1. How and why did you get started investing? What is your background?
When I was a teenager my Dad gave me the book the "Intelligent Investor" for me to read on a trip to Hawaii. For the first time investing, which had previously seemed a very abstract concept to me, made tangible sense. I found it so interesting that the relatively simple concept of value investing, which has been used by so many successfully, was the furthest thing from the status quo on Wall Street. I have a naturally contrarian personality so value investing was a great fit for me.
I have a B.A. in business and economics from the University of California Santa Barbara, and I’ve worked for a variety of different companies in the industry, including Vanguard, Scottrade, and A.G. Edwards & Sons. After working at those companies and some smaller firms, I realized that if I could offer what I believe to be the best investment methodology at a reasonable price, I could add tremendous value to most clients. Big firms often don’t have the flexibility to take concentrated investment positions or utilize tools such as covered calls and cash-secured puts to generate income and reduce risk. Most firms take a cookie-cutter approach, using funds or ETFs and their focus is only on asset gathering. Our focus is on performance and specifically maximizing risk-adjusted returns and by doing so we’ve gathered assets with little to no marketing.
2. Describe your investing strategy and portfolio organization. What valuation methods do you use? Where do you get your investing ideas?
Our investment strategy is deep value investing. We focus on buying businesses at a 40% to 50% discount to our estimates of their intrinsic value. We are willing to concentrate on our best investment ideas. Rarely do we own more than 13 to 15 stocks in our portfolios. At T&T Capital Management, we only buy businesses that we understand, and we put a major focus on the balance sheet and free cash flow. Often we find that securities which may be out of favor, due to temporarily weak short-term earnings outlooks, offer the most compelling long-term value and the biggest margin of safety. This is likely a result of the fact that about 90% of market participants seem to be short-term oriented. In addition to buying stocks and bonds, we also intertwine conservative strategies such as covered calls and cash-secured puts. These strategies allow us to acquire stock at cheaper prices, enhance our income and instill disciplined selling practices. We’ve found that they offer attractive protection in cash flow over time and are definitely a major differentiator from other larger firms that don’t have the capacity to manage accounts in this way.
3. What drew you to that specific strategy? If you only had three valuation metrics what would they be?
I was drawn to value investing and our focused strategy after reading all I could on the great value investors. Major specific influences include Warren Buffett (Trades, Portfolio), Bruce Berkowitz (Trades, Portfolio), Martin Whitman (Trades, Portfolio), etc. I am a patient and long term-oriented investor, and I’m very comfortable investing in stocks that most others shun so it is a great fit. Risk can really be reduced dramatically by performing extensive and comprehensive research and by focusing on the price paid versus the value received.
If I only had three metrics to go by they would be return on capital, EV to EBIT and operating margin.
4. Which books or other investors changed the way you think, inspired you, or mentored you? What is the most important lesson learned from them? Which investors do you follow today?
Mohnish Pabrai (Trades, Portfolio)’s "Dhandho Investor" was an inspiring book. I really appreciated the analogy about starting your own business, that it is not nearly as risky as working a job you don’t enjoy 40 hours a week for 30 years. If you fail you can always have the opportunity to try again, but if you never try you’ll never even know what could have been. "You Can be a Stock Market Genius" by Joel Greenblatt (Trades, Portfolio) is a classic despite the gimmicky name, and I definitely loved Seth Klarman (Trades, Portfolio)’s "Margin of Safety." I believe the most underrated book is "Modern Security Analysis" by Whitman and Diz. To me it is the best book on value investing, and it should be required reading for anyone that is serious about investing as a career.
5. How long will you hold a stock and why? How long does it take to know if you are right or wrong on a stock?
Our average holding period for a stock is between two and three years, which obviously speaks to our long-term nature. Because we use covered calls and cash-secured puts we definitely intertwine a more active component, but we never invest in anything without being willing to own it for a few years. I don’t believe that there is a set amount of time that tells you if you are right or wrong on a specific stock, but instead it is more about your investment thesis and the ensuing events. One example of a mistake that I’ve learned from is that I believed oil prices would come back more quickly than they did. When it became clear to me that due to geopolitical and economic turmoil, OPEC was likely to be unable to reduce production to stop the supply glut, I realized that our money could be better invested in other areas. You can’t be afraid to lock in a loss as they are inevitable from time to time. I believe a lot of investors are afraid to admit they were wrong, and this can really hurt returns. In this example, we sold energy and moved more heavily into financials, which has ended up working out extremely well.
6. How has your investing approach changed over the years?
My investment approach has definitely been adjusted over time. Earlier in my career, I’d try to diversify a little more than I do now. While it might reduce short-term volatility and make things easier from a business perspective, this approach can reduce long-term returns. We’ve been wrong on very few high-conviction investments so we’ve never regretted being big in them. When we’ve tried to diversify into other seemingly “cheap” areas such as our endeavor into energy stocks in late 2014, early 2015, we’ve been less successful. Buffett invested 45% of his partnership into one stock and has done over 20% on several occasions. Concentrating on the best investment opportunities is not for everyone, but it has worked out very well for us over the years.
7. Name some of the things that you do or believe that other investors do not.
I definitely believe that the current fad of index funds will prove to be just that, a fad. These things always become vogue at the worst time possible. Seven and a half years into a bull market seems like a pretty terrible time to just buy the whole market. If you did that in 2000 or 2001, you didn’t break even for over a decade. So many financial advisers and investors allocate a huge percentage to fixed income irrespective of the fact that interest rates have nowhere to go but up. Many people rely on Monte Carlo simulations, which go back 30 years and in those 30 years, there was really only a bull market in bonds. The average 60-40 stock/bond portfolio is unlikely to do better than 5% per annum over the next decade.
8. What are some of your favorite companies, brands or even CEOs? What do you think are some of the most well-run companies? How do you judge the quality of the management?
One CEO you never hear about but who is fabulous is Dominic Frederico of Assured Guaranty. That management team has grown operating book value per share from $28.54 at the end of 2011 to about $50.09. This was accomplished despite record-low interest rates that have hamstrung new business production, which is providing insurance of municipal bonds. AGO’s management has been very shareholder friendly through retiring roughly 34% of shares outstanding over the last several years, all at a dramatic discount to operating and adjusted book values. In addition, the company is consolidating the industry by buying up the leftover assets of its former competitors at large discounts to statutory capital and book value. These acquisitions have been immediately accretive to earnings per share and book value. Now with interest rates going up this company is poised to accelerate growth. In the same industry Nader Takavoli of Ambac is doing some interesting things. Outside of finance I really like the job Carlos Brito has done at Anheuser-Busch.
Another guy who took a horrible hand and has dramatically improved it despite huge commodity headwinds is Lourenco C. Goncalves of Cliffs Natural Resources (CLF, Financial). All of these CEOs are great stewards of shareholders’ capital, which is by far and away one of the most important characteristics of a good CEO, along with integrity. I really dislike companies that serial stock issuers like you see often in Silicon Valley. I always want the focus to be on maximizing growth in per share intrinsic value as opposed to growing just for the sake of getting bigger.
9. Do you use any stock screeners? What are some efficient methods to find undervalued businesses apart from screeners?
I don’t use any stock screeners because often it is not about what the numbers are but instead is about what they mean. The perfect example of this is when you look at all of the companies using adjusted earnings per share. In many cases it is the best way to examine companies, but in others it is incredibly misleading. Companies such as salesforce.com are still not profitable on a GAAP basis and are only mildly profitable on an adjusted basis when you discount stock option compensation in addition to many other GAAP costs. When those stock option compensation plans can be in excess of 6% to 10% of revenues, there is a huge problem in transparency. The best way to find attractive opportunities is to read obsessively. That is what I spend the majority of my day doing and what I’m looking for is an unappreciated story or opportunity. Often these opportunities exist in industries that are currently out of favor but that offer much more attractive long-term prospects.
10. What kind of checklist or homework do you utilize when investing? Do you have a specific approach, structure, process that you use? Or do you have any hard cut rules?
Before making an investment I make sure that I read several of the annual reports and the last few quarters of earnings transcripts. This is part of my regular reading routine so I’m constantly improving my knowledge database of companies that I understand and follow. At the same time, there are some companies I simply don’t understand and when that is the case we just let those pitches pass us by. I believe one of the best pieces of advice that I’ve heard Buffett give to others is to act as though they can only make 10 investments in their lifetime so be very careful the pitches that they swing at. I’ve found that there are opportunities where every fiber in your being tells you that you are going to be successful and make a lot of money and that confidence is based on extensive fundamental analysis. There are times when we will contact management, but when you have a good management team it usually is not necessary to do so, which is the best situation possible.
11. How do you go about valuing a stock and how do you decide how you are going to value a specific stock? When is cheap not cheap?
In valuing a stock I think of it as if I was buying the whole business. What price would I be willing to pay for the entire operation, including debt? Certainly a company that is capable of producing higher returns on capital and that offer higher operating margins are worthy of higher multiples. We are willing to pay up for growth on business that we understand and that have durable competitive advantages that make it likely that they will be able to maintain higher rates of profitability. One area of focus for T&T Capital Management is our focus on the balance sheet. We look for companies that we can buy at a 30% to 40% discount to net asset value, when we believe they can grow that net asset value by in excess of 10% per annum adjusted for dividends. AGO and the big banks have been opportunities that have met these characteristics for the most part over the last few years. Lower interest rates have reduced returns on equity but to me this is a transient issue, so taking a long-term perspective on things, I find it difficult to see how we would lose money given their fortress balance sheets. So far it has worked out well despite rates staying lower for longer than I anticipated.
12. What kind of bargains are you finding in this market? Do you have any favorite sector or avoid certain areas, and why?
Not to be redundant, but in today’s market the best value is in financials. They have run up a lot lately but are still really cheap. This year has been a roller coaster with massive selloffs in January and June with the Brexit. We were big in financials before each selloff, and we added materially because the fundamentals kept improving regardless of the short-term price movements. If you look at aspects such as book value growth, capital ratios and capital returns, the improvement was obvious to anyone that understands how these companies work. Lately, we have also been finding some opportunities in health care, specifically some of the drug stocks.
13. How do you feel about the market today? Do you see it as overvalued? What concerns you the most?
This is an expensive market in both equities and fixed income so I believe one wants to be security specific. We also really like selling cash-secured puts on stocks we want to own to manufacture cheaper entry-prices or to generate income.
14. Any advice to a new value investor? What should they know and what habits should they develop before they start?
To a new value investor, I’d advise also being a student of history. It is important to understand what has occurred in various industries and markets in the past so that you really get a full grasp of how dynamic things can be. Then it is just really important to get some experience using real money on businesses that they understand and that are available at really attractive prices. Everybody is going to make some mistakes so it is best to make them when you are young. Try to imagine what scenarios will kill the business. How will it react in a tight liquidity scenario like we saw in 2008? Is the company exposed to commodity risks? What about government involvement?
15. What are your some of your favorite value investing resources or tools? Are there any investors that you piggyback or coattail?
Well there is definitely a lot of value in websites like GuruFocus and seekingalpha where you can find quality research reports and updates on what other successful investors are doing. I read the Wall Street Journal, Barron's and Bloomberg each day as well.
16. Describe some of the biggest mistakes you have made value investing. What are your three worst investments that burned you?
One of the biggest mistakes I’ve made in investing was buying energy stocks in late 2014 and early 2015. They weren’t big positions fortunately, and they were bought at large discounts to our estimates of net asset value. Unfortunately, those net asset values declined at a greater rate than we had anticipated and production maintained at higher levels for longer than we had expected. While companies were able to sell assets to generate cash, many of the shale drillers were overly reliant on capital markets. We did well buying the debt of many of the companies in the sector but the common equity wasn’t nearly as profitable for us. Another big mistake was Fannie Mae (FNMA, Financial) and Freddie Mac (FMCC, Financial) during the financial crisis. Both stocks were insanely cheap, but I underrated the role the government would play in that situation. From a logic standpoint, the companies have generated well over $100 billion in profits since the crisis, and the GAAP earnings they reported during the crisis greatly overstated the actual losses due to mark to market accounting. I believe I read the economic aspect of it correctly but I underestimated the probability that the U.S. government would take them over and basically just confiscate private property, as they did with the net worth sweep. It will be interesting to see how those court cases play out moving forward.
17. How do you manage the mental aspect of investing when it comes to the ups, downs, crashes, corrections and fluctuations?
The mental side of investing is by far and away the most challenging aspect for most market participants. Personally, I don’t have a problem when stocks drop dramatically even if it means we are showing big losses during the short term. The reason for this is that we know what we own and why we own them. Markets can be irrational but over the long term they tend to become more sensible. That is always an exciting thing as we are much more likely to add to our holdings in situations like that, like we saw in January and June of this year for instance. From a business standpoint and managing money for clients, is where anxiety can come from. It is frustrating when you see someone panic unnecessarily during a big downturn, so sometimes as an adviser one has to act like a bit of a psychologist in those situations. At TTCM, we put a huge emphasis on educating our clients on the strategy and our specific investments so that they have the same confidence that we do. Often our long-term clients will add money in downturns and I’m very happy to say we’ve had far better fund flows than the majority of our competition over these last five years, and I believe our communication and performance are big reasons why.
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