Before he became a money manager, Mr. Dorfman was a financial journalist for many years. He covered the world of investments and related topics at Forbes (1982-1984) and Consumer Reports (1984-1986). From 1986 through 1997 he was a Senior Special Writer for The Wall Street Journal. At the Journal, he was one of the principal writers of the "Heard on the Street" stock-market column, and also created numerous special features for the newspaper, including objective ratings of Wall Street research.
During his years at the Journal, Mr. Dorfman made the acquaintance of many of the most famous money managers of our era, including David Dreman, Sir John Templeton, Peter Lynch, Phil Carret, Jim Rogers and Michael Steinhardt. Inspired by these individuals, Mr. Dorfman at age 50 made a career change into investment management.
In 1997 Mr. Dorfman began to work for David Dreman of Dreman Value Management, first as an analyst and later as a portfolio manager. He regards Dreman, a leading proponent of value investing, as his mentor.
Since 1997, he has written a stock-market column syndicated by Bloomberg News. In addition, he has written nine books, including Family Investment Guide and The Stock Market Directory. He appears frequently on radio and television including "Nightly Business Report."
John Dorfman was kind enough to answer several questions about value investing and his Bloomberg columns. Below is our conversation.
I would like to especially thank Beth Kittredge Marketing Associate of Thunderstorm Capital, who devoted a lot of time and effort to making this interview possible.
You are a value investor writing for a 24 hour news agency. Warren Buffett has stated “Only buy something that you'd be perfectly happy to hold if the market shut down for 10 years.” How hard is it to maintain a value approach while working for a company that has up to the minute business coverage?
That is a very good question. It hasn’t been hard because of the leeway my editors at Bloomberg give me. They are very flexible and I make it clear in my columns that my recommendations are long term picks ranging up to five years. The editors are okay with this because they feel there is an audience for longer-term advice. We try to make this clear in the column. Other Bloomberg columnists touch on value investing, but I am the only one for whom it’s a central focus.
I always ask this question to value investors. Value investing is contrary to human nature, how did you come along the path of becoming a value investor? What inspired you?
The natural reaction of human beings is to run away from ugly stocks, and sell in times of economic uncertainty. However, David Dreman has documented that stocks with lower expectations perform much better than stocks with high expectations.
There were two great influences that got me on my value investing path.
The first person is Sir John Templeton. My father bought shares in Templeton Growth Fund in 1954; the year it first opened. He put in $500 for each of his children. When I needed the funds in the early 1980s, I sold out for $13,000, up 25 fold in approximately thirty years! Since I was an investor in the fund, I received annual reports from the fund over the years. Reading them as a teenager and adult is how I was acquainted with equities at a very young age.
David Dreman also greatly influenced me through his books and his columns in Forbes Magazine. In 1997, I applied for a job with him at Dreman Value Management. I was happy when he agreed to hire me.
He hired a variety of people to work with him from various backgrounds. Many people he hired came from non financial backgrounds. There was a professor, an astrophysicist, and me, a journalist. I asked him why he hired all these people and he told me, “this way I don’t have to un-train them from their bad habits.”
I had been reading David Dreman’s columns for years prior to working for him. I finally met him as a Wall Street Journal reporter in 1986. I interviewed him10 or 12 times over the years, and overtime we became friends. When I decided to make a career switch from financial journalism to fund management in 1997, he hired me. A few years later I decided I wanted to launch my own firm. Surprisingly, David allowed me to continue my work with him, while I ran my own fund. I launched Thunderstorm Capital in 1999 and continued working with him part time till March of 2002. After that point, I left his fund and decided to devote my time exclusively to Thunderstorm Capital.
David Dreman is my mentor and I have said that various times in print.
You launched your fund in late 1999. What was it like launching a value fund at the height of the tech bubble?
We did our first trade in November of 1999, which was fortunate because it was at the end of 1999. Since growth and value indexes have been kept, 1999 was the worst year for value versus growth stocks in history. So, I am glad we missed that period of underperformance. We started with around one million dollars under management in my basement, and right now we manage a little over $50 million, mostly for high net worth individuals.
Our Separate Account Composite outperformed the S&P 500 in 9 out of 10 years, and has beaten the S&P 500 by 167.79 percentage points since inception. Of course, past performance doesn’t guarantee future results.
We also have a mutual fund, Thunderstorm Value Fund, which launched on January 2, 2008, and beat the S&P both in 2008 and 2009.
Can you clarify exactly how many products Thunderstorm Capital offers?
Thunderstorm Capital offers three investment products.
We run separate accounts for high net worth individuals. We also have a mutual fund, Thunderstorm Value Fund - fund ticker (THUNX). The two products are run in a very similar style – long only, deep value with a focus on valuations, balance sheets, and insider buying. But, the separate accounts tend to focus on small and mid-cap companies while the mutual fund is all-cap. Also, the separate accounts can be tailored to the individual needs or specifications of the specific client. Finally, we have a long/short strategy.
I tend to ask this question when I interview value investors. There is no set definition of value investing. In fact there are numerous styles of value investing. Warren Buffett looks for moats, Martin Whitman emphasizes the balance sheet, David Dreman looks for low metrics such as P/E, P/B etc. I know you have mentioned Dreman as your mentor but do you subscribe to his value style of investing.
My style is very similar to David Dreman’s. We look for stocks that are cheap based on traditional metrics such a price/earnings and price/book ratios. We look for strong balance sheets. One way I differ is that I place more emphasis on insider buying. Also, David puts more emphasis on large cap stocks, while we are more focused on mid and small cap stocks.
You write about very low P/E investing, it’s interesting because many value investors will avoid the lowest P/E stocks. I believe Joel Greenblatt tends to avoid companies with a P/E below 5. Do you believe stocks with such low P/Es might be value traps?
There have been numerous studies which break up the stock market into five quintiles or ten deciles. The evidence is pretty clear that the lowest quintile outperforms the rest. David Dreman has clearly documented this as have numerous studies. But there is little data focusing on the lowest 1% P/E stocks, which could have P/E ratios as low as 3, 4, or 5.
I did my own research on the ten lowest P/E stocks each year among all stocks with a market cap of $500 million or more, and debt less than equity. Many times these stocks sell for P/Es of 4,5 or 6. I studied these each year from 1999-2007 and published the results in my Bloomberg column. I also have two years of unpublished data on these stocks for 2008 and 2009. For 2008, the results were awful down 60% while in 2009 they were up 93%. For those last two years, since I wasn’t writing the column, the stocks were selected subsequent to January 1, so the data quality is a little lower. For all 11 years, the compound average return is 16.7%, compared to 0.8% for the S&P 500.
Some of these stocks could be value traps like Joel Greenblatt says, but you can do fundamental analysis to avoid the problems that Joel Greenblatt mentions. I am not afraid to include very low P/E stocks in portfolios. I recently purchased Innophos, ticker IPHS. This is a small chemical company that makes chemicals used for water treatment, flavor enhancers, pharmaceuticals and other purposes. The P/E of IPHS is between3 or 4.
You wrote an article researching the results of how the analyst’s favorite stocks performed over the past 11 years, can you tell us more about this?
I analyzed the four stocks with the highest consensus ratings score versus the four stocks with the lowest consensus. The most hated stocks outperformed the loved stocks. However both groups underperformed the S&P 500. The lesson to learn is that analyst research can be useful, but when they develop a herd mentality it is a bad sign.
I have read that you favor stocks with low P/E and high growth prospects. This sounds similar to the approach John Neff used. Can you tell us more about your research in this area?
Growth investors do not want to pay too much for the growth, while value investors do not want companies with too little growth. However, when push comes to shove, I prefer value. The reasons are that earnings are cyclical and companies that are growing fast attract new competition. Additionally, forecasts of growth are often inaccurate. Of course I would prefer both value and growth!
You have mentioned the merits of strong balance sheets. Bruce Greenwald stated recently that many value investors performed poorly during the recent market crash due to their focus on earnings potential and paid little attention to balance sheets. How important do you believe balance sheets are to a value investor?
I put heavy stress on balance sheets. Most investors look at balance sheets to evaluate a company’s bankruptcy risk, but a balance sheet is much more than that. A strong balance sheet gives a company strategic flexibility. Companies with strong balance sheets can buy back stock, issue dividends and buy competitors at distressed prices during economic downturns. Strong balance sheets can also protect a company from the need to conduct fire sales.
Sometimes companies who have a strong balance sheet are a disadvantage. If the Fed is easing, and the economy is doing well crummy companies with poor balance sheets can do well, but overall I think companies with strong balance sheets perform better in the long run.
Working for one of the financial media’s largest agencies, and as a value investor, why do you think analysts get it so wrong?
I think they extrapolate the recent past. Many analysts unconsciously presume that the conditions that have prevailed over the past several years or even several months will prevail forever.
Analysts also confuse good companies with good stocks. A good company with a high P/E multiple is not necessarily a good stock. Similarly an ordinary company with a low P/E multiple might be a good stock.
I see you own Berkshire Hathaway. I am always curious to hear different value investor’s insights on the company. Can you tell me what you think of the company?
Actually we no longer own Berkshire Hathaway stock in our mutual fund, but we do own it for some individual clients where we take a more conservative approach. I think the company is attractive from a value perspective. The problem is that it has become so big and diverse that it offers much less growth prospects than it has in the past. In addition, Warren Buffett is almost 80 and I am confident he will find an excellent successor, but he is beyond excellent.
I am curious as a former Berkshire Hathaway holder what you think of the Burlington Northern deal? Bruce Greenwald has called it insane, and Bruce Berkowitz thinks it is a good deal. Overall most people seem to side with Bruce Greenwald. What is your opinion of the acquisition? Have you done a fair value estimate of BNI?
I have not done an in depth analysis. The price of the company in my view was fair but did not seem like a terrific value. I think Warren Buffett purchased BNI because he thinks the American economy will recover and BNI will benefit from the recovery. In addition, if energy prices rise railroads like BNI will benefit because railroads are more energy efficient than trucks in moving large amounts of freight. However, I don’t think Buffett got it especially cheap. Its 2.4 times sales 2.6 times book and has 20 P/E. It was a fair price but not a bargain.
You own Humana. I saw a statistic a few years ago that approximately 70% of Humana’s earnings come from Medicare. Despite the low valuation of the stock, do you see a possible value trap here with healthcare reform up in the air?
Yes that is a risk. I do not prefer the Government being my main customer because I believe the Government might be stingy with their future payments. Still at 8 times earnings I think the valuation is good and the stock is attractive. I think investors are over reacting to the situation.
On a similar topic General Dynamics is a stock you own in some of your accounts. The company is reliant on the Government for its revenues does that concern you at all?
Same story as Humana. The government is not my favorite customer but I think investors are being compensated well for that risk
General Dynamics has a great record of increasing earnings and is a big player in the defense sector.
Garmin is another stock you own. I wrote a bullish article about Garmin. Many readers commented that with Google entering the market Garmin will not be able to compete with them. Do you believe Garmin will be able to compete in this competitive industry?
The competition scares me but so far every time I do analysis I find Garmin to be worth keeping.
The risk of course is everyone starts using their cell phones for GPS, and Garmin will no longer be able to compete. Garmin wins if people decide it’s worth having a GPS separate for the car. It is bigger, easier to see, more accurate, and in general a better product than phones with GPS capabilities.
Garmin is designing a cell phone which is supposed to have better navigation features than other cell phone devices.
I am depending more on the first reason because the smart phone field is very competitive.
If consumer spending picks up, I think it could help Garmin quite a bit.
Garmin has no debt, and their return on equity in 2008 was 32%. It probably will go down and it can come down quite a bit and still be attractive. The arguments for keeping the stock seem to me stronger than for selling it.
Just a note: Garmin is a very volatile stock. It was up 58% in third quarter of 2009 and down 19% in the fourth quarter of 2009.
With the recent selloff this year in stocks, are you seeing any value in areas whereas it may have been overvalued only several weeks ago? For example US steel was trading around 65 on January 19 and on February 4 declined to around $42 per share?
I think the stock market was undervalued even before the recent sell off. Yes the market P/E is around 18 but only because it is based on trough earnings. Now, with the correction, valuations have come down a bit. The field is always changing and there are some companies that might be coming onto my value screen.
As an investor and a financial columnist do you have an opinion on the economy?
Yes, I think the economic recovery is sustainable at this point. According to the Conference Board, the index of leading economic indicators has been positive for nine consecutive months.
In addition, we have experienced two consecutive quarters of positive GDP growth. Auto sales are increasing, technology orders are up, and home prices are firming in many cities.
The recession we went through was so bad, people are afraid to believe things are getting better even though they are.
How important is it for investors to have exposure to foreign equities?
It is wise to have exposure to emerging markets. A third of the world’s wealth is in emerging markets, but emerging markets only make up one sixth of the market capitalization. So there is room in these areas for considerable expansion.
Also many emerging companies have younger populations and lower debt which works in their favor.
Do you think US has slight advantages over Europe in regards to demographic issues?
Demographics give a slight edge to the US. I also think there is more information available about US equities than there is about equities in other countries. To my knowledge the US is the only country that legally requires disclosure of insider purchases, which is big advantage to investors.
But still important to look for bargains wherever you can find them so I wouldn’t rule out mature markets in Europe despite all their problems.
Do you apply discount to foreign equities versus US equities?
I am a bottom-up analyst. To me, it depends more on the company than the country. The world was intertwined more than most people realize 50 and even 80 years ago. However, today the world is getting even more intertwined. I focus more on the valuation of the company than where the company is headquartered.
John Dorfman’s Bloomberg columns can be found at the following link
The link to the Thunderstorm Value Fund is www.thunderstormvalue.com.
and the link to Thunderstorm Capital (John Dorfman’s money management firm) is http://www.thunderstormcapital.com/