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Top Managers Opine on Quality, Bailouts, and Imbalances

Several recent letters showcase feisty, unconventional opinions.

Gregg Wolper, 03/15/2011

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For a dedicated investor, one highlight of a new year is the chance to read the lively, thought-provoking, and often instructive words of top fund managers in their annual reports. Some highly esteemed managers, such as Bill Gross of PIMCO, also send out monthly or quarterly commentaries that are pored over by a wide audience. But the long and detailed year-end letters sent out by many other managers--even well-known ones--often escape wide notice.

That's understandable; everyone's time is tight. However, these letters often contain forthright, thoughtful nuggets on topics of interest for many investors. Below are some of the more interesting, contrarian, even cantankerous ideas from recently released annual reports.

A High-Quality Debate
For more than a year now, many respected fund managers, along with some other investors, have pointed toward "high quality" companies as the most attractive plays in the stock market. The definition of such firms varies, but the label generally refers to large companies with strong balance sheets (with emphasis on low levels of debt, hefty cash stakes, or both); high returns on equity; and products or services for which reasonable substitutes are not easily found.

At least one management duo apparently is getting a bit tired of being told it's missing the boat on quality. In their letter featured in Longleaf Partners' LLPFX recent annual report, Mason Hawkins and Staley Cates don't hold back. "Throughout the year we increasingly heard clients and others call for 'high quality' equities for several reasons," they wrote. After laying out the traits those observers say such companies to possess, the managers fire back. "Broadly used quality categories or metrics do not adequately capture the strengths of many businesses."

They explain what they consider to be the marks of successful investments, which in some cases seem to overlap with broadly held definitions of "quality," but in others do not. For example, in evaluating a company, Hawkins and Cates place great emphasis on their personal opinion of management's skill in operations and capital allocation, a factor that often plays little if any role in most conventional judgments of what makes for a quality stock. And they say it's much more important to take a deep and detailed look at the often-complex structure of debt on a balance sheet and then weigh it against other characteristics of a company, rather than to rely on a number such as the company's debt/equity ratio.

"Sometimes investors question the 'quality' of our holdings," Hawkins and Cates wrote, "usually because these companies either do not fit a formulaic definition of quality or because of a recent headline scare that obscures an incredibly strong long-term competitive position." Such misperceptions do them a favor, the managers say, for it allows them to buy these allegedly low-quality companies at bargain prices, rather than paying up for companies that "have universally achieved consensus as 'high quality' based on simplistic measures that may or may not properly reflect the risk of losing permanent capital."

Hawkins and Cates also stress that being able to buy at a deep discount is always critical. Finally, they add, "We strongly disagree with those who equate stock price volatility with low quality and increased risk. ... Price movements have no bearing on capital loss unless one is forced to sell at a low point."PAGEBREAK

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