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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

Don't Use the "B" Word
Over the past few years, the policies of the U.S. government and the Federal Reserve have come under fire from many managers. Some of the most pungent criticism has emanated from Bob Rodriguez of FPA, most notably at the 2009 Morningstar Investment Conference and in a recent talk with Morningstar. Similarly harsh comments have come from Rudolph Riad-Younes of Artio International Equity BJBIX year after year in his lengthy and detailed annual letters, including the most recent.

One might have expected Marty Whitman of Third Avenue Value TAVIX to have a similar attitude. He's been investing longer than anyone and doesn't hesitate to speak his mind, and that combination rarely results in a gusher of praise for government officials. But on at least one subject--the bailouts--Whitman's got nothing but praise, along with scorn for those who don't understand.

"What is the difference between a bailout and an investment?" he asks in the just-released first-quarter report. "A bailout exists when a capital infusion is made into an entity with no hope and no prospect of earning a decent return. ... [But] the stimuli given to the economy by the capital infusions promulgated by both the Bush and Obama administrations were enormously successful, measured by both profit to the government and aid to an ailing economy." Therefore, Whitman concludes, "These capital infusions were investments, not bailouts."

If a private company puts capital to work, he notes, everyone calls it an investment. So, "if governments are making reasonably sound capital infusions these should not be denounced with unacceptable pejoratives, specifically [by] calling them bailouts."

Out of Balance?
Finally, one of Younes' main concerns since before the financial crisis--and he's had plenty of company among observers in think tanks, CEO suites, academia, and the investment community--has been the detrimental effect of "global imbalances," of which the uneven economic and financial relationship between the United States and China is one example. These conditions could have dire effects that investors ignore at their peril, in this view.

David Herro doesn't quite agree. In fact, in a short but pithy note in his recent letter to shareholders, Herro, lead manager of Oakmark International OAKIX and Oakmark International Small Cap OAKEX, seems to be replying to those thinkers. "Yes, there are (and always will be) imbalances in the global economy." Herro wrote. "For example, I would love to see the U.S. deleverage, China float its currency and Japan allow more immigration. But ultimately, positive investment results over time depend on low valuations and a fertile environment for stronger corporate profitability."

Those conditions, Herro says, are in place today. So, in his view, there are plenty of opportunities to obtain "acceptable" equity returns despite these larger global concerns.

Gregg Wolper is a senior mutual fund analyst with Morningstar.

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