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Q: Would you give us an overview of the fund?
We have managed our income equity income portfolio since the end of 1999, prior to launching the mutual fund version with American Beacon on May 29, 2012. Everything we do at The London Company is built around downside protection.
This is a conservative, large-cap fund that also offers a premium dividend yield relative to the benchmark. Right now the yield is about 3.2% or 3.3% before fees, but the focus has always been on protecting the downside.
So if you look at the longer-term performance, you will see that our performance over full market cycles has very attractive risk characteristics, with lower standard deviation and a lower beta than the benchmark.
The fund has an upside/downside capture of about 85%-to-65%, meaning we participate in positive markets, but capture much less of the downside when stocks are weak. Relative performance tends to be best in slightly positive, flat, or down markets.
The mutual fund has about $700 million in assets under management. The total income equity portfolio has about $12 billion in assets if we include model portfolios sold through third-party broker/dealers.
Q: What is your investment philosophy?
We start with the belief that markets are much less efficient at assessing risk than they are at assessing reward. Most investors are trying to forecast future earnings and find the next big winner—but we acknowledge that we can’t predict a company’s earnings any better than anyone else. Instead, we build the investment thesis for each stock around the strength of the company’s balance sheet
We do not focus on dividend yield versus dividend growth. We are in the middle. Our focus is on high return on capital businesses. We think like a business owner; we look for companies that have some sustainable competitive advantage that we can hold for a long time, and buy them when they are trading at attractive valuations.
We use what we call a balance sheet optimization process to look at the intrinsic value of each stock. This is a way for us to build the investment thesis for each stock around the balance sheet, around what exists today, and see how companies can benefit by lowering their cost of capital.
We do not assume future growth. It’s a different way of looking at investing; it’s very conservative. We build a margin of safety by buying stocks whose balance sheets are strong enough to withstand any downturn in the market.
We also spend a lot of time watching management’s actions rather than focusing on what they are saying. Then we tilt the portfolio toward higher-yielding stocks, to get a premium yield versus the benchmark. The yield is really a byproduct of our focus on high return on capital businesses that are under-leveraged and that are generating a lot of cash that they can use for things like share repurchase. It’s fairly streamlined and specific.
Q: What is your investment strategy and process?
Our process is built around risk control and downside protection, eliminating left-tail risk as much as we can. We start with thousands of companies and we look for higher return on capital businesses where we think the returns are sustainable, based on an evaluation of the specific company and its industry.
Then we look at free cash flow yield and earnings yield to give us some comfort in the valuation. We typically start with the top 200 large cap names, and then we dig in with further research to determine the intrinsic value of each one. That is the most important aspect—for each stock we purchase, we want to buy at a discount of roughly 30% to 40% to our estimate of intrinsic value.
We calculate intrinsic value by using the balance sheet optimization approach. In other words, what we do is a simplified debt recapitalization. We look at the current balance sheet and ask what would happen if the company were to add leverage up to four times interest coverage (with interest coverage being operating profits over interest expense) and then use the low-cost debt proceeds to buy back its higher-cost equity. What would the balance sheet look like then?
So, we optimize the capital structure and in effect lower the cost of capital. Then we use that new lower cost of capital to discount the current free cash flow of the business. In this way, rather than trying to speculate about future earnings, and discount it that way, we look at the current run rate of the business and assume it cannot grow. Then we look for ways to create value with the balance sheet, and to lower the cost of capital that way, to come up with our intrinsic value. It’s very conservative and leaves a nice margin of safety.
Once a stock passes that test we spend a lot of time looking at management’s actions. We see somewhat limited value in what management has to say, because most management teams tell you the same thing—“We’re growing 10%; we’re taking share.” We look at insider activity, at what board members and corporate executives are doing with their own money, whether they are buying back stock themselves.
We also believe that incentives matter. Incentives drive behavior, and so we look at management’s long-term incentives to make sure they are aligned with shareholder interests. We look for companies with metrics that we think are good for shareholders, metrics like return on capital, economic value add, and total shareholder return. We avoid companies where the incentive structure is based more on sales growth, which in a slowing economy might encourage management to do something imprudent outside the core competency, or to make an expensive acquisition that destroys shareholder value in order to hit their sales targets.
Finally, we look at capital allocation. This is a review of how management has managed the company over time, how they have used the cash and the balance sheet. We look for companies with a good history of dividends and share repurchase at the right price, and avoid companies that are making a lot of acquisitions, diluting shareholders through excessive employee option grants, or even hurting shareholders by sitting on too much cash.
Using those key metrics, we hopefully find names that are trading at a 30% to 40% discount to intrinsic value.
Q: What is your research process and how do you look for opportunities? Can you give us a couple of examples?
We don’t do a lot of trading; we typically do one buy and one sell per quarter. We have a very low-turnover approach to investing. We think like an owner, as if we own the whole company, and own it for a long time.
One place where we have recently found some potential ideas has been in large cap technology. One of our recent purchases is CA, Incorporated, which is the old Computer Associates. It is mainly a mainframe software company and also has an enterprise software business.
Mainframe software still brings in about 60% of revenue, although it is not a super growth story. Tech investors often want to find the next cool thing–but this is not it. We liked CA for its consistent record of high returns on capital, its very asset-light business model, and its high margins. Those things all fit well with our process. It is also a very sticky business too, because companies that use mainframe software usually want to find one provider, sign up for a three-year-plus time track, and then not have to deal with it. So for CA that leads to a nice recurring revenue stream and high margins.
When we ran it through our balance sheet optimization model we came up with a nice discount to intrinsic value. Assuming the current balance sheet of about $2.7 billion in cash, and about $1 billion in debt, CA has a lot of room to take on additional debt if it needs to.
The important part about balance sheet optimization is looking at the company’s cost of debt versus its cost of equity. In most cases the cost of debt is much lower. By taking on additional debt and using those debt proceeds to buy back higher-cost equity, you can lower the average cost of capital overall and create value for shareholders.
In the case of CA we assumed it could take on a few billion dollars in new debt and use that to buy back stock. With no growth assumptions, we were coming up with a very attractive intrinsic value estimate of about a mid-40s price, and the stock was around 30. So it was very attractive.
We did not see much insider activity in terms of buying or selling. With regard to capital allocation, CA generates more than $1 billion in operating cash flow each year with very minimal capital spending needs. That cash flow goes back to shareholders through dividends and share repurchase.
Incentives were decent as well. They were aligned with shareholders and were really focused on operating margins and operating cash flow growth. We feel the downside was protected, and over time the market value of the stock will participate, if not outperform.
So that was a name we bought. It hasn’t done much for us yet in the past year but we think the downside is very much protected and over time, as the market rallies, the stock will probably participate and outperform. But again, the most important thing is not having any downside risk.
Another example is BlackRock, Inc. Initially, BlackRock was not at the top of our screens, but in late 2012 one member of its board purchased an amazing amount of stock for his own portfolio. When we see older board members pumping the likes of $120 million into a stock, it certainly gets our attention.
As we looked at the company we felt it had a nice competitive advantage within the ETF market. The business was strong and asset managers had attractive margins overall in the 30% plus range. We felt it was well positioned for future growth.
As a result, we ran it through our balance sheet optimization. The stock was trading at about $160, and we were coming up with values in the $300 to $350 range, assuming little growth. And we noticed the tremendous amount of cash it generates each year that can go back to shareholders through dividends and share repurchase.
We had already looked at the name and we liked it. We were waiting to see a conviction sign from management and the huge amount the board member was buying gave us that. We bought it in late 2012 and it has done very well for us.
Importantly, we do not buy a stock just because we see insider buying from an executive. We like to see that, but combined with a high return on capital and sustainable returns. But again, most importantly, we look for a balance sheet that gives us a margin of safety.
Q: What is your portfolio construction process?
It is diversified, but not overly so. There are 30 to 35 stocks, and we start in the 3% to 5% position range. We really want the larger positions to drive the alpha over time.
We take a tax-efficient, low-turnover approach. Usually we have about 20% turnover; we think on a five-year hold period. Active share is usually in the mid-80s, if not higher, for this portfolio.
We tilt toward higher-yielding stocks that have downside protection, which allows us to offer a premium yield. We also can own preferred stocks up to 20% to 30% of the portfolio if we choose to. That helps diversify and boost the dividend yield of the portfolio.
We manage against the Russell 1000 Value Index. We are somewhat benchmark agnostic; the only limitations we have are that we will not be more than twice the sector weight of any sector in the benchmark that is greater than 10%. So if information technology is 12% of the Russell 1000 Value, we would not be more than 24%.
The portfolio is driven from the bottom up. Our goal is to find the best stocks we can, regardless of how Russell classifies them in terms of sector. Diversification is important, but we think 30 to 35 stocks is the appropriate number. Anything more than that waters down your portfolio so much that no stock can add a lot of alpha.
We start in the 3% to 5% range for position size and generally leave them alone. We do not see a lot of value in rebalancing throughout the year, so as long as we are comfortable with the competitive advantage of the business and the valuation of the stock, we do not rebalance.
The most we allow any one holding to appreciate is to 10%. We rarely see a stock reach 10% of the portfolio though. Typically, our largest position is in the 5%-7% range. And we do not like to have any holding below 2%.
Q: What is your buy-and-sell discipline?
We have a team of six portfolio managers and three research analysts. All are generalist analysts. We have a voting committee of five portfolio managers that meets twice a month to review ideas. When someone pitches a stock, we want the person championing the idea to sell us on the downside protection.
We have to see something on the balance sheet or some hidden asset that provides downside protection, combined with catalysts of positive actions from management. Then the five of us have to come to a unanimous decision.
It is a very deliberate process and it leads to very little trading.
We include everything over $3 billion in large cap. There are a handful of names in the portfolio in the $3 billion to $10 billion range. The average market cap for the portfolio is about $90 billion.
Our sell discipline is built around risk control; much of it is the opposite of why we buy a stock. If we suddenly see misallocation of capital, that’s a reason to sell. If we own a company for a long time and management suddenly starts veering off and making acquisitions outside of its core competency that is often a reason for us to sell.
If we see cluster-selling from insiders, multiple executives all selling the stock at once, that is usually a sign that either bad news is on the way or the company is slowing down, and we will sell.
We also use our soft stop loss rule. This works for newer positions, stocks purchased in the past two years where we do not have a history with the stock or the management. That’s where we have made our biggest mistakes in the past, and the soft stop loss is designed to protect us from that.
If any new position reduces the total portfolio value by 1% at our cost, it triggers the soft stop loss, and we start reviewing it and, probably, selling it. If I initiated a 3% position in IBM today and a few months later the stock falls enough to reduce total portfolio value by 1%, it would trigger the soft stop loss. At that point, we would review the holding and likely sell.
Even though we are value investors, we do not want to fall in love with a name or be over-confident. Sometimes you have to recognize you are just wrong. Rather than throwing good money after bad, we would rather just sell the stock and move onto something else.
We do not want to let that one mistake turn into a colossal error that damages portfolio performance.
Q: How do you define and manage risk?
Risk to us is the permanent loss of capital. Everything we do is designed to preserve capital for our clients and provide downside protection.
We manage risk on a bottom-up basis, by going through the universe and looking at the high return on capital businesses. We judge their sustainability and, importantly, look at the balance sheet optimization model.
A great way to reduce risk is to find good companies where you do not have to assume any growth at all, and they are still trading at a discount to intrinsic value. Watching management’s actions is also a big part of risk control.
And finally, there have been a lot of cycles over the past 15 years when the market was down. We have learned to adhere to the soft stop loss rule; when you are just dead wrong on a name, get out of it before it damages the portfolio.