Moderate-growth companies that stay out of the spotlight will likely face fewer competitive threats while being more attractively valued, say BBH Core Select's managers.
Timothy Hartch and Michael Keller are comanagers of BBH Core Select
Additionally, they commented on two high-quality companies that investors have ignored, and they addressed the reason behind their optimism for so-called boring investments in today's environment.
1. Berkshire Hathaway is the largest holding in the fund's portfolio. Did the David Sokol incident affect your views of corporate governance at Berkshire's Hathaway? Why or why not? Are you concerned at all about the firm's eventual change in management?
We were disappointed by the departure of David Sokol, not only from the perspective of losing a proven manager who could have potentially stepped into the top operational role at Berkshire (5.6%)*, but also because the circumstances of his resignation indicated a major ethical lapse on his part. Nonetheless, we continue to believe that the quality, strength, and diversity of Berkshire's operations along with its formidable pool of capable managers and potential successors make it unlikely that Sokol's departure will affect the current or prospective value of the enterprise.
Having owned a large position in Berkshire for some time, we are well aware that Warren Buffet prefers to run the company in a decentralized manner, with operating units run by talented, independent managers. In the future, it may be the case that Berkshire will need to augment its corporate infrastructure to deepen its governance and compliance policies, but we do not envision any material changes to the basic operating structure.
Succession is definitely a key long-term issue for Berkshire, and it would be a mistake to think that Buffett's successor will possess all of his extraordinary qualities. Nevertheless, we believe that Berkshire has a number of very capable senior executives within the company who would likely be excellent CEOs. It is important to note, though, that from our vantage point Buffett continues to execute quite well. Buffett guided Berkshire brilliantly through the global financial crisis, and Berkshire's key operating businesses (particularly the insurance businesses) have been performing quite well. Accordingly, barring any sudden health issues with Buffett, we would expect Buffett to continue as CEO for a number of years. Lastly, we view Berkshire as trading at a meaningful discount to our estimate of its intrinsic value. In our view, there is no Buffett premium in Berkshire's current share price.
2. You like high-quality companies, but you also like to buy them at the right price. Are there any companies that you've bypassed because of valuation concerns that have continued to defy expectations?
Yes, there have certainly been companies that we have passed on because we thought the valuations were too rich but where the stocks have continued to move higher. One common fact pattern where that has occurred is with attractive, growing businesses that fit most of our qualitative business criteria, but which trade at what might be described as anticipatory valuations, meaning that the public market price embeds a very high level of sustainable future growth. We definitely like owning companies that can generate profitable organic growth, but other investors appear more willing than us to pay a premium for really high-growth companies. What has worked well for us is to stay disciplined on valuation and to only make new purchases when companies are trading at 75% or less of our intrinsic value estimates.
In our view, the risk of missed opportunities on the upside must be viewed alongside the potential for permanent capital losses that could arise when a richly valued stock falls short of expectations.
3. In the fund's latest quarterly commentary, management expressed concern about inflation, a sharp increase in interest rates, or a dose of both, which could hamper the ongoing recovery in the economy and markets. While management's portfolio decisions are not too driven by macroeconomic factors, are there ways that the portfolio is hedging against these potential risks?
We believe the best hedge against macroeconomic gyrations through time is to own a focused portfolio of high-quality, well-managed companies that provide have-to-have products and services to loyal customers. These types of businesses have the ability to withstand periodic economic headwinds, and in many cases, they can use the tougher periods to get stronger via market share gains, acquisitions, and the ability to make investments while weaker businesses are forced to retrench. In our due diligence process, we do look at multiple macro scenarios and how they could affect our businesses. However, the purpose of the exercise for us is not to try and invest according to our best guesses about the economy, but instead to better understand our downside risks and avoid situations where the potential exposures are too large.
With respect to the specific risks of inflation and higher interest rates, we continue to see them as potential long-term threats to economic growth and the value of financial assets. Fortunately, we believe the holdings in BBH Core Select are well-positioned. A substantial number of our companies have pricing power in their markets by virtue of their strong brand positioning, customer value proposition, asset base, or some combination therein. As such, we believe that rising input costs can be passed along to end customers. Moreover, our companies typically operate at levels of scale and procurement strength that allow them to manage through varying cost environments over time.
A scenario of sharply higher interest rates could have broad implications including higher funding costs and lower levels of demand. Our defense against these types of risks is inherent in our approach; we focus exclusively on companies with solid balance sheets and resilient demand streams. At a more tactical level, we do own certain companies in the financial-services and business-processing industries that could directly benefit from a more normalized interest-rate environment.
4. Could you provide an example of an exceptional firm that has being ignored by investors and Wall Street? What are other investors missing about it?
We invest in companies with market capitalizations exceeding $5 billion, which suggests that our portfolio holdings as well as our wish-list stocks are companies that are generally well-understood and followed by Wall Street. Nonetheless, we do believe that certain companies can fall out of favor regardless of whether their fundamentals justify it. In these situations there is often opportunity. In our present portfolio, we would cite two fine businesses that seem to fly a bit under the radar: Chubb
Chubb is a leading property and casualty insurer focused on the commercial and consumer markets. The company has an exemplary record of underwriting, cost control, management discipline, and capital allocation. In part because of a soft pricing market, Chubb's valuation has remained pretty flat during the last few years. Management's response has been to repurchase a substantial amount of stock, thereby creating additional value for continuing shareholders. Whether pricing improves to any significant degree, we believe that Chubb will maintain its strong franchise and that its management team will act in the best interests of shareholders. Interestingly, Chubb's management team prefers not to participate in any investment conferences and rarely speaks with investors except on its quarterly earnings call. We applaud Chubb's focus on business fundamentals rather than quarterly earnings expectations.
With Dentsply, in our opinion it is one of the best businesses that most people have never heard of. The company is headquartered in York, Pa., and is the leading global provider of dental supplies and light equipment to dentists and dental labs. The company enjoys real scale advantages in distribution and manufacturing and possesses a large and highly satisfied professional customer base. We view the dental industry as one of the most attractive submarkets in health care as a result of the positive demographics both in the developed world (that is, the aging population) and in the developing world (that is, the rising standard of dental care among the growing middle class). Although these positive qualities are quite evident in the company's superb financial performance during the past decade, we believe that the company is often overlooked by Wall Street because there are no other large, pure-play dental competitors, and it is a very stable business that does not change dramatically from year to year. Lastly, the dental market is small relative to certain other health-care subsectors, such as pharmaceuticals, and therefore does not get as much attention.
5. In an article printed February 2010, management was quoted saying that low-risk opportunities were presently the most attractive, and that "boring is likely to be better in the next 12 months." Does this stance still hold true today?
Yes, we continue to believe that boring is likely to perform better. Almost by definition, exciting companies command lots of attention and their share prices get bid up to high levels. The enthusiasm for Twitter and other social media companies is a good recent example. Rapidly growing industries also attract more new entrants, including disruptive venture capital-backed companies.
We have found that moderate-growth companies in stable industries generally face fewer competitive threats and are often more attractively valued. Nevertheless, companies do not have to be boring to be out of favor with investors. For example, the two large banks that Core Select owns (U.S. Bancorp
*April 30, 2011 positions as measured by asset weight of the fund. Positions are subject to change.
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