Q: How has the fund evolved in the last two decades since its inception?
Since the fund’s inception, the investment process has emphasized analyzing balance sheets to discover under-appreciated assets, as opposed to focusing on income statements; the traditional research approach of most investors.
It is important to note that the fundamental investment process has remained rooted in balance sheet analysis throughout all the changes of ownership of the fund from Wachovia Asset Management, to Evergreen and now with Wells Fargo.
At the time of the launch in the early nineties, the fund was named The Biltmore Special Values Fund. Since 2002, Jim has been leading the investment strategy team and prior to that, he had been a member of the strategy team for five years. Throughout this time, we have lived through more than one economic cycle—a couple of economic downturns and a couple of economic recoveries. We have also seen interest rates in the mid-single digits and in the low-single digits.
Q: What investment philosophy underpins the fund?
Over time we have created a stronger identity of who we are. While the philosophy has not changed, we have always maintained a strict focus on balance sheet analysis. Since 1994, every member of the team running this strategy has been a Certified Public Accountant and that has infused the process.
Moreover, we have become more focused on what we are good at; keeping track of hidden assets, finding the extra increment of value, either from a tax asset or a mismatch between Generally Accepted Accounting Principles (GAAP) based accounting and cash flow based accounting. But, none of that matters if one does not have a high degree of accuracy in terms of estimating future operating earnings.
Some of the underlying principles of our philosophy stem from our tenure and ability to analyze where we make more mistakes than not. With that learning process in mind, we have become more focused on higher quality companies that have stronger balance sheets along with an identifiable, sustainable competitive advantage.
We believe that we have an inherent advantage in valuing assets on balance sheets because market participants frequently misprice assets, and our process helps us in exploiting this inefficiency. As long as we continue to exploit that, we will be able to create additional returns to widely followed indices and distinguish ourselves from our peers.
Q: How does your philosophy translate into a consistent investment process?
First of all, we are always focused on three key criteria that need to be present, and these are distinctly different from the market view on equities.
We start with the balance sheet, which we see as the platform giving us stability. What everybody wants to see in a management team is the freedom to create value for shareholders. Therefore, we pay attention to what is special about that company from a long-term competitive advantage perspective.
Next, we focus on long-term free cash flow rather than reported earnings, and that is where our accounting background has an impact; not on determining what is likely to happen next quarter, but rather with a perspective based on a three-to-five-year outlook.
And the third key criterion for us is to focus on reward in the context of risk, one company at a time. We look at the upside potential for the stock but we also look at the downside and we relate the two in a ratio that helps us in comparing various investment opportunities. If the upside is 100% and the downside is 50%, the ratio is a two-to-one.
This metric serves as a yardstick in comparing hundreds of companies and getting a sense of different degrees of risk that might be worth taking or not.
The procedure is not just about uncovering hidden value, but it is often a great way to uncover hidden liabilities. As far as assets are concerned, there is often hidden value in the tax category, and we are always looking for companies that use their balance sheets to create value.
Q: Would you share some examples of finding hidden value in balance sheets?
About 16 years ago accounting rules changed. For the purposes of GAAP accounting, the accumulated goodwill through the purchase of assets is no longer deductible. However, the goodwill is still deductible for tax accounting. Quite often, when companies make large acquisitions with cash, they are picking up several millions of dollars of goodwill along the way. While this is not the same as having money in the bank, the net present value of the tax assets can be quite significant, especially in the long term.
Over time, an acquisitive company can almost perpetually lower its cash tax rate to several percentage points below its reported accounting based tax rate. The company that pays 5% less taxes than a similar one has quite a bit more free cash flow on a perpetual basis and is valued more in the market.
There can often be hidden liabilities, so we are always trying to see where those might exist. For example, these liabilities can be found in the pension account. The underfunded pensions do not necessarily create a cash strain on the company, but if interest rates were to change in a certain way, or the market environment changes, something that seems benign can become a serious problem. Something that may show up in our upside analysis can become a big negative when we think about what could go wrong in our downside analysis.
To give another example, a company may have a joint venture that creates a few million in equity income each year. That may be completely unrelated to how much capital that company may have put into the joint venture over a number of years. The bottom line is that you have to do a lot of digging in the same way as an accountant would and determine a broad and more complete picture.
Furthermore, companies that incentivize their employees often use cash or some form of stock based compensation. Although that may be totally different from debt, we still view it as a liability and make sure that we are accounting for that. The shareholder dilution is likely to pick up in certain downside scenarios for companies that are heavy stock option issuers.
As a whole, we want to make sure we view equity investing in a broader way, rather than being too rigid. But in general, we do not focus on companies that are highly capital intensive or on companies that are highly levered.
Q: How is your research team organized?
Our global research team is organized along sector lines. We have a 14-person team consisting of four portfolio managers, nine analysts, and one research assistant. Some of those analysts are primarily focused on international and others on the U.S. based companies.
In our conversations and weekly meetings we take a global view on investment ideas. Not only does this help us in understanding what goes on in the world, but it also enables us to be better stock pickers in our respective geographic areas.
Everyone on the team uses the same set of principles to generate investment ideas. At the beginning of every year, each analyst has a well-defined coverage list. Then, over the course of the year, there may be some names that have been acquired or that they want to put on the back burner, but we do not revise our coverage or our investment focus every week.
Our analysts have in-depth knowledge of about 60 companies in the coverage and because of the stability of our investment platform that allows us to execute our intricate strategy to generate alpha. Each week, we regularly check with each analyst the names on the coverage list, giving higher priority to any opportunities that may be bubbling up to the surface.
Only after we have reviewed the evolving dynamic in detail, we decide what analysts will be working on for the next week or two.
We look over the analyst’s models to make sure we agree with the assumptions that have been made. We either agree to buy the stock in the market or we agree that a certain idea is attractive and we want it in the portfolio, but we need to wait before we can make it happen.
Q: Can you share a company that met your criteria?
WD-40 Company, the maker of specialty maintenance products, was originally added to the fund in 2007. The company has been around almost 100 years and the balance sheet is nearly debt free. In fact, there is really no replacement for the company products.
From our perspective, the business model was not sensitive to the economic cycle and in combination with the balance sheet the company offered an attractive investment opportunity. What is more, we felt that the company could withstand turbulent times, especially during the economic downturn in the following three years.
In early 2010, we increased our stake after the company clarified its strategy. Management was going to focus on its core products and run the personal care product portfolio for cash. Additionally, they were ready to expand their presence in emerging markets. Over the past decade, the company had spent significant capital to build infrastructure.
When expenses fall well ahead of revenues, we get excited. The company continued its heavy investment in foreign markets, but international revenues had not become significant so far. When revenue growth was ready to emerge in those markets, the marginal profitability on those incremental dollars was going to be quite high.
For a long time, the WD-40 product line has been a profit-maker for the century-old company and management began to develop an adjacent line. By using the WD-40 brand name equity, the company was ready to penetrate the motorcycles and bicycles market. Not surprisingly, the company was in a net cash position.
The reason we increased our stake in 2010 was because there seemed to be so much the company had in its own control.
Q: Were there any other factors that motivated your decision to increase exposure?
To sum up, the financial flexibility in 2010 was only going to increase. The new product line combined with the de-emphasis of the personal care line was likely to result in superior profitability, growth in operating earnings, and a tremendous amount of free cash flow.
We believe the investment thesis is still intact and there is even more room for the stock to grow. The stock was trading in the thirties when we first started buying it, and since we increased our exposure in 2010, the stock has steadily climbed in the eighties. Along the way, the company has continued to pay healthy dividends and bought back shares, reducing to 15 million from 17 million only a few years ago.
To our delight, the company’s financial flexibility has only grown in the last five years and we believe that the management is not likely to make a subpar acquisition and destroy the earnings stream.
We believe that there are two possible outcomes in the long term, and both are positive. The company may pay a large one-time dividend or may end up selling to a larger company at a premium; either of these outcomes will be favorable to us.
Q: What is your portfolio construction process?
We begin with the names in the index, but through quantitative screening and market cap segmentation, we can trim the number of names to focus in the index by half.
So, we start with names in the index and then focus on companies that are in market cap between $150 million and $4.2 billion. According to our prospectus, 80% of the portfolio must be within that market cap range.
On that shortened list of companies, every analyst in the team will be responsible for a particular sector, with a focus on companies that possess profitability, strong and sustainable free cash flow, and balance sheets with flexibility.
We like to be diversified and our portfolio is built stock-by-stock and we do not like to have large sector bets or industry bets. We do not want style factors to be the main driver of alpha generation in the portfolio.
We will often resort to selling if we feel it is the right thing to do and we do not mind if cash builds in the fund. Still, we do not want cash to become something in the portfolio that serves as an alpha generator or an alpha detractor. We would rather express ourselves through stock selection.
We also have an active reallocation discipline. We are ready to act when we find opportunities to reallocate capital in order to improve the risk-reward profile of the portfolio.
Q: Has merger activity in the industry impacted the fund?
Merger activity has been beneficial to the fund. This is a powerful factor that can have significant impact on returns when it happens.
Looking back over the past 15 years, we have had at least three or four acquisitions in the portfolio per year. We need to replenish about one third of the portfolio every year, so we cover ten times as many names.
Historically, portfolio turnover has run in the 40% to 50% range, which tends to be a byproduct of our three-to-five-year time horizon and the fact that, over time, we have been a significant beneficiary of merger activities.
Q: How do you manage risk?
We look at risk at many levels, starting from the individual stock, sector and at the aggregate portfolio level. Rooted in balance sheet analysis, our investment process also offers us another level of risk control because our priority in the fund is not to lose money.
Above and beyond that, we rely heavily on our risk team and its statistical analysis searching for risks and exposure in unusual places. This analysis points us where our risk exposures are based on various perspectives.
In addition, not being a momentum investor, we avoid financial leverage in our fund, which in turn offers us another level of cushion in times of market volatility. Our risk team helps us in understanding what our performance drivers have been in good and challenging times, and how style-related factors have influenced our performance.
Overall, from security selection to the price we pay for a stock, the risk control process adheres to our discipline in selecting quality companies that have financial flexibility in weathering unpredictable times.
