GuruFocus readers asked Charlie Bobrinskoy, Ariel Investments vice chairman, head of investment group and portfolio manager, their questions about investing several weeks ago. Charlie has responded to the questions below.
Ariel Investments is the $13.2 billion Chicago-based value asset manager founded by John Rogers (Trades, Portfolio).
Question: I understand that Warren Buffett closed his IBM (IBM, Financial) position earlier this year. What are some key reasons why you sold IBM?
Bobrinskoy: IBM performed well for us in the early years of Ariel Focus Fund. Management at the time used cashflow from operations to repurchase stock and increase earnings per share. Current management have not been good capital allocators. They have sold multiple businesses at prices which reduced future earnings instead of using cash flow from these slower growth businesses to fund higher growth opportunities. Fundamentally, IBM has not proven it can monetize its big data investments in Watson. A return to profitable growth was always “just around the corner” but somehow never came.
Question: I am curious to know what your thoughts are on the trend in consolidation we are seeing among major corporations. As larger conglomerates are formed, what does it mean for those companies that are left behind? Do you see any trends?
Bobrinskoy: Growth through acquisition, often forming large conglomerates, goes in and out of fashion. In the 1950’s and 1960’s, management talent was considered a scarce resource. CEO’s justified acquiring often unrelated businesses, arguing “We can manage it better.” GE bought medical equipment businesses and The National Broadcasting Company, which had absolutely nothing to do with each other. So long as these large companies had access to cheap acquisition capital, either in the form of low interest rate debt or high multiple stocks, they could produce earnings growth paying almost any acquisition price. When this strategy is in favor, diversified companies can trade at prices greater than the sum of their parts, i.e. more than the businesses they own would be worth if they stood alone. But on a regular basis, the market falls out of love with these conglomerates. Usually one division will dramatically underperform, dragging down the entire company. This happened to GE (GE, Financial) during the financial crisis when GE Capital (GE’s financial services arm) underperformed the company’s industrial businesses. Today, low interest rates and relatively high stock prices are making the math of acquisitions look good. Almost any deal can be accretive if financed with 3% debt financing. This trend toward diversification through acquisition will end in the next economic downturn when past deals are viewed in a harsher light. In the meantime, we are asking our portfolio companies to consider whether there is not someone who would like to overpay for them today!
Question: What do you think about consumer staples stocks right now?
Bobrinskoy: We at Ariel have generally been avoiding consumer staple stocks for the past several years. With only a few exceptions, we consider the sector overpriced. Companies like Coke, Pepsi, and P&G all had their share prices bid up by two forces. First, investors have vivid memories of the last financial crisis and have sought “safe” stocks perceived to be less economically sensitive. These consumer staple stocks outperformed in the last downturn and many investors sought to “hide” in these names. Second, historically low interest rates have sent many investors in search of “bond substitute stocks” which might produce some yield with relatively little risk. Consumer staple stocks seemed attractive in this low interest rate environment as many paid healthy dividends. Principally for these two reasons, consumer staple stocks saw their PE ratios driven quite high, often above 20, making them unattractive to us at Ariel, at least for the time being. There have been exceptions. The JM Smucker Company has seen its stock price driven down by fears of competition in coffee and low growth for its bakery products. Its PE is now approximately 12 and we believe it is trading below its intrinsic value.
Question: How do you find Ben Graham-type ideas in the era of investing sites and stock screeners?
Bobrinskoy: Ben Graham’s key investing insight was the idea of “margin of safety.” If you could buy a stock significantly below its liquidation value you could avoid the probability of significant loss. And: the first rule of investing is still “Don’t lose money” (or at least, try very hard not to.) At Ariel, we apply Ben Graham margin of safety concept by calculating a Private Market Value (“PMV”) for every stock we purchase. The PMV is what a rational fully informed buyer would pay for the entire company were it ever put up for sale. In today’s world of modern finance, large companies are rarely liquidated with their inventory, plant and equipment sold off separately. Instead companies hire investment banks to explore strategic alternatives including a sale of the company to a strategic acquirer or a private equity firm. If we are able to purchase a stock below this PMV, we believe we have the margin of safety Ben Graham taught his students to seek.
Question: When analyzing stocks, how much of your analysis would you say comes down to art/feel versus a scientific/rule-based approach?
Bobrinskoy: The answer to this question varies from portfolio manager to portfolio manager. I am personally more of a rules based investor. The world can be divided into two camps: Those who trust their “gut” and those who trust a “process.” I am more in the later camp. If I am told to look at a “great” company that is trading at a high multiple of its profitability, I will usually want to know why their greatness has not produced cashflow. As Billy Beane said in "Moneyball," “If he is such a great hitter, why doesn’t he get a lot of hits?”
Question: How do you determine what percentage of portfolio a position must take?
Bobrinskoy: Position weights are determined by a combination of perceived value and conviction all in the context of general portfolio construction. To illustrate, for much of the last two years, KKR Inc. (KKR, Financial) has been my largest position because I considered it a great company with strong barriers to entry in a growing business while simultaneously trading at a large discount to its intrinsic value. Once individual positions are appropriately sized, I examine the overall portfolio to measure exposure to macro factors. It is often the case that “value clusters” meaning the same kind of companies can all become cheap at the same time. A portfolio consisting only of one’s cheapest stocks might be over exposed to a fall in oil prices or a rise in interest rates or a downturn in the economy. The portfolios I manage are always built around the idea that my own money, and that of my friends and family, is at risk.
Question: How do you hedge your investments (if you do that)?
Bobrinskoy: We do not hedge our investments other than being aware of exposures in our portfolio.
Question: When looking for potential investments what types of metrics are most important to you during the initial screening phase?
Bobrinskoy: Ariel Focus Fund has always been acutely aware of the Price/Earnings ratio. There is a great deal of academic research conducted over many decades showing the tendency of low PE stocks to outperform high PE stocks, although this has been less true recently. Debt to EBITDA is an important metric for measuring balance sheet strength. Sell Side Buy Ratings are a good measure of investor sentiment with few buy ratings acting as a potential signal of opportunity. M&A strategic multiples are a good measure of how industry participants value current profitability. Finally, I am not dismissive of the Capital Asset Pricing Model and its emphasis on Beta as a measure of risk. While imperfect, it is not irrational for investors to hope their portfolios will outperform in down markets. Beta does a reasonable job of predicting this.
Question: If you were currently sitting on 50% cash in your portfolio, would you be looking to invest it all in the near term, dollar cost average it into the market over the course of the next couple of years, or sit on it and wait for the right opportunities?
Bobrinskoy: If I had 50% cash, my investment approach would depend on my risk tolerance, expectation of future cash inflows and my age. A young person who could reasonably expect to earn more than he/she spent could be confident in future investable income and could therefore invest more aggressively today. For example, a new business school graduate working at a technology company receiving a large year-end bonus in cash would not be irrational to invest 75% of that money immediately into equities, keeping 25% in cash for opportunities during the next year. Over long periods of time, equities outperform bonds by the “equity premium.” That excess stock return has exceeded 5% per annum over the last 50 years. A good rule of thumb is that the percentage of your investments in stocks should equal 100 minus your age. The younger you are, the higher percentage of your Invesments should be in stocks which should outperform bonds over the long life you hopefully have in front of you. So a fully employed 30 year old should probably have 70% of his/her investments in equities.
Question: How does your investing approach change in a rising interest rate environment? Or will it not change at all?
Bobrinskoy: Interest rates remain lower than historical averages because central banks around the world have engaged in monetary easing. Lingering risk aversion from the financial crisis has also put a premium on “low risk” bonds. Finally, China has enjoyed significant dollar inflows from its large trade surplus, much of which has been reinvested in dollar denominated bonds also pushing interest rates lower. We at Ariel believe interest rates are likely to increase, perhaps faster than many are expecting. Inflation is increasing, fiscal deficits look to exceed $1 trillion for many years, and monetary policy will almost certainly tighten over the next several years. For all these reasons, we are currently avoiding stocks which will perform poorly in a rising rate environment. These include most REITs, MLPs, utilities and high dividend paying “yield stocks.” We will also adjust our valuation methodology to increase the discount rate we use to perform discounted cash flow analysis should interest rates move significantly higher. Certain companies will perform better in a high interest rate environment. Bank of New York, for example, will earn higher rates of return on its customers’ cash balances.
Question: If you started from scratch today, how would you construct a portfolio that you couldn't change until the year 2029?
Bobrinskoy: I would not make significant changes to my current portfolio even if I knew I could not sell anything for 10 years. All of my positions are based on companies with long-term competitive advantages which I expect to increase over time. I expect KKR to be a much larger money management firm in 2019 than it is today. I expect Lab Corp (LAB, Financial) to be the leading health care testing company with a higher market share given its cost advantages over hospitals. I expect Snap-On (SNA, Financial) to be selling more specialized automotive tools to help repair more complex cars in the year 2029. I expect Exxon (XOM, Financial) and Apache (APA, Financial) to produce a greater share of the world’s energy particularly as natural gas replaces coal as the primary fuel in electric utility production. I expect the content of Viacom (VIA, Financial) and CBS (CBS, Financial) to be acquired by a media or telecommunications conglomerate in less than ten years and therefore expect both to be part of other larger companies.
See the portfolio of Ariel Investments here.
