hagstrom. The first few chapters give you a synopsis of those aforementioned books, and then the rest of the book is made up of individual case studies. I’d also recommend “Essays of Warren Buffett” by Lawrence Cunningham which is a compilation of Buffett’s shareholder letters organized by topic. I also really enjoyed Poor Charlie’s Almanack. If you’re looking for a technical book, I’d go with “Valuation: Measuring and Managing the Value of Companies” by Copeland, Koller, and Murrin. Then, get investing! And if you don’t have money to invest, you can start getting experience by going to a website such as www.stocksquest.com. You need to start pulling the trigger sometime.
Question 7. What are some typical options strategies you have found profitable over the last year?
Brian: This will come as a surprise to you given we’ve gone through the biggest market crash since the Great Depression – but a profitable strategy has been cash secured put options. Some history will help that make sense. I’ve been feeling uncomfortable with the market’s valuation for years. In 2002, it bottomed at levels that have been prior market peaks! By 2005, I was getting really uncomfortable, and yet I looked really dumb because I was building cash and the market just kept on climbing. I got more uneasy the further it went. In the middle of 2007, I met with some investment friends about forming our new company. I told them that with mortgage resets coming due that I felt by the end of the year, or at least by early next year, I thought we were ready to peak out. I’ll chalk it up to luck – but sure enough, the market peaked in October 2007. All of this is to explain that because I had a hard time finding buying opportunities, most clients were 30-50% cash at the market peak. Then, the market made its gradual decline. I patiently waited until October 2008 when it fell off a cliff. At that point, the market reached what I felt was fairly valued (around $900-1000). I wanted to jump right in because I was so value starved and I was finally seeing stuff, but I also knew history has shown markets tend to overshoot to the downside. So, I began writing put options like crazy. I figured if the market took off again, at least I would pick up some premium. But if the market dropped some more, the premiums would buffer my mistake of pulling the trigger too early – which it did (thus under the assumption I would have bought, it was profitable because the alternative was I was going to make outright buys). The market kept heading down, and I kept writing more put options all the way down. Through these options, I finally became fully invested. In some cases, because implied volatility was so high, I ended up owning some stocks at prices that were below what prevailed in the market place even at the market bottom in March! Now, the market has swung back around and is about right back where we were a year ago. While there are still some places I’m writing puts, I’ve found myself doing a lot of covered calls as of late.
Question 8. The Yacktman Fund (YACKX) and the Yacktman Focused Fund (YAFFX) both seek long-term capital appreciation and, to a lesser extent, current income. Over the next decade, which fund do you expect to offer the best rate of return and why?
Don: I feel The Yacktman Focused Fund will do better because it is a concentration of our best ideas. All of my SEP-IRA money is in it.
Question 9. In your view, does USG have competitive advantages; If so, what are they ?
Don: USG has a huge market share of the wallboard business. Normally a company that has a 40% share of a market will make four times (not double) as much money as a company that has a 20% share.
Question 10. What do you find attractive about COP? What do you think COP can do to improve upon its current strategy and execution?
Brian: Turns out both my dad and I own this, so I’ll pipe in – no pun intended. My fear in buying oil companies is that my returns are dependent upon oil prices and their supply/demand factors. For that same reason I don’t like owning gold. So, I liked to see that COP is more diversified (50% of production is natural gas and they have other businesses such as chemicals that aren’t directly linked to crude and natural gas prices). But in the end, the merits of an investment come down to price. I looked at the other diversified majors (XOM and CVX), but COP was the cheapest. I estimated what I thought was a reasonable bad scenario with oil priced at $50 and natural gas at $5, and in that bad scenario I felt COP is likely worth around $65, and I was purchasing it at a 30% margin of safety on top of that. I also flipped it around and said, “Well, what prices must the market be assuming to price COP shares this low?” and it seemed as though they were expecting oil prices to be below $30…forever! I disagreed. I am concerned about management behavior – they overpaid for acquisitions in years past, and now it looks like they’ll likely be selling off undervalued assets. But I suppose kudos to them for using their times of prosperity to pay down their heavy debt burdens. Another company I like (well, less so now that they’ve performed well) is PTEN, and given they are very cyclical, I especially like that they have no debt, unlike their peers.
Question 11. What do you do to stress test the companies you pick either qualitatively or quantitatively?
Don: The best predictor of a company’s future is its past but it is very important to understand the company and how it is likely to behave in all types of economic environments.
Question 12. Not specifically asking for numbers here but at what level do you reevaluate an investment thesis and what kinds of factors commonly come up that have forced you to reevaluate a stock pick? (ie. valuation miscalculation, not understanding business fully, overweighting wrong factors, etc.)
Don: As an investment is made and monitored over time an investor develops greater understanding of the business and builds an internal data base of the strengths and weaknesses of the business and its management. It is important to be both patient and objective and as they say on “CSI” “see where the evidence leads you.”
Brian: That’s a good question – I can guarantee we’ll make mistakes and it’d be good to identify a common theme. But truthfully, I think it depends in each scenario. The primary factors I look at are 1. Is the price right given the predictability of cash flows?, 2. Is it a profitable/growing business?, and 3. Is management shareholder-oriented, making decisions as we would if we were in their shoes? Typically, you can analyze number one and two great, but normally, when an investment goes bad, usually it’s because management did something to mess things up.
Question 13. How long did it take you to hone your investment process?
Don: It took me several years to have the major pieces fall in place and I made plenty of mistakes along the way. In this business, we are almost always wrong because no one buys everything at the bottom or sells everything at the top. Hopefully people who read about good investors and can truly understand how to value businesses will not “wander in the wilderness” as long as I feel I did.
Brian: Still honing…and will always be honing. But I’m grateful for my father who did indeed prevent me from “wandering in the wilderness” and placed me on the proper path. I think that likely those who subscribe to gurufocus are on the right path because they are probably believers in the true principles of so-called “value investing.” I say “so-called” because I really dislike that terminology. I’ve never heard an investor say their strategy is buying overpriced stocks!
Question 14. How hard is it to admit a mistake on an investment thesis and what do you do to not repeat the mistake?
Don: It is important to be objective and not let our ego get in the way. As Will Rogers said, “Good judgment comes from experience and a lot of that comes from bad judgment”.
Brian: I agree. In addition, we can’t let our emotions get in the way. When a mistake has been made, you can’t cross your fingers and hope to recoup your losses. You have to ask yourself, where do I go from here? On this day, what are my best options, where are my highest yielding assets? Where would this capital best be allocated now? Once you’ve experienced a permanent loss of capital, there’s only one gear from here and that’s forward. But the key in this business is to avoid the permanent losses. And as my father has often said, “A low purchase price covers a lot of sins.”
Question 15. How long does it take you to understand the business of a company (not just what it does) where you become comfortable with the unpredictable but knowable risks?
Don: By now I can understand the basics of a business very quickly because my internal database is large. What is history to many others is a current event to me.
Brian: Ha! – and his gray hairs prove it (we like to tease each other). Over time you build a database of individual businesses you have already researched, and also, you become familiar with businesses in general and how they make money. In other words, you start to group businesses into categories, even if they’re in completely different industries. For example, banks, retail, and pharmaceutical distributors are all “conduit” businesses – the same thing that comes in goes back out. Thus, these will all be thinner margin businesses. Then, you can build a comfort level in the different types of businesses.
Question 16. Although your focus (both) is stock-picking, do you occasionally get caught up with big pictures issues that distract you from your main goal of picking great stocks? How do you deal with it and why do you think it can happen to investors?
Don: I don’t get distracted by big picture issues but I think many others do. I think most people have trouble buying stocks that are in price decline either because of lack of knowledge, a short time horizon, or emotion. It is important to be objective.
Brian: Well said. I think this age of information has created a second by second mentality. We are constantly barraged by data, opinions, and flickering computer screens that nearly suffocate us. Rather than allow this stream of information be like a leash, sometimes investors just need to shut off the world. We need to find a quiet place and sift and focus in on the most important information. Reminds me of the poet T.S. Eliot who wrote, “Where is the knowledge we have lost in information?” Mind you, that was written in 1930…who knows what he would’ve written about our day! Investing is a business of patience – just like individual investments, it can take years to grow a tree, but if you’re patient, eventually it’ll produce a lot of fruit and shade.
Question 17. What other investors (not Buffett and Munger of course) do you admire that some of us here may not know of?
Don: Good investors stand on their own two feet and have excellent 10 year or longer track records. Actually I think the best time frame to evaluate managers is from peak to peak. Many who have good records are on the GuruFocus list. Some not on the list could include Jeff Auxier, Roy Papp, Lou Simpson (although tied to Buffett) and Dick Weiss.
Brian: Truthfully, I’d like to bring up my brother Steve, because I don’t think most people are aware of him. My father is always in the spotlight, and so he is overlooked. But I can honestly say he’s the most intelligent investor I am aware of. I think two others that have proven to protect the downside and be successful over long periods of time with concentrated portfolios are Bruce Berkowitz of Fairholme, and Robert Rodriguez of FPA, although he’s gone on sabbatical.
Question 18. How would recommend a person who is greatly interested in value investing, but is currently working in a completely unrelated field, break into this field? More specifically, is there certain positions that would stand out or completely eliminate a candidate? Your take on this question is much appreciated as Seth Klarman has stated that the trading program at Goldan Sachs is excellent while Andrew Weiss has stated that he would never ever hire someone who has worked at a big investment bank because "they will have learnt the wrong things".
Don: Covered in #6.
Brian: I, too, refer you to my response in #6. I see what Andrew Weiss is saying. But I think working at Goldman Sachs or Morgan Stanley is part of building the network I was referring to. I think if you read the books I recommended, you’ll be thinking about things from the proper perspective, and working at an investment bank (can we still call it that?) won’t do any harm, but could potentially build your network. Breaking into the “buy-side” usually requires somebody else pulling you through the door.
