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Oracles of Alabama

Jeff Cavender and Lyle Watts heed the value investors' call of buying securities on the cheap.

Jerry Kerns, 10/30/2008

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Walk into the Huntsville, Ala., office of Jeff Cavender and Lyle Watts, and it's clear where their alliances lie. On the wall are photos of the partners posing with managers Bruce Berkowitz, David Winters, John Keeley, and Dan Fuss. On a separate wall hangs a framed note from the man himself, Warren Buffett.

"Value investing fits our character," Cavender says. "In every area of our lives, we like the idea of buying bargains. Buffett said it's like an inoculation: You either get it or you don't."

There's no denying Watts and Cavender get it. Though they came of age as investors during the growth-led bull markets of the 1980s and 1990s, they saw the advantages of a more measured, long-term investing approach. Twenty-percent annual returns common then didn't impress them because those gains came with too much downside. They preferred steady returns that sometimes lagged in exchange for a low probability of a loss of capital.

"First, do no harm," Watts says. "That's the way I view the world. If I can avoid huge losses, I'm willing to trail."

Sweet Home
Both born and raised in Alabama, Watts and Cavender were on the same page investing-wise before they met each other.

In 1990, after college, Cavender went to work at a wirehouse in Huntsville. Bitten by the value investing bug early on, he became frustrated because the managers he wanted to use for his clients weren't available to him through the firm. He also tired of the frequent changes to the mutual fund lineup for reasons based more on marketing than fundamentals. Instead of focusing solely on performance, he was interested in the process.

Cavender looked at Buffett's approach at Berkshire Hathaway. "He didn't make that money overnight. There was a process behind it, and it wasn't a process of jumping in and out." He concluded that if he was going to make a career out of being a financial advisor, he needed to have access to like-minded value managers and be free to pursue his strategies. Cavender made his move in 1996 and started his own firm.

Meanwhile, five miles across town, at a different wirehouse, Watts was coming to the same conclusions as Cavender.

Watts thinks of himself first and foremost as  an investor. It's why he got into financial planning. He had come across the writings of Buffett and Ben Graham in the early 1980s  and was fascinated by the idea of being able  to compound money to build wealth.

"I was raised on a farm," he says. "It was real appealing to discover that I could build wealth using my mind instead of doing manual labor." And farm life left him prepared to be a value investor. "There are a lot of ups and downs in a farmer's life -- plenty of disappointments. To succeed, you have to be real patient and real disciplined."

One and Done
Cavender had no intention of taking on a partner. He figured it would lead to too many headaches. Then he met Watts, and they had an immediate rapport. "I went into this like a marriage," Cavender says. "In other words, if I do a partnership, I'm one and done."

The two agreed up front that every aspect of the business -- ownership stakes, revenue splits, expenses, and client accounts--would be divided 50/50, a stance they've maintained for 12 years. They were also honest about their different, but compatible, skills. "He's smarter; I admit it," Cavender says. "That's why he's my partner." Watts is analytical. He likes thinking about investing and researching new ideas behind the scenes. Cavender prefers the people side of the business. He likes learning about clients' lives, and it's his task to guide clients through the firm's investing process.

Today, Cavender & Watts serves about 200 clients, with assets under management in the "nine figures," Watts says. Their clients are Huntsville's small-business owners and doctors in the prime of their working lives and longtime corporate workers heading into retirement.

A typical new client meets both advisors together to discuss goals and risk tolerance. Watts and Cavender then separately create a portfolio for the client. Although it's largely a subjective process, Cavender says that he and Watts usually pick the same managers for the client and that their allocations are always within 3% to 5% of each other. The advisors resolve any discrepancies and then analyze how the portfolio would have performed during two bear markets and one bull market. They also demonstrate the effect that withdrawals during down markets can have. "We really want to magnify to clients what will be the effect on their portfolio if they make ill-timed withdrawals in a declining market," Watts says. "Clients should know how that looks."

Pleased to Meet You
Watts and Cavender aren't big on pinpoint allocations and diversification. They don't pay attention to style-box breakdowns. Instead, they leave the investing to a handful of mutual fund managers who have the proven ability of unearthing great values -- managers such as the Keeleys in Chicago, the Auers in Indianapolis, Berkowitz in Miami, and Fuss in Boston.

"We want our managers to purchase our businesses at a fair discount to intrinsic value," Watts says. "We want companies that compound their business value at a far greater rate than their share prices. We want good free cash flow, sensible business models, transparent accounting, and companies that don't use a lot of leverage." PAGEBREAK

Whether it's in the balance sheets of companies or investors, debt is a red flag. Watts and Cavender believe that it magnifies weaknesses in difficult periods and leads to irrational decisions. "You have to be prepared for 100-year floods every 10 years." Watts says. "You want to be able to sell when you 'want to,' not when you 'have to.' "

In addition, the partners require their managers to have equity ownership in their own firm, invest the majority of their net worth in their portfolios, and have at least 10 years of experience managing money.

Finally, they won't invest with people they don't like. They want to meet managers face to face at least once a year and talk with them at least once a quarter. "It gives us a chance to view the culture of the firm and to see what they're all about," Cavender says. "If they say they're not willing to meet with us, even for just a few minutes, we'll sell their fund. It's happened before." They also go to investing conferences, including Morningstar's, to meet managers. The year's highlight is the Berkshire Hathaway  meeting. "It's our holy grail," Cavender says.

Rocky Times
Watts says that the partners' goal is to avoid a permanent loss of capital -- which he defines as capital that cannot be returned to the client within a reasonable time period. That goal, it seems, will be tested by the current market. But where others see pessimism, they see opportunities in the market's volatility.

"It's amazing to see how many companies see their share prices fluctuate annually 50% from peak to trough," Watts says. "But markets aren't perfectly efficient. Intrinsic values of companies don't swing that quickly. They're not like yo-yos. If you can understand this and use the market to your advantage, that's when you can make a lot of money."

Jerry Kerns is executive editor of Morningstar Advisor magazine.

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