In our previous article, “Gurufocus Exclusive Interview With François Rochon Of Giverny Capital, 20x In 20 Years, Part II,"Â we discovered an outstanding investor: François Rochon, president, portfolio manager and founder of Giverny Capital. The Rochon global portfolio has had an outstanding track record of a 15.5%* annual return over the past 20 years, compared to 8.3% for the index. If you had invested $100,000 in 1993 with François, your assets would have grown close to $2,000,000 today. François is not only a great investor but also a great art collector. His approach towards collecting art and investing is similar, as he is looking for greatness, uniqueness and characteristics that will pass the test of time. Here is the following interview to help us learn from François’ outstanding investment process.
Interview:
In past letters you mention that you have measured the intrinsic value of a business by its owner’s earnings. Also, in an article you have mentioned that you essentially define earnings’ potential by what a company can earn in five years and what is the reasonable assumption for the PE ratio in five years. Can we ask you to describe us a little more your process to find opportunities in that regard?
Ok, what we do is not complicated; let’s say Carmax, we think they could double their EPS in the next 5 years; we try to assess what we expect is going the be a reasonable P/E in 5 years; and if you compare it to today’s P/E level, it could give you close to 15% a year.
We have in our spread sheet a target of EPS projected in 2019 and a reasonable P/E at that point. We take a look at the price and the annual return we could get over five years from this level.
Do you use other measurements other than EPS?
No, only EPS. Of course, we look at margins, balance sheet and return on equity; but in the end the main driver of a stock price increase is EPS growth.
Do you use a different approach when investing in international equities?
No, it's the same thing. Since the companies are a little further from here we are even more selective. So we need to be even more confident about management, about the financials, about the solidity of the business. For a few years, we owned a Japanese company. It did quite well. And we’ve looked at many European companies.
In your 2013 and 2007 letter you mentioned that the Canadian dollar was overvalued by 10-16%. How do you measure that?
For this purpose, we use the prices and purchasing power parities (PPP) numbers of the OECD. And the PPP has been pretty stable for the Canadian dollar over the last ten years. The OECD believes the Canadian dollar is worth about USD $0.80 to $0.82. So when I mentioned this in 2007, I think the dollar was at par. So it was probably overvalued by about 20%. It began in 2014 at USD $0.94, so it is probably still overvalued by at least 10%. It's a very simple thing to find, you can get everything on the OECD website. Every year, they publish what they believe is the PPP value of the different currencies of the countries composing the OECD.
Do currency levels influence how you allocate your capital between Canada and the U.S.?
Not that much because I don't think the currency will play a significant role over the years. It hasn't played such a big role over the past years at least. If you take only one or two years, it can have a lot of impact, but if you look over a period of 20 years, the impact is very minimal. I think when I started, the CAD was at $0.77 and today it's at $0.88 so that's probably one half of one percent loss on an annual basis: It had a mild effect on our returns. The longer the track record, the milder the effect will be and in the end, the CAD will probably stabilize at its PPP, which is around $0.82. It's getting closer to its intrinsic value. For a while, there were those enormous fluctuations. In the beginning of the years 2000s, the CAD was probably 15% to 20% undervalued and it got revalued in the mid 2000s.
But you know, if we believe the CAD is overvalued it's one more reason to purchase U.S. securities. We have avoided some countries in the past because we thought that their currency was a bit high. I'm thinking about countries such as Sweden, Denmark, Norway and Switzerland.
If you had to define your success with one word what would it be?
Patience.
Between mistake of omission, analytical mistakes and patience mistakes and others, which one has been the most costly and how have you tried to avoid those kinds of mistakes over the years?
The biggest mistake over the years has been to not be ready to pay a higher price for a truly outstanding company when we found one. I’m thinking of one for example: Stericycle (SRCL, Financial). It was named in the mistakes section in our annual reports from two years ago. Stericycle was and still is an outstanding company. When I looked at it, I think it was trading at 29 times earnings; if it would have been 15-25% lower, I would have probably bought it.
Again today its stock is at a similar P/E multiple. So I’m still making this mistake: I have those thoughts that, if it would go down15-20%, that I would buy them and I wait for this to happen.
The biggest mistake is really when you find a truly outstanding company and you are not ready to pay a little premium, but not a big premium. I would not buy Facebook (FB, Financial)Â at 50-60 times. But when a company is young and small, you should not focus too much on the P/E. For companies that have the potential to increase by thousands of percent over the next decade, the P/E ratio is not that important. I’m not saying you should pay a 100 times earnings. When there is excitement for a new company, the stock can get to a very high P/E. But on the other hand, there is not that much of a difference between a 20 times earnings and a 25 times earnings for a young and truly great growth company; if you are right about a great growth company it’s not a slight difference in the P/E ratio that is going to make that a big difference.
The thing is that we get spoiled from time to time, and we buy some great companies at a very attractive level, and we make a lot of money. Which is why we want to wait for such similar opportunities; but sometime those opportunities don’t present themselves for a very long time. So you would have been better off paying a higher multiple than holding cash or owning some slower growing companies. Some investors were raised in the 70s and were able to buy great companies at 6 or 7 times earnings, so these people weren’t prepared to pay 15 or 16 times earning a few years later. Sometimes we are just spoiled for a while and it prevents us from making intelligent purchases afterwards.
The question is always the same: with the dollar I have today, what is the best place to put it to work? Obviously the best thing to do 25-30 years ago was to invest in Microsoft (MSFT, Financial) and Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial), but you can’t do that today. So you have to look at where your best opportunities are and find 20 companies that are outstanding. And you have to accept that it’s hard to make 20% a year, so you have to settle for a little less.
For the benefit of our readers we have copied this section directly out of Giverny Capital’s annual report from 2012:
Gold Medal: Stericycle
About a decade ago, a fellow portfolio manager spoke to me, with great enthusiasm, about a company called Stericycle. The company is a leader in the collection of medical waste and thereby absolutely my kind of business: unexciting, tending to not attract competition, and not affected by technological change. While the business isn’t exciting, its financial results most definitely are. Over ten years, annual revenues have increased from $400 million to nearly $2 billion. EPS has risen from$0.55 to $3.30 this year, with an annualized growth rate of 20%. The stock has risen from $16 to $92.You might have noticed − given your usual perceptiveness − that the stock’s P/E ratio was 29 times in 2002 and is still 28 times at the current moment. The stock has always traded at lofty P/E ratios. I have therefore made an error that I have, unfortunately, made many times: avoiding a high quality enterprise due to a valuation that seemed higher than what I would have liked to pay. I waited in vain for a better price… for a decade. It’s very difficult to find a company that can maintain an annual growth rate of more than 20% over a long period of time. When we find one and we have confidence that the future outlook is promising, refusing to pay a slight premium relative to average companies often becomes a very costly mistake. It was an error of almost 500% in this case.”
You've mentioned several times that it's important to follow your own rules but you also need to have the wisdom to know when to break them. Can you elaborate a little more on that analogy?
Well, we own Valeant (VRX). It's been three years since we've bought it.
I have a good friend who is a fund manager, and he really knows how I invest. He's a great investor and even if we don't have the same investments we really understand each other's philosophy. He recently told me that he really doesn't get why I invested in Valeant. He says that such an investment is unlike me, that it’s not my type of company. He's right. The accounting is complex; the balance sheet is leveraged, more than I would like it to be. But I truly believe that its CEO, Michael Pearson, is an outstanding manager. So we decided to buy it. It's an act of faith in Mike Pearson, and it's an exception because I wouldn't want to own 20 companies like Valeant. I think this is an outstanding company because it is truly well managed. But it's a different style from what we usually do.
What do you think about what is going on right now with the bid for Allergan?
I think they're being aggressive trying to buy Allergan (AGN, Financial), but I trust their judgement. If it doesn't work out then Michael Pearson will buy something else. There are rumours now that they would buy Zoetis (ZTS, Financial), which is the animal medication company that was spun off from Pfizer (PFE, Financial) some years ago. It's a good company and if they were to buy this one instead of Allergan, we would be OK with it, too. But Allergan is a great business. It's a company that I've been following for many years, and it should be in my top mistakes standing in the annual letter, because I looked at it probably many years ago. I think I first looked at it when Botox was first released. It was something like 15 years ago.
When you say risk, are you talking about volatility?
Well no. Volatility is just market movements. The important risk is the intrinsic risk in the company itself. And there's an intrinsic risk in almost every investment you make. Whether it's a bank or a retailer, I always say that companies that are indestructible, there are a lot of them in the corporation’s cemetery! That's just the nature of the capitalist world: It's a very destructive force. It tends to destroy most companies in the end. If you look at many companies that were dominant 50 or 75 years ago, most of them don't exist anymore. So there's some intrinsic risk in all companies. Some are pretty low and some are high, but there is some risk nevertheless and we accept that. We try to focus on companies that we believe the intrinsic risk is on the low side.
We don't think we're shielded from anything that can go wrong with the companies we buy, and we're extremely prudent of not putting more than 10% in a single security. The only exception is Berkshire Hathaway because it already has some significant diversification built in. For other stocks, we would not go over 10%.
* See disclaimer on returns at: http://www.givernycapital.com/en/rendements
About the authors:
Charles Matte and Jean-François Nobert are two students from HEC Montréal, passionate about capital allocation.
