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Holly LaFon
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GuruFocus Podcast With John Dorfman: Transcript

Conversation about investing in small and mid caps with Dorfman Value Investments founder

October 13, 2018 | About:

Holly: Hi, welcome to the GuruFocus podcast. I’m Holly, and I'm here with John Dorfman today. We're very excited to have him because he is the founder of Dorfman Value Investments, which he founded in 1999. He also is a former writer for The Wall Street Journal and a columnist for Bloomberg. And he also has a syndicated column, which is on GuruFocus every week, which we always look forward to, it's always very interesting, and colorful, and full of excellent ideas. And he also has a very impressive track record on his portfolios. He has more than doubled the S&P. He has a cumulative of 462% versus about 165% for the S&P since inception, so annualized, that's 9.79, versus 5.4 for the S&P, which is really quite, quite good. So John, thank you for coming on and talking about investing with us.

John: Well, thanks so much for having me.

Holly: Okay, well, to get started, how did you get started in investing? What drew you into the field? And maybe what also drew you into your approach that you take, which we'll also get into the details on that.

John: My dad, who lived till he was 98, loved to invest in the stock market. He was fully invested up to that age. And he [inaudible] for stocks when I was a kid, including the Templeton Growth Fund, run by Sir John Templeton, which he bought almost when it was issued in 1954. And I had the honor later to [inaudible] for Sir John. That was really a very distinct honor because he’s a legend in the investing field. But I was a financial writer for about two decades, and interviewing Sir John for The Wall Street Journal kind of helped tip me over to changing professions because I just loved the way he thought. And I don't know if I could ever think as incisively as he does, but I love that way of thinking.

Holly: Yeah. Wow. That’s great that you got to have such close contact with someone who's so well known in the industry. Can you tell us just a little bit about your approach? I know you're a very strict adherent to value investing, and you think about small and midcap stocks, mainly. You look at their balance sheets, their ratios, and you're looking for also out of favor opportunities, I believe, right?

John: That is very true. And Warren Buffett (Trades, Portfolio) says that he used to look for a good company at a great price, and now he looks for a great company at a good price. And he disparaged his former approach as being akin to cigar butt investing, meaning, I found a cigar butt on a sidewalk, and it still has a couple of good puffs in it. Well, I'm an unabashed practitioner of cigar butt investing. I look for good companies at great prices, and most years, that's been a successful strategy. It doesn't work every quarter, but I think it's a great long-term way to grow profits.

Holly: I see. And what do you think of the performance of value investing lately? Do you think it's going to make a comeback any time soon?

John: Yes, and I may be wearing rose colored glasses here, but I think the comeback could happen as soon as November, around the time of the midterm elections.

Holly: Oh, really?

John: Value investing has been out of favor for longer than ever, but depending on how you measure it, most people could say eight to 10 [inaudible] growth has been outperforming value. And growth has been a scarce commodity, so people have been willing to pay up for it. And I do think that value will come back, and perhaps sooner than most folks are expecting.

Holly: And whenever you're looking at these companies, and you're looking for the out of favor company or the company that has bad news recently, how do you know when it's temporary because I noticed you didn't recommend Wells Fargo (NYSE:WFC) in one of your columns, which is having what I thought might be temporary bad news. Why is that bank not a recommendation for you, and how do you know it's not going to come back?

John: This is always a judgment, but I felt that some of the problems are embedded in their culture, and therefore it would take longer to work out, maybe another year or two years. We do look for problems that are real but temporary. You almost never get a stock cheap unless there are visible problems.

One of my favorite examples is, years ago, we owned a little position in the uranium miner, Cameco. And its principal mine flooded, and production was shut down for a period, and we said to ourselves, this is exactly the kind of real but temporary problem we should be looking for because that mine is going to be down. We don't know if it's going to take a month or six months, but they’re going to be back to producing uranium. And as it turned out, they didn't lose any sales because they had sufficient stockpiles to tide them through the-- I think it was three or four months it took to get them working again.

Yeah, it can't be automatic, like tapping your knee with a hammer and your leg jumps up. But whenever there’s bad news, we look at it, and we ask, does this company have staying power? Does it have a strong balance sheet? Can it get through this problem, whatever the problem is? For example, we looked at Toyota (NYSE:TM), when it had the sudden acceleration problem, but stock never got cheap enough to satisfy me, so we didn't bite on that one. But whenever there's news affecting a company, particularly if it's a company we've kind of had our eye on, we look to see whether it may be a buying opportunity.

Holly: So does that help you when you're also looking for, you say, obscure stocks, because I read all the articles that come through GuruFocus, and a big complaint is there are no obscure stocks because there's just so much information right now. And everybody is just poring over the internet constantly, so it's hard to find a situation where other people aren't going to notice it. So how are you finding situations that other people aren't noticing? Or are you having to look at companies where they're having big problems, but other people aren't seeing how they’re going to overcome those problems?

John: I guess it's just a matter of degree. A lot of the stocks that we favor are followed by no analysts, or one, or two, or three, as opposed to a company like IBM or Microsoft, that may have 25, 35, 40 analysts. So we probably [inaudible] finding something that people are overlooking.

Holly: And another point in your approach that you discuss is that you read between the lines of corporate statements and reports, and I feel like that's hard for the average investor to do. So do you have any tips for people? What can they look for to be able to understand or infer that there is something going on that the management isn't being forthright about, or that you can kind of interpret from what they're saying?

John: That is a great question. I think you have to look for sincerity barometers, and what you want to watch out for is defensiveness and puffery. If a CEO is always blaming his troubles on short sellers, that's usually a sign of weakness because successful CEOs don't have to look for scapegoats. We met once with a manager, and we asked him some moderately probing questions, nothing out of the ordinary, questions that most analysts might be likely to ask, and he got very indignant and stalked out of the room, and said, "I don't have to listen to this, I have a plane waiting for me to take back to headquarters."

We shorted that stock, but there's two sincerity barometers you can look for, one is if the company raises its dividend. That usually means that earnings progress is sustainable because it's too embarrassing to raise the dividend, and then turn around and cut it right away. So no one has a crystal ball, not even the insiders, but if they're raising the dividend, that's a good sign that when they say things look good, they're not just whistling in the dark. And another sincerity barometer is insider buying. Look at what the insiders are doing with their own company's stock. That information is available freely on the internet, and I think most people don't pay attention to it, and they're missing a good source of leads there.

Holly: I see. So moving onto small-cap stocks, this is an area that I don't know as much about, but I know it does has a tendency to do extremely well, and has done extremely well recently. And I was impressed to read that of all asset classes, small-cap value outperformed over a certain time period, I think 57% of times, from some study I read, and that it's been outperforming in historical numbers recently, as well. So what do you think is the outlook for it going forward? Is this going to continue?

John: When I became a money manager in 1999, small-cap value had been out of favor for quite a while because, in the late '90s, big cap internet growth stocks were all the rage. So I'm very lucky I didn't start my firm one year earlier because that would have been the worst year for value relative to growth in the history of separate indexes for monitoring growth. I was lucky that when we launched the firm in late '99, early 2000, it was a period where value did extremely well, and small-cap value did extremely well. Then the past five years, both have been out of favor, and just lately, as you correctly observed, small caps and small-cap value have been heating up again. So these things go in cycles. Nothing is perfect all the time. And I feel that people who try to shift with the winds, and go with what's working lately, often don't do as well as people who have a philosophy and stick to it because if you're good at picking growth stocks, or you're good at picking value stocks, you develop a skill set. And your obligation is not just to see what's working right at this minute, but how can I apply the skills I have on behalf of my clients, or, if you're an individual investor, on behalf of yourself. So we stick pretty much, certainly-- for the part of the portfolio I manage, personally, we stick very closely to value. I guess I think the next two years are going to be a lot kinder to small caps and small-cap value than the last two years were.

Holly: Great. And do you think that has anything to do with the tariffs that are happening in international trade because I read that the small caps are less international, so they aren't going to be hit as much by those kind of events. Do you think that is going to come into play?

John: Yes. However, I think that if the US and China can't reach a compromise, it's going to be bad for everybody and be very regrettable. I think the history of the 1920s and '30s should have taught us that tariff wars are usually a bad idea. So I hope we won't go too far down that path, and I'm waiting with bated breath to see what happens.

Holly: How do you think the stock market is going to react if there does become more of a protracted tussle?

John: I think that a protracted tussle will raise both for Chinese consumers and for US consumers, and give us a little more inflation. So if that happens, probably stocks that are hurt badly by inflation would suffer a little bit, and that might include retail. And stocks that are maybe helped by inflation, like perhaps banks, which may earn better spreads on their loans in times when interest rates are creeping up, which tends to be more in inflationary times, may do a little better. But I think it's just overall a dampener if you have a trade war.

Holly: So if you're going to just keep applying your approach, no matter what happens, as you were suggesting, how can a regular investor, who's looking for small-cap stocks-- what are some tips they can use because I feel like they're harder to research. There's, like you said, fewer analysts on them, and less information and news reports. So what can they look for?

John: Well, I have to plug your website, GuruFocus.

Holly: Go right ahead.

John: You have history on just about every stock, and you can track things over a nice, long period, and a huge number of variables, and it's presented in a pretty understandable way. So I would urge people to look. Also, there are good screening programs on GuruFocus and some other sites that I would suggest investors use. And personally, I think the most important things are not to pick multiple of earnings, and sales, and book value, and to watch the debt load. I do expect, and I expected this in the past year or two, and I was wrong, premature-- what's the difference between being early and being wrong? There is none. But I do think over the next two to three years, interest rates will be rising, and therefore debt will be more clearly a negative than a positive for companies. So, personally, I don’t invest in companies whose debt exceeds equity. And these days, that's a lot of companies.

Holly: I was looking at a Royce Funds commentary, and they were talking about how they're looking at cyclical companies because the earnings there are going to be stronger in small caps than in the defensive industries going forward. Do you think that cyclicals-- do you agree with the idea that cyclicals are the place to have your money right now?

John: I would actually have a balance. But yes, I think the US economy is hotter, and still accelerating. I mean, it's hotter than people think, and still accelerating. So yes, I would definitely have a good slice of cyclicals in the portfolio.

Holly: Okay. And they also noted that they think there's a risk for growth stocks and defensive industries because of the higher valuations and less attractive earnings profiles in those companies right now. Do you think that's true, as well?

John: I think earnings are going to slow down, even though the economy is strong because companies are operating at unusually high levels of profitability right now. Typically, historically, analysts lower their earnings estimates as each year progresses. So they start out really optimistic in January and come down quite a bit by the fall. That didn't happen this year because of tax cuts, but I'd say about three-quarters of the earning progress this year is due to tax cuts. Next year we won't have that force propelling earnings upwards. So I think it will be-- yeah, some of the big growth companies are going to disappoint folks.

Holly: So people who are invested in FANG stocks, for instance, do you think they're going to see any difference? Are they relying too strongly on those kinds that have been moving the market so much recently?

John: My view on the FANG stocks is that it's a very catchy name, but that they're not the same. F is not the same as A, and A is not the same as N, and N is not the same as G. But I happen to like Google, who are now called Alphabet. And I like Apple, who are, I think-- the valuations are not as extreme, and the earnings progress, in my view, is probably more sustainable, whereas Facebook and Netflix I view as more vulnerable.

Holly: Why do you think that Facebook (NASDAQ:FB) -- is it because of all of the difficulty they're having with the government right now?

John: Yeah, and it's not really just with the government. I think they're going to have to spend more to police the website and try to reduce some of the abuses that have occurred from domestic actors, or foreign actors. So that's going to be a new expense for them. And it's also just a pretty expensive stock.

Holly: Okay, and moving on, so you have been doing a study for 19 years of the most loved and most hated stocks by analysts. And this is really interesting because John has found that the stocks that analysts like the most have only beat the stocks they hated the most 10 out of 19 years, and there's been one tie. So what have you learned from your study there that you've been doing for a long time?

John: I really do like analysts. I just don't think anyone, no matter how wise, well-equipped, and well-paid, can predict the future. So I think the study kind of demonstrates that. I look each year at the five stocks that analysts most unanimously adore, and those that they most despise, and the most despised usually have a few sell ratings on them, and sell is a word rarely heard on Wall Street. And as you said, Holly, in 19 times, the analysts’ adored stocks have beaten the despised stocks 10 times, but eight times, the despised stocks have won, and once it was a tie. And the averages aren't too different, 8.85 for the adored stocks, 7.57 for the despised. That’s the average annual return. And the S&P for the same 19 years is up 11.8 on average; those are just [inaudible] averages, not compounded. So the S&P has beaten both the adored stocks and the despised stocks.

So I would say use analysts, by all means, to get information, to get perspective, to get thoughts, but don’t hand over your stock picking to them, because they don’t necessarily do it any better than you would.

Holly: Do you think it’s a good argument for buying a good index fund?

John: Well, I'm wildly prejudiced, since I make my living tracking the stock market. But I wouldn't buy an index fund, personally, and I know that's not the popular view now. Everyone thinks index funds will outperform because of their lower cost, and there are some wonderfully well-run, low-cost index funds, including Vanguard 500, which I guess is the biggest. But I think the challenge and the joy of trying to beat the market is so great that to give that up in advance is something I would never do. And knock on wood, the past 18 and a half years, we've more than doubled, and close to tripled the return on the S&P. I don't know if we can do that the next 18 years, but I certainly look forward to trying.

Holly: Yeah. It seems like finding that good money manager would be the top pick from you. Do you think that looking through their rejects is a good place to start looking for good stocks?

John: That's what I suspected when I started the study, but my data don't prove that. The most despised stocks have also underperformed the S&P by a substantial margin. So apparently the best buys are not those that are unanimously favored or unanimously scorned, they're from among the stocks in the middle. One thing I sometimes look for is I like to see analysts having divergent opinions on a stock because that means it could move either way and perhaps with good judgment and diligent research, you can figure out which way it's going to move.

Holly: Yeah. I feel like every day, I read somebody who says to sell, for instance, Tesla, or that Tesla is the best thing that's ever happened to the planet. So it's hard to say who's correct on certain companies, especially one as embattled as, say, Tesla, for instance. But that's not something you would be interested in, right?

John: I'm personally not interested in it. I think Mr. Musk is erratic, the CEO of Tesla (NASDAQ:TSLA), and a little bit self-destructive lately, and so they're going to have a leadership crisis to deal with. In the meantime, they have high valuations because their cars are so popular and spiffy and cool. But I don't want to pay for glamor. I want to pay for results.

Holly: Right. Yeah, with that kind of management, it's really tough, no matter how the company looks, to get involved. So you also did another interesting study on the lowest P/E stocks, which is really eye-grabbing because they did extremely well, much better than the S&P. The low P/E stocks, since you started studying them, returned 15.66% on average, and the S&P returned 6.02. So should we all go buy low P/E stocks?

John: I do believe in it. It's certainly not infallible, and it hasn't worked as well-- as we said at the beginning of this interview, it hasn't worked as well in the past eight years as it had for decades before that. The research on low P/E stocks goes all the way back to the 1930s, and the concept goes back much further, buy on the cannons, sell on the trumpets. The idea of buying out of favor stocks has been for more than a century, but not until the 1930s did people really start to quantify it. And most of the studies deal with the lowest decile, or the lowest quintile, compared quintiles by low P/E and high P/E.

P/E, for those who don’t follow this stuff closely, is price ratings ratio, the stock’s price divided by the earnings per share. So the more popular a stock is, the higher its P/E is. The higher the hopes, the higher the P/E is. But the reason not to necessarily buy the stocks that people have the highest hopes for is that a stock can only succeed by exceeding prevailing expectations. It’s a lot easier to exceed low expectations than to exceed high ones. So that's why, in my opinion, I've gotten the results in the study that I have. I'm looking at really the bottom 1%, or even a little less, really the outliers. And these are stocks that are just scorned.

For example, last year, there were several coal stocks in there [inaudible] and a few insurance stocks, and during the big bust in oil prices, there were several other energy stocks, not just coal. So they’re always the most unpopular stocks. I publish the results of this every year, except I was temporarily retired for 22 or 23 months as a columnist, but I kept the study going. So in 2008, when the market was down 13%, I thought these very low P/E stocks would be down less because I thought the low P/E would give them some defensive qualities. But they were not, they were down almost 61%, and in light of that gigantic loss, they’ve recovered to both a cumulative return of over 1,400% and a compound annual average return of 15.6.

Holly: So even though they tend to swing more than the market overall, they're more apt to come back. Is that what you're saying?

John: Yes, it's exactly what I'm saying. And these are companies with very visible problems. That's why the stocks are so cheap. So it takes courage to buy them, and if you're a professional investor, it involves career risk. If you buy Microsoft, and you turn out to be wrong, your clients are not going to lynch you, but if you buy some really out of favor stock, they may. Or your boss, if you have a boss, may fire you. So it takes a lot of courage to buy these stocks.

And incidentally, Holly, there's another study, not done by me, but a couple of professors who found that value indexes outperform growth indexes. Value has been [inaudible] on paper over the years. But a growth manager is more likely to outperform his or her index, and a value manager is less likely, and I think that's because it's very hard for a value manager to [inaudible] by these extremely out of favor stocks.

Holly: Also, it seems like the chance that they could go out of business-- the companies that are having this kind of trouble, like coal stocks, for instance-- that they might not come back.

John: Yes. That is a risk, and in my study, I'm only looking at stocks over 500 million, and only those whose debt is less than equity. So I've excluded already at least a third of the stock market by requiring that debt be less than equity, and that it just-- in the stock, we have a certain size, so that reduces the bankruptcy risk some.

Holly: I see, so it is more just that you would need to find a money manager who's okay being able to buy names that aren't as attractive.

John: Yeah. I think if you are researching managers, it's good to look for those who are willing to stick their neck out and go against consensus. The famous manager, Steinhardt, said that there are two things you need to make money on the stock market. One is to have a view that's different from most people's, and the second is to be right.

Holly: Right. So right now, looking forward-- I know you don't want to give away your secrets, but what are the unloved sectors of the market that you're interested in right now?

John: Well, some technology stocks right now are quite out of favor, Micron, which we do own for clients, and Western Digital, which we currently don’t. Okay, so these very low P/E stocks, which I call, in my syndicated column, The Robot Portfolio. I only publish it once a year, it’s the first column I do every January, but one can run the screen any time and see what’s out of favor now. So right now, beside Micron (NASDAQ:MU) and Western Digital (NASDAQ:WDC), you see GameStop (NYSE:GME), which is quite understandable. So much gaming is available online, why would you go into a GameStop store? But they've had a lot of good years after people thought they were washed up.

Some other names that appear on here are Ultra Clean, Mallinckrodt, Hi-Crush Partners, which is a fracking company, Electro Scientific, Green Stone Energy. And you'll notice, a lot of these are pretty obscure, even though they're all over 500 million in market cap. But those are some of the names that pop up now if you're looking for really out of favor stock.

Holly: Yeah, I haven't heard of a lot of those names. But it's interesting because I hear so much about people not being able to find as many out of favor situations. So it's interesting to hear from someone who is finding a lot of them still in the market, and excited about them.

John: I am excited about them, and I, too, am finding it harder to find values than I did. I mean, the market has been up nine years in a row, so I guess it makes sense, but I used to think that people who said, "I have trouble finding bargains now," were just lazy or unimaginative, but now I feel the same way.

Holly: Happens to everyone in this market. And this might not even be something that you think about or talk about, but what do you see happening in the market going forward, with all of the forces that we're seeing right now?

John: Well, a little over four years ago, when the Dow was at 14,000, I predicted it would go to 25,000 by the end of 2017. And a lot of people made fun of me for that prediction, but it was right within four days, the first week of 2018 that we got to 25,000. So I was pretty bullish then. Now, valuations are higher, the fed is tightening, then sometimes behaves erratically, and the market has been up nine years in a row.

So I'm less bullish for the next few years. But I guess if you put a gun to my head, and said, "Well, will it be up or down in the next five years?" I would say up because the American people are still inventive and hard-working, and that's true of the youngest generation, as well as older folks. And there's a lot of innovation going on in this country, technology companies, and biotech companies and elsewhere. So I'm bullish, but I think it'll probably be more subdued, more like single digits over the next few years.

Holly: Great. And last, but not least, do you happen to have-- we always like to ask people if they have any book recommendations that they've been reading lately.

John: I was thinking about what I should recommend, not necessarily among things that were recently published, but it can't hurt to read Ben Graham's book, as edited by Jason Zweig. He modernized the language a little bit. So The Intelligent Investor, even though it's a very old book, is one I'd recommend. My mentor in the business, David Dreman (Trades, Portfolio), has written some books called Contrarian Investment Strategies, and I like those. And especially if you're kind of new to the markets, very readable would be Andrew Tobias's books, The Only Investment Guide You'll Ever Need, and The Only Other Investment Guide You’ll Ever Need. So I recommend those.

Holly: Okay, great, those sound very interesting. Well, it was really wonderful to talk to you. I learned a lot, and thank you so much for joining us with your morning.

John: My pleasure. Thanks for having me, Holly.

Holly: Okay, have a great day. Bye-bye.

John: You too.

Listen to this and other podcasts here.

About the author:

Holly LaFon
I'm a financial journalist with a master of science in journalism from Medill at Northwestern University.

Visit Holly LaFon's Website


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