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Finding Refuge in Value

Don Yacktman and Pat Dorsey look for undervalued firms with margins of safety, and they see a lot to like in today's market.

Ryan Leggio, 10/08/2011

“Don Yacktman’s Wild Ride--Fall of a Fund Manager”

 

That was the headline of an article in Kiplinger’s about fund manager Don Yacktman in 2001. While not as famous as Business-week’s cover story on “The Death of Equities” in 1979, it proved just as accurate as a contrary indicator. (To be fair, Morningstar’s track record analyzing Yacktman at the time is mixed.) From 2001 through Aug. 15, 2011, the Yacktman Fund YACKX appreciated by an annualized 11.4%, versus a 1% annual gain for the S&P 500. That showing earned Yacktman one of the five nominations for Morningstars Manager of the Decade award in 2010.

As the 2001 headline suggests, Yacktman’s performance the past decade has been a turnaround of sorts. In the late 1990s, he loaded up on small-cap companies he thought were cheap as the market rewarded large-cap stocks year after year. In 1999, for example, his fund fell 17% as the S&P climbed 21%. Investors, having endured two previous years of underperformance, left in droves, and the fund’s asset base fell from $1.1 billion in assets in 1997 to just $70 million in 2000. Despite a current asset base of $5.4 billion, one thing seems clear: Yacktman’s disciplined, concentrated approach to uncovering the market’s cheapest stocks--along with the manager’s willingness to sit on cash when bargains are scarce--hasn’t changed much through the years.

The same can be said for Pat Dorsey, Sanibel Captiva Trust Co.’s vice chairman and director of research and strategy. Longtime readers will remember Dorsey as Morningstar’s former director of equity research. During his career here, Dorsey helped develop Morningstar’s economic-moat rating--analyst-assigned ratings that gauge a company’s competitive advantages and its abilities to keep rivals at bay and to withstand tough economic times.

We invited Yacktman and Dorsey to discuss where they see bargains today and why both currently favor beaten-down technology stocks such as Cisco CSCO. Our conversation took place Aug. 12 and has been edited for clarity and length.

Ryan Leggio: Don, we’re talking in early August and the markets have been quite volatile recently. [The S&P 500 dropped 6.7% on Aug. 8, one of its steepest single-day drops in decades.] What’s your take on the concerns that are out there and how that is affecting your investments?

Don Yacktman:
I think the situation like we’ve had in the last week or so really creates opportunity for value investors. While I have an opinion on all the economic and political things that are going on, the reality is that it wouldn’t change what we do, because we’re very systematic, and we try to be objective in the way in which we approach things. So, it’s just been a great opportunity, and it certainly has allowed us to do some things that have come to fruition.

Leggio: Are you basically saying that even if Europe’s fiscal situation gets worse, tha it wouldn’t have a big impact on the values of a lot of the companies you own in the fund?

Yacktman: It doesn’t affect the process. It may affect the pricing on individual issues, but what it does is allow us to do things. I think the best way I could reflect that is to go back and look at what happened in 2008 and ‘09. We have, really, three goals. The first goal is to avoid the permanent loss of capital. The second one is to make equity-type returns, double-digit-type returns, over long periods of time. And the third one is to beat the S&P over a cycle, and because cycles vary in length, we use 10 years as our pick, if you will, or our hurdle.

And so, we try to project a forward long-term rate of return, saying, “If we were to buy something and own it for a long period of time, and throw out market fluctuations, what kind of a rate of return would we expect to earn on this?” And then we try to adjust for the predictability of that by using quality standards. In other words, the more predictable the cash flows are, the higher the quality and, probably, the less spread we need in order to make that investment.

Leggio: Pat, what’s your take on recent events?

Pat Dorsey: Well, if you own Greek debt, or if you own a European bank that owns Greek debt, you probably ought to be pretty worried right now. But if you don’t, as Don said, it’s much more of an opportunity than anything else. And I think that one of the sort of aftershocks of 2008 was that everybody became a macro investor. Suddenly, macroeconomics was cool, and everybody wanted to make their own macro-economic predictions. Frankly, it’s a loser’s game. The Wall Street Journal does this survey every quarter of 46 economists, and they give an award twice a year for whoever gets it all right. It’s never the same person. On the Journal’s website, to their credit, they post these historical predictions, and they’re inevitably wrong, whether it’s interest rates, GDP, unemployment, inflation, you name it, they start out to high or too low and eventually converge on the actual value by the end of the year.

And what that tells you is that you can accurately predict a year’s GDP in November of that year. That’s not real useful from an investment perspective.

So, we feel it’s best to be mindful of the macroeconomic environment but not really let it affect how you select securities, unless it specifically impacts a security that you’re valuing. Otherwise, it’s just noise.

Yacktman: Ultimately, this business boils down to what you buy and what you pay for it. And it’s very similar to being a good shopper. Except in this case, what you’re doing is buying pieces of businesses.

Dorsey: That’s what a lot of investors forget. The stock market is one of the few places where when things go on sale, people like them less. If you put a giant sign up at your local Whole Foods that said, “All produce half off,” people would go bananas. But an equity goes down, without a corresponding decline in business value, and people run for the hills. It’s quite an unusual phenomenon.

The question is always, What is discounted? And if you’re buying a security that where the price implies a very, very low rate of growth, or even shrinkage, and it’s very probable that security will generate a higher rate of growth, then you’re probably on the right side of the bet.

Right now, the market seems to be implying that there’s a recession coming up. If there is, then securities are fairly valued. If we just go to slower growth, then you’ve got some opportunities.

It’s not really a question of whether it’s structural or cyclical. It just depends on what you are paying for the securities you’re buying. If I am buying Cisco at a 15% free cash flow yield, there’s a lot of bad things that can happen, and I still get a pretty good prospective return.

Yacktman: That’s our number-five holding. Its very rare, ironically, that we should be talking the day after two of our stocks went up over 15%--two of our top five, News Corp NWSA and Cisco, which rarely happens. I can’t remember a time when we’ve had that big of a move in two of our stocks or that big of a move in our two mutual funds, either. So, it was a very remarkable day.

Dorsey: It is interesting, and I think that Cisco in particular illustrates a great lesson for investors, which is that some problems are fixable, and some problems are not. If you remember a darling stock from some years ago, Garmin, which made GPS devices. That became, basically, a feature in your smartphone. That’s a disruptive change in the industry that means that most of their business is going away. You can’t fix that. If you’re Kodak, an the world is going from film to digital, you can’t fix that.

But if you’re Cisco, and you’ve made some stupid investments into a consumer arena in which you have zero competitive advantage, and you hired too many people, those are fixable problems. And w got some good hints the other day that [Cisco CEO] John Chambers has found out at which station the clue train boards, and he’s getting on. So, the problem is getting fixed And that’s why--in my opinion--the stock went up 15%.

Yacktman: When a company has a very, very dominant market share, somebody can’t really take it away, unless, as you point out, you have this leapfrogging in technology. And that’s one of the difficulties in technology--you can’t always predict what kind of leapfrogging event will occur. But once a company gets that kind of a dominant position, they have to lose it. Nobody can really take it away, barring this leapfrogging kind of event.

Dorsey: Yep, and you had a lot of Street analysts and CNBC pundits absolutely wringing their hands in despair at Cisco losing three or four points of market share to HP in the switch market. Well, OK, losing share is not great. But losing three or four points of share when you have dominant market share is also not the end of the world, and it’s a fixable problem.

Yacktman: Correct.

Inching Our Way In

Leggio: Don, given your propensity to usually own very high-quality companies, and since you haven’t owned technology for most of your career, at what price-at what forward rate of return did Cisco finally become too cheap that you couldn’t pass it up?

Yacktman: I think maybe I want to come back to the model and describe that a little bit. We started to buy Cisco before the end of the year, and we just gradually built a bigger and bigger position as the company’s stock went down.

What we do in the way of controlling risk is that when we start to see something that is showing up reasonably attractive, we’ll maybe inch our way in. But then, as it goes down, you want to buy more of them, not less of them, barring that there’s no dramatic change in the overall business form.

That’s what happened with Cisco. But think about the elements that go into a rate of return, [and] a forward rate of return. And always remember that nobody can predict the future with 100% accuracy. And so that’s important to leave some room for error. But there are certain things one can gauge at least reasonably closely, and then there are others that have to take into account business knowledge and expectations and so on and so forth. First of all, as Pat pointed out, you’ve got the free cash flow--in other words, the amount of cash that’s being generated by the investment. And that can be measured relatively accurately with companies that have less economic sensitivity. One has to take into account, to some degree, where margins and business is, and so on and so forth. But you can come up with a number that is halfway reasonable.

Now, out of that cash flow, two things happen. Part of it, in most companies, is given to the shareholders, so you can measure that part relatively accurately, because, in effect, that’s your dividend. You know what the yield is.

Now, you have two other elements. One is the reinvestment of the money the shareholder gets. That one, you can reasonably come close to, based on your own experience as to what kind of a rate of return you feel you can earn on that money. So, that leaves the other element--which is the wild card--and that is predicting what will happen internally in the company as far as unit growth goes and reinvestment of the cash flow that they’re generating.

The management has basically five option with the cash flow. They can put it back in the business--and I would argue that that is the most important part of their allocation process--R&D, marketing, cost reduction, distribution, etc. All the things that will enhance the existing business. And returns on marginal unit growth in a dominant business yield very, very high rates of return, so those are very, very important.

But generally, profitable businesses create excess cash flow because they cant grow their units fast enough to absorb the cash. And usually we’re dealing with companies that have some degree of maturity. Early on, you may have a situation where they need all the cash they can get, and then some. But as they start to mellow out, that changes as they get larger.

So, the next one they have to consider is acquisitions. And here there are two things to take into account. One is the price that they’re paying for something and the synergies that it brings to the table. And unfortunately, a lot of times, the egos of management get in the way of doing those things right. But if they do them right, they can be spectacular, and they can be very helpful and enhance the value. The third one is buying more of the same, which in effect is buying back your stock. Again, the critical variable is, what price did they pay? If they buy it at reasonable prices, that can enhance the valuation. The fourth one is paying a dividend, and with tax rates where they are now, that’s an attractive use of cash. The fifth one is basically sitting on it through paying down debt, or just letting cash build.

Those are really the basic five options management has. And how they do in predicting that requires some experience. As Will Rogers said, “Good judgment comes from experience, and a lot of that comes from bad judgment.”

We all make mistakes over a period of time, and hopefully, as a result of doing this process over and over again, we get better at it.

Dorsey: That’s a thing that I think many investors underanalyze: the talent or lack thereof of management at reinvesting capital. Buffett made a comment at this year’s annual meeting that a dollar in the hands of Montgomery Ward’s CEO in the late 1960s had a much different destiny than a dollar in the hands of Sam Walton. That’s something people frequently forget about. That compounding effect can be absolutely enormous, and management teams typically neither gain nor lose IQ points overnight.

John Chambers didn’t suddenly wake up and get a hole cut out of his head. He may have done some things that were mistaken, but it doesn’t mean that he’s lost his ability to run a business. On the flip side, you get poorly run business that suddenly kind of does a Hail Mary exercise, or announces a big restructuring or whatever, but they’ve basically never invested capital terribly well--a grain of salt is probably a good idea.

Yacktman: We’ve talked about two parts of the process. One is the valuation, one is managing reinvestment, which to some degree affects the valuation and the whole process.

The other one is the business model. I would argue that if you were to take a grid, and on one axis used fixed assets, and the other, you used economic sensitivity, that you could basically plot any business. What we are looking for are businesses that have high returns on tangible assets and that tend to have a central drive toward businesses with low capital requirements and low cyclicality. The problem is, most everybody else is sensitive to that, and so they price them high.

The area that I think is toughest to manage is businesses that are cyclical and require a lot of fixed assets, particularly if they’re mature You can go through the landscape and see the results of those kind of businesses over the last 10, 20, or 50 years of my business career. We have seven children; discussions would come up from time to time at the dinner table, and I remember one of my sons--Brian--not the one that’s working with me here, but one that actually now has his own company, Yacktman Capital Group, and does individual accounts and stuff.

He said to me, “So, what you’re telling me, Dad, is that basically, if you buy above-average businesses at below-average prices, on average, you’re going to come out ahead.” Now, that was a very astute comment for a young man to make, I thought at the time, because he was still pretty young.

We sometimes overcomplicate this business, too. I think the big difference, and one of the things that I think we’re good at, is being studious and also having this very long time horizon. Lack of patience is a very deadly disease in this business. Because stocks fluctuate in price--and a big company wil fluctuate maybe 50% from low to hig over a 12-month period--there is a central tendency to overtrade. As the price of trading has come down, that’s accentuated it.

Leggio: So, finishing up on Cisco, Don, given Pat’s observation that the past recent investments of the CEO have not been stellar--

Dorsey: The move into consumer was, frankly, just not smart. I mean, the fact that my set-top box has a Cisco logo on it drives me nuts every time I turn on my TV. But you look at some of their earlier acquisitions, and some of the ones they’ve done in the networking industry, they’ve still been pretty good, in my opinion.

Leggio: Don, what about the predictability of a business like that? How much more of a margin of safety do you want to build into a Cisco, rather than a Pepsi, because of the type of business they’re involved in?

Yacktman: You’ve hit it on the head. The less predictable the business, the more you want to leave yourself some cushion. That can be done in two ways. One is by having a lower investment amount, and also allowing for a little bit higher return, so that you’re trying to adjust for that risk that’s inherent in a business that has more unpredictability to it. That’s basically what we did with Cisco and why our big position was built at prices that were quite low.

High Quality on Sale

Leggio: I thought we could switch gears a little bit and talk about the investment opportunity landscape today. Don, it seems like your fund is full of, going back to your grid, low-capital-intensity, less-cyclical, high-return-on-invested-capital businesses. Is that where you’re finding the best opportunities today?

Yacktman: Yes. I’ve said before that I’ve been in this business over 40 years, and on a relative basis now, I have rarely, if ever, seen as many high-quality, good businesses selling at the kind of prices they are, relative to what else is out there. I look at PepsiCo PEP in amazement at the pricing of that particular security. Because of the predictability of the cash flows and the quality of the company, I wonder why anybody would choose a 10-year Treasury over Pepsi.

Leggio: Pat, you helped develop Morningstar’s Economic Moat methodology. Would you agree with Don that, on a relative basis, these wide-moat companies are very, very cheap?

Dorsey: Yep (laughter). Not much more to add on that front. I mean, the fact is a fact.

Leggio: I think a question some investors are asking is why these companies are so cheap, especially given their high predictability, high returns on invested capital, and-- to Don’s point about the 10-year Treasury yield, which is yielding about 2.4% as we speak today--many of these companies yield 3% to 4%, or even more. In other words, how can this be the cheapest area of the market?

Dorsey: It’s hard to divine why things get cheap and why multiples compress. But my argument here would just be: It’s simply performance-chasing. These kinds of compa-nies that Don and I are talking about got absurdly, insanely, ridiculously expensive in the late 1990s. Wal-Mart WMT was 40 times earnings, Coke KO was 60 times. Cisco, for goodness’ sake, was 90 or 100 times earnings. It takes a lot of multiple compression to work that off.

Just to take an example: Johnson & Johnson JNJ. Johnson & Johnson basically has gone nowhere in 10 years. I mean, the share price has done absolutely nothing. But if you look at the free cash flow they generate it has almost doubled. So, the business is worth more. People were just paying too much for it back then. The unfortunate thing is that investors tend to chase performance. They tend to say, “Whatever has performed poorly recently will continue to perform poorly. Whatever has performed well should perform well in the future.” I was trying to answer this same question, why such wonderful businesses are getting so cheap. I asked a friend of mine who deals more with retail clients, and he said, “Pat, a 10-year chart of J&J is not a good sales tool.”

(laughter) But unfortunately, that’s the truth of the matter.

Yacktman: Music to my ears.

Dorsey: You simply have to realize that what a stock has done has nothing whatsoever to do with what it will do in the future. Security prices and business values can become very, very divorced from one another. That’s why you focus on the business value and not what the security price has done.

Yacktman: I couldn’t have said it better.

Leggio: So, it sounds like you both agree on the consumer staples. Don, big-cap tech companies, as Pat mentioned, were very expensive 10 years ago. Microsoft MSFT is a top holding, as is Cisco, and Hewlett Packard HPQ. It sounds like you didn’t have anything against tech companies 10 years ago; was it just that they were too expensive for you, or have you gained more clarity into their long-term business prospects?

Yacktman: Well, I guess I didn’t think that they would ever come down to these kind of prices, either. Usually, tech is exciting, and people love to own it, and so on. But we classify them as old tech, because they’ve been around for a long time.

Dorsey: Yes, and I think the market in general is wrestling with, What does a mature tech company look like? Because most tech investors are growth guys. They want huge growth. They don’t mind paying up for a big multiple. And frankly, the companies are faced with this kind of a cultural dilemma as well, and that’s why so many of them are so reluctant to pay out cash.

Microsoft is kind of utilitylike now. They should be paying out far more of their cash than they are, but they’re probably still stuck in this mind-set of “tech companies just don’t do that,” which is unfortunate. Because like any industry, parts of tech can become mature, and once you’re mature and middle-aged, you need to act differently than when you were a teenager.

Yacktman: It keeps coming back to that basic, systematic way of looking at them. What are you buying, and how much are you paying for it? We will look at a lot of different industries if the prices are right. As Jason [co-portfolio of the funds] said, “It’s almost always about the price.”

The longer I’m in this business, the more I realize that flexibility is needed whe one looks at it. I remember when I first started managing Selected American SLASX many, many, many years ago, in early 1983, and the telephone company split up. Ameritech and Bell Atlantic--they were like shooting fish in barrel. I mean, they were earning 15% returns on equity and selling at book value.

Now, that’s a simplistic way of looking at it, I agree. I couldn’t understand how they could be selling at these kinds of prices. So, the market is kind of wacko at times. But over a long period of time, the central tendency is for it to move toward the valuations. And in the meantime, I’m glad that there are fluctuations because they create opportunity.

Looking Ahead

Leggio: Don, you’ve built an exceptional long-term track record over the past 10 and 15 years. The fund has appreciated around 10% a year, and that was while holding a decent amount of cash for most of that time. Looking forward, how would you characterize the return prospects?

Yacktman: On a relative basis, we’re in great shape. As I said, prices were clearly lower at the bottom in 2008, ‘09. But I don’t see that kind of market environment opening up. From a valuation standpoint, a lot of these companies are still down dramatically from where they were over a long period of time, and you’ve had years and years for the earnings to grow.

Conceptually, I tend to look at the individual stocks that we own, as opposed to the overall market. But when I look at them, to me, over and over again, what I see are beach balls being pushed underwater, and the water level rising. And so I feel very, very comfortable with the mix that we have.

But as far as cash goes, cash is a residual to us, and we would much rather be owners than creditors. So, while we’ve had, typically, recently, about 10%, and we’ve had in the past as high as 30%, I don’t feel comfortable when the cash goes up, because that makes me nervous about the market. It tells me we just have a hard time finding things t buy that we feel comfortable with.

Leggio: So, you still think low double-digit returns are a possibility?

Yacktman: Sure. I see double-digit returns, over and over again. And some of them--like News Corp., which is our biggest position, have returns well above that. So, yeah, I think over and over again, I look at this list and almost drool.

Leggio: Pat, any last words?

Dorsey: The only final comment I would make circles back to an earlier idea we touched on--for investors to not focus on what a particular security has done in terms of price over the past five or10 years but to focus on how much it is earning today, how much cash it is generating, relative to the price you’re being asked to pay for the shares. Because that is what will determine your future return, not the securities return over the past five or10 years.

I see a lot of investors still making the same mistakes that they’ve made for years and years. They go after hot asset classes, hot stocks, and move away from the stuff that makes both Don and I drool, which are securities that, by and large, were priced very richly 10 years ago, which have gone sideways for 10 years, while increasing their level of cash flow generation That’s a very easy psychological trap to fall into, but it’s one that can be deadly for an investor or an advisor. Focus on the price you’re paying today, not the returns in the past.

Yacktman: I would say, two watchwords. Objectivity and patience.

Ryan Leggio, Esq., is a fund analyst with Morningstar.
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