Q: How has the fund evolved since inception?
The fund was established on June 10, 1996. Originally, it was run by another team and had a slightly different investment style. It was a deep value, concentrated fund, which owned less than 30 holdings.
I joined the organization in 1999 as a portfolio manager; Mike Johnson joined the organization in 2005 and became co-manager in 2007. In mid-1999, we opted for a diverse sector exposure and increased the holdings to a range of 60 to 70 names. We also felt that the fund needed to be fully invested, so we decided to keep less than 5% in cash.
Our concept is to own good businesses at attractive valuations. We aim to find quality companies trading at a discount to our estimate of their fair value.
Q: What core beliefs drive your investment philosophy?
Our objective is above-average returns, below-average risk, and long-term time horizon. A key aspect of our philosophy is the belief in active management. We believe that small caps are a great asset class for an active manager. In this asset class, there is a higher probability for companies to be mispriced. Through fundamental bottom-up research and through our ability to understand the companies, we can identify good investments and add value.
We are value managers, but we don’t just focus on cheap stocks, because we want to avoid value traps. Instead, we look for a combination of good business and attractive valuation. Good businesses have the tendency to appreciate over time and to provide more downside protection in weak economic environments. Stocks trading at a discount produce outsized returns as the value gap closes and they also offer a margin of safety, which helps to control risk and manage volatility. Our principle is to purchase an appreciating asset at a discount to its fair value.
We like to understand the business that we own and to be able to figure out where that business is headed over the next three to five years, so visibility is important to us. We like owning quality businesses that generate good returns on capital. We look at the financial statements, particularly the balance sheet and the cash flow statement, because we feel a high quality company generates free cash flow over the long term and has low debt.
Although we don’t draw a particular line regarding the appropriate level of debt, we make sure that the company has enough free cash flow to comfortably cover the interest expense over the long term. The debt of the companies we own tends to be less than that of the benchmark.
Q: What is your investment process?
We are primarily a bottom-up, fundamental research driven firm. We look at stocks as individual businesses, but we don’t ignore the macro picture. We incorporate our macro view for the industries or sectors that might be affected as a part of the company research process.
We begin our investment process with about 1,900 to 2,000 stocks. We utilize a quantitative process to discover companies that look attractive from a historical and financial perspective. We also find investment ideas through company research, discussions with company management and analysts, as well as from attending conferences. We pay attention to market sectors and aim to understand what’s going on in those sectors. Essentially, we find ideas by accumulating knowledge.
The analysts on our team are primarily responsible for identifying and researching investment prospects and for monitoring the holdings in the portfolio. When they find ideas that they are interested in, they write a short report describing the basics of the company, the opportunities, the risks and the valuation. Mark and I read the reports and discuss with the analyst the pros and cons of each potential idea.
We prioritize the analyst’s research, eliminate some of the ideas, and clear the analyst to go back and perform a full fundamental review on one or more of the businesses. That review involves going through the 10-Ks, 10-Qs, the earnings reports, Wall Street research and the company’s presentations. We also talk with Wall Street analysts and/or the company’s management team.
After the analysts have completed a full report, they distribute it to the entire investment team. After we have had a chance to review the report, all the analysts and portfolio managers meet to discuss the idea. Everybody on the team has the opportunity to ask questions and to play devil’s advocate to that idea. At that point, the formal research process on the idea is concluded and Mark and I determine whether or not to include it in the portfolio.
The team process is important in vetting ideas; it is one of our key risk control mechanisms. Even in our weekly news meetings, the entire team discusses and evaluates companies and earning releases and asks critical questions about the businesses we own. Our team is incentivized based on the overall strategy performance, so everybody has a vested interest in the outcome that we deliver to our clients. Those discussions are designed as a way to spot potential risks in proposed ideas or in current holdings. We feel, however, that the final decisions should be made by the portfolio managers.
To summarize, our process is both quantitative and qualitative. On the quantitative side, we look at valuation, returns on capital, interest coverage, earnings estimates and long-term growth. From a qualitative standpoint, we need a good understanding of the business. We look for visibility and consistency over the long term. We also evaluate the experience and the strategy of the management team, its openness, and its results.
Q: Could you illustrate your research process with a few examples?
In the last couple of years we’ve owned Dorman Products, a consumer discretionary company participating in the aftermarket for replacement parts in cars and light trucks. The initial idea for Dorman came from the quantitative side. The stock historically had high returns on capital with solid growth. It screened out from a financial standpoint as a higher-quality company.
Initially, we were attracted by the consistent performance. When a car breaks down, it needs to be fixed and parts have to be replaced, so people are dependent upon Dorman. It is a less cyclical consumer discretionary story and we found solid consistency and visibility over the long term.
Another positive factor was that the balance sheet had no debt. They also have a great management team, which owns about 11% of the company’s stock. We feel comfortable with management teams that are also shareholders, because it means our and their interests should be in alignment.
Q: Why do you believe that Dorman represents a good growth story?
Dorman has been growing organically at a slightly faster pace than the industry. It has a small share of the total market, so it can continue to increase its share. The size of the auto and truck aftermarket business is about $350 billion, while Dorman has less than 1% share.
The company has done a great job coming up with products that are equal to or better in quality than the original equipment manufacturer parts. It has good relationships with the distribution channels and has been able to organically grow its business over the last 10 years. With such a low share of the overall market, it still has a long way to go. We believe that it can continue to develop products and grow organically for a long time period.
Q: Is distribution an issue for Dorman?
Distribution has been an issue for the stock lately, but that issue has provided an opportunity to add to the stock. We believe that many of the controversies surrounding AutoZone, Inc or O’Reilly Automotive Inc are misunderstood. We believe those issues are more related to commodity products rather than the higher value-added products produced by Dorman.
Even if AutoZone or O’Reilly’s business declines, mechanics still need replacement parts, so we are agnostic as to where they get it from. At the end of the day, cars will continue to break and Dorman will continue to make parts. The delivery method may change as time passes, but we are confident that there will be demand for the products. In the case of significant problems at AutoZone or O’Reilly, the notable risk is the inventory that would need to be cleared out. That could cause a short-term hiccup but isn’t indicative of the health of the auto parts market.
Q: What is the manufacturing base of Dorman? Is it U.S. or international?
A unique feature of Dorman is that it does not do its own manufacturing; it outsources it. Dorman does the engineering and other companies manufacture the parts. The company has a diverse manufacturing base, so it can be flexible if the environment changes, because it doesn’t have fixed investments that couldn’t be moved.
About 29% of Dorman’s manufacturers are in the U.S., while the rest are primarily in China. No manufacturer accounts for more than 10% of the total production.
Q: Can you give one more example from another industry?
Another example would be American Woodmark Corporation, a manufacturer of kitchen and bath cabinets. We were looking for businesses with some exposure to housing, but we weren’t comfortable owning an actual homebuilder.
While we were exploring this theme, the sector analyst came across American Woodmark. At the time, half of its sales were from repair and remodeling and half were from new construction. So the company had exposure to new construction, but revenues were somewhat more stable and predictable.
The company is a strong free cash flow generator with good market share. The other characteristics that we liked were the solid financial performance including return on equity, the lack of the debt, and the level of net cash. It was evident that they were looking for an acquisition, so we discussed the cash situation with the management to understand the parameters and how they would utilize the balance sheet.
We purchased the stock last year and later they acquired RSI Home Products, a lower-end cabinet manufacturer. American Woodmark didn’t have products at the entry level, so it filled out its product line. RSI had higher operating margins and added over $1 billion of sales to American Woodmark. However, the acquisition also increased its leverage. The exposure to repair and remodel will increase, with the revenue split moving to about 65% in repair and remodel and 37% in new construction.
The market liked the deal and the stock rallied substantially on the announcement. We trimmed the position, taking advantage of the rally. The stock backslid in the beginning of 2018 due to rising interest rates and the concern about the impact on the housing market. The stock fell back to a point where it again became attractive to add to our position.
Q: How do you construct your portfolio?
We have a long-term investment horizon and our annual turnover is 25% to 35%. We evaluate companies on a three-to-five year horizon. If the investment thesis remains intact and the valuation is attractive, we are comfortable owning companies for long periods of time.
We keep cash below 5% and our sector allocation is similar to that of the Russell 2000 index. We don’t feel that our aptitude is making market calls and we don’t think that we can consistently outguess the market from a sector allocation standpoint. Instead, we dedicate our efforts to selecting good companies. We feel that we can identify good companies over the long run and do that consistently, so stock selection will likely be the key driver of portfolio performance.
For individual positions, we hold at least 1% and can go up to 5% in a position. Typically, our largest position would be about 3.0%. In terms of sectors, we aim to have exposure to all the economic sectors. The sectors that are more than 10% in the Russell 2000 can have a weighting of 75% to 125% of the benchmark. For the sectors under 10% of the Russell 2000, there is no outside bound or minimum requirement.
Q: What factors drive your sell discipline?
We have an intrinsic value estimate on every company we own and the numbers are constantly evaluated and updated by our analysts.
Approximately seventy percent of our sales have generally been for valuation or market cap reasons or a combination of those two. From a valuation standpoint, as a stock approaches its intrinsic value, its margin of safety declines and we would look to reduce the position. If we believe that the stock is fully valued, we would exit the position.
In terms of market cap, we initiate new positions within the strategy with market caps below $2.25 billion and are willing to hold them until they reach market cap of $5 billion. It is not an automatic sale, but as the stock approaches $5 billion, we recognize that it will have to be replaced and begin searching for ideas.
Another reason for sale would be invalidation of the investment thesis because something has changed or emerged about the company that causes us to change our opinion of the business. The last reason for sale would be a merger or an acquisition of one of portfolio holdings.
Q: How do you define and manage risk?
We characterize risk as permanent loss of capital or a decline with no prospect for recovery. That’s what we try to avoid. We control that risk by selecting sustainable businesses at reasonable valuations with solid balance sheets and free cash flows.
We believe that companies that burn cash tend to present higher risk than companies that generate cash. Free cash generators control their own destiny, because they don’t have to go to the market for new capital. On the other hand, companies that burn cash depend on the market’s willingness to provide that capital. In certain environments that can become difficult.
On the individual company level, we evaluate the downside scenario for each stock. On the portfolio level, we limit the position size to 5%, but the largest positions are typically about 3.0%. Another risk control is maintaining a diverse sector exposure.
