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Buying AAA quality at BBB prices

by Altais on December 11th, 2012

Donald Yacktman is one of the not so written about Investment Gurus, maybe because he is neither fully in typical value camp, nor in typical growth camp.

He, along with team, manages around USD 7 billion through the Yacktman Focused Fund and the Yacktman Fund. In the last five years (to 2011), his cumulative return is 47.2%, compared to -3.1% for the S&P 500. He has also beaten 99% of his peers in the last three, five, ten and fifteen-year periods. (source: gurufocus)

I had earlier also read his interviews, but could not fully appreciate the wisdom of his approach. My recent experiences in equities and vicarious learning from other investors I observe, led me to re-read his interviews. I have got fully hooked on, and have been reading all I can find on his approach. I would advise you to do the same!

I read the following:

http://www.gurufocus.com/news/187901/donald-yacktman-interview-with-gurufocus

http://www.gurufocus.com/news/171597/investing-great-donald-yacktman-answers-gurufocus-readers-questions

http://online.barrons.com/article/SB50001424052970204582404576214643228390606. html#articleTabs_article%3D0

http://www.yacktman.com/pdfs/flexiblevalueinvesting.pdf

http://www.yacktman.com/pdfs/value_investor_20091231.pdf

In the spirit of Lawrence Cunningham collating excerpts from various annual letters of Warren Buffett and neatly arranging them in relevant headings, I have attempted to do the same.

Investment Goals

Our process is basically is a function of our goals. The first one is, protect the clients’ capital over time. This is a portfolio level goal, and understand that not all investment ideas will work out. We have a significant amount of our personal net worth in our strategies and we manage them as though we were managing a client’s entire net worth.

The second goal is obtaining what we’d call equity-type returns, approximately double-digit annualized.

Our third goal is to beat the (S&P 500) index over a full peak-to-peak cycle. If you go back and study our results from the times when the market has peaked, I think you’ll find that the performance has been very, very good. More importantly, I think that our risk-adjusted returns are really excellent, and that’s what it’s all about.

(Most investors focus on 1st and 3rd goal, 2nd goal is equally important.)

Defining Quality of Business

We think quality is a combination of characteristics. We like to start with high return-on-asset businesses. We also like predictability. We prefer businesses that have fairly stable operating results in both good and challenging economic environments. Below is a simple chart we use to demonstrate characteristics we like.

We believe that companies that have low capital intensity and low cyclicality like Coke (KO), Pepsi (PEP), or Proctor & Gamble (PG) have the ability to earn some of the highest returns. What you’re looking for is both the low asset requirements and low cyclicality. It is at its best when a company sells a disposable product or a recurring service. We also like to see a large market share.

We’re not usually looking for the scruffy cyclical or turnaround story, but for businesses with high market shares in their principal product or service lines, with long product cycles but short customer – repurchase cycles, and with relatively low capital requirements that allow the company to generate high cash returns on tangible assets while growing. We’ve always considered businesses requiring enormous amounts of capital for fixed assets, especially when they’re economically sensitive, to be at a big disadvantage. That’s why something like the airline industry has been a growth business for most of the past 100 years but doesn’t make any money for shareholders.

Something we find that isn’t often fully recognized by the market is how incredible the returns on the marginal unit sold can be for low asset- intensity businesses with strong market positions. That’s why growing businesses can pay off so well – you get the one-time appreciation from a lower base to a higher base, but on top of that you get the compounding effect of significant operating leverage.

The Triangle

Basically, we are investors in businesses and we view the selection process as though we were buying a long-term bond. Our logo is a triangle.

1. The base of the triangle is a low purchase price. We look at businesses as if we were going to buy them and own them for a long period of time. We look at the rate of the return we would earn and the quality of those businesses. The higher the quality is, the lesser the required rate of return. It’s very much like a person buying a bond. But we don’t like to calculate returns to the fourth decimal; we try to make sure we have a lot of room for error.

Think of everything being priced against the long-term Treasury, and we want to see a large spread over what the long-term Treasury yield is.

Then we try to get as much as we can of the other two sides of the triangle, namely good businesses run by shareholder-oriented managers.

2. On the good business side, our sweet spot is businesses that have low capital intensity and low cyclicality. One of our largest holdings, for instance, is Coca-Cola (KO). It fits our criteria very well. We will also move away from those components if the rates of return are adequate for the additional unpredictability that comes with the business, whether it has more fixed assets or more economic sensitivity. We have moved in both directions, but we don’t typically invest in businesses that have both enormous amounts of fixed assets and cyclicality. The airline industry would be the classic example. Coca-Cola is the opposite side of the grid. If you think of it like a bond, we’re buying high coupon bonds.

3. The third part of the triangle is the management. The difference between a stock and a bond is with a bond, the investor reinvests the cash flow most of the time. In the case of an equity owner, a lot of the reinvestment is done by the manager, so we like to evaluate the manager on the basis of how well he has invested cash in the past. We look at five basic options the manager has. The first option is putting the money back into the business through R&D, marketing, cost reduction, distribution, etc. The second option is making acquisitions, but the acquisitions should be synergistic and the manager should not pay too high a price for them. The problem is, in a lot of cases, the egos of managers get in the way of doing a proper job. Another option is buying back stock, which is buying more of the same. The fourth is paying a dividend and the fifth option is paying down debt or letting it accumulate, which is pretty much the same thing.

(Thinking of equities as bonds is great, with accepting lower returns for high quality & predictable business, and swapping only when risk reward greatly in favour)

Forward Rate of Return

This number is a calculation of a normalized free cash flow yield plus real growth plus inflation. If the business is stable, this calculation is fairly straight forward.

<Nov 2009> The first thing we do is normalize what we think the company’s earnings power is. A lot goes into that, but it essentially means looking at what the business has traditionally been able to generate over time and adjusting for various factors that might make it more or less attractive going forward. We then estimate the percentage of those normal earnings that the company will keep after things like capital spending and investments in working capital, resulting in a free cash flow number we can divide by the current market value to get a freecash- flow yield. On top of that we’ll add inflation and the annual growth in free cash flow we expect in order to arrive at our estimated rate of return.

As an example, Coca-Cola [KO], whose free cash flow is a high percentage of net income, trades at a free-cash-flow yield on our normalized numbers of about 5.5%. Inflation adds another 3% and we assume another 2% in organic growth, so that gives us an estimated compound annual return of 10.5%.

Compare that to the S&P 500. We estimate normalized per share earnings for the S&P 500 of about $60, of which you keep maybe 45% as free cash flow. At 1,100 on the index, the resulting $27 in free cash flow gives you a 2.5% freecash yield. Add on 3% inflation and 1.5% for cash-flow growth, and we believe the average investor today on a cash basis is looking at a 7% annual return from the market.

Given our belief that Coca-Cola is a higher-quality business with lower risk than the average S&P 500 company, it should trade at a premium to the market, not a discount. When an excellent company like this trades at a solid annual rate of return and that kind of discount to the market, that’s attractive to us.

<Apr 2012> For instance, on the S&P 500 we would normalize earnings. We would then calculate what percentage of those earnings are not reinvested in the underlying businesses and are therefore free. Historically, for the S&P 500, this has been just under 50% of earnings. Currently, we expect the S&P to earn about 70 on a normalized basis, a number which is far below reported earnings due to our adjusting for record high profit margins. $70 X ½ / 1400 gives you a normalized free cash flow yield of approximately 2.5%.The historical real growth rate of the S&P 500 is about 1.5%.

Assuming an inflation rate of 2.5%, the forward rate of return on an investment in the S&P 500 is about 6.5% today (2.5% free cash flow yield plus 1.5% real growth plus 2.5% inflation).

One thing I would like to point out is, if we’re looking at a company and it has a forward rate of return of 12% and another one has a forward rate of return of 20% and we buy it, we don’t necessarily get that extra 8% a year right away. The market might not recognize what we see and the market may take a few years to play out. The good news though is that 8% a year of excess return is accruing in the background. Then it will just explode to the upside when the market finally realizes what we realize. We’re not really worried about whether or not the market recognizes it right away. The good thing is when the market does finally recognize it and also presents us with other opportunities, we are able to move rapidly from one to the other

(Look at current free cash flow yield and not 5 years in the future as the starting expectation – at 5% free cash flow yield, it will eliminate paying more than 20 P/E for any stock as FCF will be lower than Earnings)

Fascination with Consumer Stories

Most of the consumer businesses we own make disposable products with very little economic sensitivity. The consumer goods I’d still be somewhat concerned about in this economic environment are those that have long lives, like autos and appliances, where the replacement decision can be easily delayed.

This goes back again to what we said earlier about the virtue of companies without heavy reinvestment needs. The average company has to pour more than half its earnings every year back into the business to maintain itself. If you don’t have to do that – like most consumer products companies, for example – you have more to invest in new businesses, to give back to shareholders, or to keep on hand for a rainy day. That’s a huge advantage that we don’t think people are correctly evaluating.

Assessing Management

The most important aspect of analyzing management is how well they’ve invested cash in the past, not what they say they are going to do. Because we typically own companies generating a lot of free cash flow, we’re in trouble if management doesn’t allocate that cash wisely.

(See what I do, not what I say)

Swapping quality for valuations

There is no magic decision point, however when the potential rate of return becomes significantly higher on a less predictable security, we may be willing to trade quality for valuation. Each situation is unique to the security we appraise. In 2008-2009, we think we generally moved from high quality to slightly lower quality that was offering significantly better rates of return. We generally avoid low quality unless we expect that we can manage the downside and get paid extremely well compared to alternatives.

We generally demand an annual high single-digit or low double digit forward rate of return for a high quality business and more for one we think is lower quality.

Edge over Market

People often ask us what unique insight we have in buying something like Pepsi. It’s almost as if to be considered astute, you need to have some complex thesis that no one else comprehends. The fact of the matter is that there are times when quality businesses are undervalued and we just have to be smart enough to recognize when that is and own them. It doesn’t have to be more complicated than that.

There was an article in the 1930s, describing what a great growth story Coca-Cola was. It went on to say, though, that it was too late to benefit on the stock because the story was so well understood. Sometimes the market understands, and sometimes it doesn’t.

On Selling

Many people set a price target by saying, “Okay, I think it is worth $X.” Well, we don’t think that way. We look at what the forward rate of return is, stack it up against other investments and determine which one is the highest and which one is the lowest and what risk we are taking to get that rate of return. We account for things like leverage, cyclicality of earnings, and the quality of the business.

A sale is triggered by two things. If the rate of return is not sufficient or if there is a better opportunity elsewhere with a larger margin of safety to get a similar or higher rate of return, we’ll sell it.

On being in Cash

But in the present environment the dollar is being deflated and the Treasury rate of return is very low. At some point we say, “Hey, the rate of return of an investment is not acceptable to us.” We walk away. It’s the hardest thing to do because we have to wait for something else to come along. We can’t create something out of nothing.

Unfortunately, in an environment where everything goes up, is fewer of these returns are satisfactory and we end up more heavily in cash. It’s not that we’re trying to time the market; it’s just there’s nothing to buy.

But the reality is that in a typical year, the average large-cap stock fluctuates about 50% from its low to its high. If you’ve done your homework and you’re patient, more than enough opportunities will come along.

(Be patient, prices will come to your buy price)

On Diversification

We’d love to be widely diversified if everything had the same return characteristics, but they obviously don’t. There are some rules on diversification for mutual funds, but we basically rank the stocks that meet our minimum-return requirements and try to have as much of the portfolio as possible in the companies with the highest expected rates of return, adjusted subjectively for risk. Right now that leaves us with around 50 positions in the Yacktman Fund, with close to 60% of the portfolio in the top 10.

In our less-restricted accounts, we have 75% of the portfolio in the top 10 – we’d sleep well at night with that at 100%, but that doesn’t work for most clients. As a result, we spread the last 25% in names that are typically smaller and with very high potential, but with more expected variance in the outcome.

Risk Management

Ultimately, in our minds, risk is losing money. There are two ways to minimize risk. One is by making sure the forward rate of return is significantly higher than Treasuries or at least is high enough on a historical basis to justify making the purchase. The other thing is to take into account quality measures so the amount of risk taken as a business owner is warranted. We take into account things like cyclicality, leverage, management and other kinds of considerations that would influence the rate of return. We used to comment on the difference between Coca-Cola and Tyco as being like comparing a AAA bond with a single A bond. We basically come back to the grid of looking at the forward rate of return and level of quality.

To us, that’s risk management, looking at the individual security and making sure we were correct about our assumptions and know what we bought and have a high degree of confidence we are going to get our money back in the worst-case scenario.

(Valuations and Quality as cornerstone of risk management)

Avoiding Value Traps

I tend to favor “escalator”-type businesses over what I call “moving-sidewalk”-type businesses. Businesses that earn high returns on tangible assets and can grow their units have an edge over the other kind.

We think the best way to avoid a value trap is to have a company that produces durable free cash flow.

That doesn’t mean you can’t make money on the slower-growing or non-growing businesses, if you buy them cheaply enough. That’s the key. But what happens is, you get that one-time revaluation, you need to get it quickly, and once you get it you need to move on. A value trap, to me, is a grubby business not bought cheaply enough.

Time will tell.

(Quite in line with our earlier post http://altaisadvisors.com/blog/2012/04/11/hidden-value-or-value-traps/)

Macros

Another one is that our attitude has been… we should focus on things we can control. We believe you can find investments that could do well even if the economy is challenging or the market suffers. Even though the U.S. stock market has done poorly since 2000, we have achieved strong results because we focused on and invested in individual securities. We can set the sails, we can’t control the wind. It’s fun to talk about the economy, don’t get me wrong… I’ll be happy to answer your question directly. But when push comes to shove, it’s what you buy and what you pay for it.

We spend almost no time trying to forecast things like inflation, interest rates and the value of the dollar, but we do try to pay a lot of attention to cycles in how we normalize earnings. If margins are at a peak, for example, we don’t necessarily assume they’ll stay there forever. That alone kept us out of a lot of the financials that got hurt the most in the meltdown.

Overall Market Valuations

Ultimately, however, investing for us is about valuing individual businesses. If we find good investment opportunities we are not generally concerned if with think the overall market is overpriced.

Taking advantage of Blood on the Street in 2008

Going into this downturn, we had some cash, but we also had a lot of defensive stocks, the Cokes and the Pepsis (PEP) of the world, and these companies initially held up quite well.

We were able to take advantage of the downturn by using our cash to purchase bargains.

After the cash was gone, we were able to essentially rotate out of consumer staples, the Cokes and the Pepsis that had held up well, and rotate into consumer-based cyclical stocks. Some cyclical stocks were trading at extremely high cash yields. So we bought USG (USG), and the retailers Williams-Sonoma (WSM) and Abercrombie & Fitch (ANF). By the time it was all done, we were buying Bank of America (BAC) and Barclays (BCS). So we were able to take advantage of the pricing disparity. Since the market’s bounce off the bottom, those stocks have performed quite well. The other area we bought into heavily was media — companies like Viacom (VIA) and News Corp. (NWS). We’ve managed to outperform on both the downside and the upside.

Looking forward, we will objectively examine our options. If we are going to get the same return, we’d rather own Coke than a bank stock or a cyclical stock. At that point, we can move back into the Cokes and Pepsis of the world and be protected.

(Note the sequence – Consumer Staples, Consumer Cyclicals, Financials)

Avoiding reversion to mean for fund managers

We think continuity of the investment team is one of the keys to long-term success. All of the key members of our investment team today have been at the firm for more than a decade and are significant owners of the firm. We also think good investing is about being flexible. Many firms have experienced performance reversion because what is successful in one period often fails to sustain. We also think it is important to recognize that producing strong results over time does not mean that your investment style will work in every short period of time.

Motivation

I’m motivated just to try to be better. I see this world as imperfect people helping other imperfect people move toward perfection, and I just want to be better in all aspects of my life: investment; as a husband; as a father; as a grandpa; and as a member of the community.

Multiple Contraction at Walmart

Over time the multiple declined as investors slowly recognized the growth would be modest. The business executed fairly well during the period of multiple compression which is probably why the multiple came down slowly.

Thoughts on RIM (Blackberry)

Here’s the dilemma with it. It has a wide array of possible outcomes. We felt we had protection with the balance sheet and customer base, but given the history of dramatic leadership change in the cell phone industry, people are nervous. I think you have three pieces. You have the cash and excess working capital, you have the patents and you have the embedded customer base. The real problem has been delays in getting a new phone to market. The length of time without a viable product has caused the customer base to become an ice cube on a hot day.

(I like the phrase “ice cube on a hot day”)

One Comment
  1. anil1820 permalink

    Vishal

    Thanks for sharing this. For me “Edge over Market” section was really eye opener. I generally do research and investment of those stocks which are not covered by any analyst or currently unloved, thinking what value can I add to stocks which are widely covered. Having said that, I think to add value to such stocks require much more experience that unloved stocks.

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