Q: What is the history of the fund?
Artisan Partners was founded in 1994 to focus on providing high value-added investment strategies to sophisticated investors. I co-founded our team, the US Value team, in 1997 as we launched our first (Small-cap value) strategy. Mid-cap value, in 2001, and an all-cap value go anywhere offering (Artisan Value), in 2006, followed as natural extensions of our research. Throughout, our investment process has remained consistent since inception and the team has a long record of creating value and delivering quality performance results over various market environments, across market capitalization sectors.
Q: How is the fund different from its peers?
We operate using an opportunistic strategy, but with risk awareness. The key to our process is always having an elevated level of risk awareness. When we make a decision on a name, we look to get properly rewarded for the risk we are taking.
The typical performance pattern is not guaranteed in bull and bear markets. We call them risk seeking markets and risk fearing markets, but the market spends a lot of time in-between. In a risk-seeking market, it is tougher to keep pace regarding valuation, business quality and balance sheet strength. In a risk fearing market, we look at the business and its financial strength and shy away.
The reason that the risk awareness approach is important is that investors often sell when things are getting tough and chase names when they are strong. We are not scared of selling during weaker time periods because we tend to show greater relative strength there.
Q: What is your investment strategy?
Our approach is opportunistic, but with a value mindset. We seek cash producing businesses in strong financial condition that are selling at undemanding valuations. We believe these three elements in combination help create a margin of safety and that margin of safety is what helps make money.
The way we find the names with undemanding valuations is look for companies that have shaken investor confidence. Examples could result from a disappointing earnings release, a change in strategic direction, or increased competition.
Because of the higher degree of fear and uncertainty, the stock weakens and a gap develops relative to its normalized earning power. A lot of times the price movement is justified, but there are circumstances where people have overacted. By being patient, allowing the business to get back to normal, and undertaking an analysis to understand what’s going on, there could be an opportunity to make money from that situation.
When it comes to assigning valuations, we don’t use a one-size-fits-all approach. We look at many different valuation snapshots like: price-to-earnings; price-to-book; or price-to-cash-flow. We do that in conjunction with having an earnings range for the company.
The financial strength relates to many things, but it comes down to liquidity and the overall debt makeup of the company. This is something that’s come into vogue with investors after the financial crisis but has always been core to our process. The less debt and the stronger the financial condition, the better and more interesting it is to us.
The benefit of having the company that is in a strong financial position is that it has wherewithal to make acquisitions and take advantage of its competitors’ weakness. That emphasis on financial strength is another critical element in protecting value.
The third element, free cash producing businesses, is an overlay with that related to return on capital as well. The idea being cash generation and return on capital capabilities of the business are really the necessary ingredients for prosperity in any business. Our focus is on the free cash flow generating capabilities of that business and our job as analysts is to assess can this company get back into the right mode of free cash flow generation.
Free cash flow is going to go back into the business and that is why we examine return on capital. One of the most important things to avoid is low return on capital, because with a low level of return on capital, there is value destruction.
As value investors, we accept a lower return on capital as long as we believe we are going to be compensated for it properly. The key is to neutralize time in our favor, rather than have it work against us. We are not market timers, so we focus only on businesses that generate an attractive return on capital.
In summary, our strategy is to seek out the names that provide a clear advantage from a business ownership, financial strength and valuation perspective. A good way to find these names is to look at the “daily downtrodden” - essentially the loser’s list. That’s where fear and uncertainty is and that’s where people are running away from a name or a sector.
Q: How do you integrate the quantitative, qualitative or macro views in your process?
Even though we are not macro investors, we are not ignorant about macro-economic issues. When we think about macro phenomenon we think about the state of the economy and the risk it might potentially present for the portfolio.
Again, so far as looking at how much cyclicality is in the portfolio we don’t want it so superior that we are either betting on a recovery or a rollover of the economy. For instance, if unemployment changes for the worst or for the better, what does that mean for our portfolio? It may be good to have exposure in a particular sector, but we don’t want it so high that it actually has become a macro bet. So, that is where macro comes into play.
We are investing in a stock, which is investing in a business, and to make a judgment about the business we need to have some business acumen to understand it. Part of that is studying businesses constantly. Rather than thinking about stocks, it has more to do with focusing on the business and understanding how it operates and what the economics of the business are. It is about understanding pressures on the business and how a business operates, as well as making a good judgment about a business’ ability to thrive.
We are risk aware so we need to understand that whole context and to make decisions and use our judgment based on what we think a company is worth. One thing I have always said is a good analyst should be able to make a pretty good assessment of the business without ever seeing any numbers.
Q: How do you narrow down your investment universe?
The traditional benchmark for us is the Russell Midcap Value Index. The typical market cap range for our investment universe is from $2 billion up to $18 billion, but we can own a name beyond that price point.
We look at one stock at a time. Ultimately what’s most important to us is to be very selective. Characteristics like our limited number of names in the portfolio and low turnover allow us to be selective to work from an investment execution process. We are not turning the portfolio over rapidly so we are not looking for lots of names all the time. In a typical quarter, we may purchase two to three names.
Q: Can you give an example to illustrate your research process better?
AutoNation, the automotive retailer, would be a good example. It caught our attention because auto sales had been strong for a long time. The availability of financing and strong used car prices had driven a lot of car purchases.
We were approaching the point where car sales look like they were peaking, people financing these purchases were tightening their purse strings, and used car prices were weakening. All those elements created earnings pressure for AutoNation. That caught our attention. AutoNation is one of the best operators out there and they run their business with a keen focus on profitability and free cash flow.
They understand how to operate their business with efficiency and a focus on free cash flow generation and a discipline about running with profit metrics, but the stock was getting knocked down. That’s when we got the opportunity to own the best operators in the business. The stock had been knocked down to near $40, in a tough environment they probably earn around $3 a share. So even in a tough market they are likely to generate healthy earnings.
On a normalized earnings perspective, we were looking at least $4 per share of earnings power. Because they acquired a number of operations over the past few years, and had been investing in some online operations, their near-term earnings power was increasing.
AutoNation is not going to instantly come back to life from an earnings growth perspective, but it’s well positioned for a long run in its business and particularly its leadership.
Q: What other factors do you consider when making an investment?
One of the things that we think is most important when assessing investment is to think about multiple scenarios for the business. We try to take in as many different scenarios as possible that could happen with the business and that’s one of the reasons why we attempt to buy at lower valuation points to allow us to make money under more than one scenario.
As far as potential profitable points, they play into that multiple scenario idea and that’s one of our greatest responsibilities of having ownership in the name. Operating in a risk-aware manner we are always scouting out where we could be potentially wrong and seeking what we call disconfirming evidence about a name or business.
Q: Is diversification part of your portfolio construction process?
We tend to have 40 to 60 names in the portfolio and it is not an index-oriented fund. We don’t manage it to the index. In other words, we are not macro, thematic, or sector weight-oriented investors. We don’t have discussions about being overweight or underweight sectors. The portfolio comes together from a bottom-up basis as a result of stock picking and individual stock picks.
We do believe that diversification is important and so the portfolio does have exposure across a number of sectors and industries. But this is a stock picker’s portfolio, a stock picker’s portfolio that is mindful of what our risk exposure looks like.
If industries and sectors are not interesting from a valuation perspective, we are content with owning nothing in them; and there are lots of industries and sectors where we do own nothing.
Position sizing is determined by this margin of safety criteria I mentioned. In other words, large positions in the portfolio are going to be the ones that show the greatest strength in all three of those characteristics. The smaller positions in the portfolio are going to be names that still meet those criteria, but might be weaker in one of the three relative to the rest of the pack.
Position sizing in the strategy is going to be 1.5-2%. Positions across the portfolio typically range anywhere from 1% to 4%.
Q: How do you define and manage risk?
Valuation, balance sheet and business economics, but what we are thinking about is the risk of a permanent loss of capital. The way we don’t define risk is with volatility.
We think volatility creates opportunity and is something we favor; however, sometimes the movement in a fund scares investors and gets them to do the wrong thing with their money. If we’ve done our homework properly in focusing on key business risk elements when evaluating the intrinsic value of a stock, volatile time periods for us should not be as severe.
