Mon, 12 Sep 2011
Owning high-quality companies will be integral to achieving growth in a low-growth environment, says the Davis/Selected American manager.
Dan Culloton: Hi I'm Dan Culloton, associate director of fund analysis with Morningstar. And I am here at the Morningstar Investment Conference with Ken Feinberg, Manager of the Davis Financial Fund and co-manager of Selected American and Davis New York Venture.
Ken, thanks for being here today.
Ken Feinberg: My pleasure, Dan.
Culloton: Well there is lot of interesting speakers on the conference agenda this week, including yourself of course, but we just heard Bill Gross speak, and he had lots of interesting things to say about the market in general.
I know you are not a top-down type of investor, but he did say something which I thought has bearing upon your portfolio and the way you invest at Davis, and that's he pointed out how real interest rates have fallen so far, that they affect not only the prospective returns for fixed income but also for other assets and stocks in particular. In fact he said that because people used the real interest rate to discount stocks, cash flows going forward, that they are so low right now that stocks are on their own, that their prospective returns are capped. Assuming that that's true, if stocks are on their own, what does a stock investor look for going forward to get an adequate return?
Feinberg: It's a very good question, and I'll start with the overall portfolio for second, because I do agree with Bill Gross. He is a brilliant investor, and one of the things or points we've been making for at least a year or so, is if the 10-year Treasury is yielding a little under 3% today, which is what it's yielding, and we look at our portfolio, and I am going to speak of Selected American and New York Venture as examples, and I am sure other fund managers have similar portfolios, the earnings multiple we would call the owner earnings multiple in our stocks is actually around 12 to 13 times. So if we invert that, we would say we're getting somewhere between a 7% and 8.5% yield today on the companies we own versus under 3% for a 10-year Treasury bond, so as a portfolio, we would definitely think with no guarantees that if you look out five or 10 years, a portfolio of companies yielding 7% to 8.5%, give or take, should do better than the 3% Treasury bond.
To get back to the question, in terms of companies, you know when we make an investment, we tend to have very low turnover. So if our turnover averages a little less than 10% a year, we are going to own a company for 10 years. And some companies we own for a lot longer, some for shorter. So one of the first questions we like to ask is, why should this business be able to grow earnings and free cash flow revenues in an intelligent manner for five or 10 years.
And so that's what we look for, and I think to Bill Gross' point, if we're not going to get multiple expansion just because interest rates are going to come down--if anything we'll probably get the opposite, because interest rates one would think over the next two to five years will be higher and the discount rates will be higher. So we're not really looking for PE multiple expansion; we'll take it on selective companies if we get it. But what we're looking for is the ability of companies either through a very successful business model--and we can talk about Costco or American Express--as examples. So they have a good business model. Their clients like them. They have got sticky relationships with their clients. They tend to have good market share positions, which give them some natural economies of scale or some good brands that attract members to stay with them because they are both really a membership model, Costco and American Express.
So we are looking for a business that can grow, either market share, revenues, free cash flow, earnings per share, which is very important, in a pie that we don't think is going to grow that much.
So that is one way. I think we hope many of our companies will do well just being able to grow their fundamentals over time.
Culloton: So what you are really saying is higher quality type companies; this is consistent with what some other managers are saying when they talk about dividend paying, global franchises. Would you agree with that?
Feinberg: I would agree with that. We have an ecletic portfolio, so not every investment will look the same for the same reasons, but one of the things that we've learned over--I have been in the business for 15 and half years--and you used the expression "quality franchises," and that's really what we're looking for, Dan.
If we can find businesses that add value to their customers, that have a very good competitive position, and Warren Buffett really thinks the same way, when he looks at either Lubrizol or one of his other companies that he is thinking of buying--he thinks about the competitive position. Do they add value to their customers? Is there any reason the customers would want to do it themselves?
So when we find companies, we like them to charge low prices for good-quality services that hopefully set them up for longer term pricing power, which is going to be very important if we get inflation again. Some companies have pricing power, some don't; some are in the middle. But you don't want a company that's going to get squeezed by input cost without the ability to pass along those costs to their customers.
That's a big part of our theme, but if we talk about the specifics of the companies, American Express and Costco, it's easy to spot a quality franchise, and that's good and bad. It's good because you sort of know it, when it comes your way. The bad news is, everyone can really see it, and usually those stocks trade at much at higher multiples, and Charlie Munger always referred to that as sort of a horse in a horse race with the weight being the handicap.
So you buy a quality franchise at 25 times earnings, there is certainly no guarantee you're going to do well, but today the good news is a lot of these companies, for different reasons, are trading at low double-digit multiples, some 12 times, some 16-17 times, but there is a lot of choose from today.