Artisan's Scott Satterwhite, James Kieffer, and George Sertl, Morningstar's 2011 Domestic-Stock Managers of the Year, explain why they see the best risk/reward trade-off in large, high-quality companies.
Greg Carlson: Hi, I’m Greg Carlson, and I’m a fund analyst with Morningstar.
I’m joined today by the managers of Artisan Mid Cap Value, Artisan Small Cap Value, and Artisan Value. They are the winners of Morningstar's award for Domestic-Stock Fund Manager of the Year. They are Scott Satterwhite, Jim Kieffer, and George Sertl. Thanks for joining me today, gentlemen.
Now, I want to contrast the last couple of years with your funds. In 2010, they posted decent absolute gains, but they generally lagged their peers by a significant margin, which is pretty unusual for these funds since they have such great long-term records. 2011, on the other hand, Mid Cap Value and Value in particular did very well on a relative basis. I wonder if you could contrast those two years and talk about what drove the differences in performance--whether it was the market environment or changes that you made to those portfolios?
Jim Kieffer: I think it was more market environment than anything else, but part of the story you have to go back further in time. In 2008-2009 you had such a strong rally, and then as it led into 2010, the cyclicals really took life, continued to maintain life. We were selling off our cyclicals at that point. They were becoming very popular, so we were exiting away from those names, and a price momentum market really came into play. Price momentum is going to go exactly against our sort of theory. Again, we sell what they're buying and buy what they're selling. So we were going exact opposite course of the market. I think that led to us ultimately lagging during the 2010 time period.
As you came into 2011, there was concern, I suppose, that that market, that sort of behavior, could continue, but how long is that going to go on? You did see some shift ultimately towards quality and some movement away from that momentum--ideas, I think, concern about the economy came in, and higher-quality influence played to our favor ultimately in 2011.
Carlson: Now, I should note here that in general, you all tend to tilt towards higher-quality firms than perhaps most value investors, and we can talk more about that in a minute.
I want to touch for a second on Small Cap Value. In contrast to the other two funds, which had great years on a relative basis since 2011, this one landed around the middle of the pack. It didn't do quite as well on a relative basis.
I know that you all mentioned earlier in the year that, particularly within the small-cap space, you were having trouble finding enough higher-quality firms trading at attractive valuations. Was that part of the issue in 2011, do you think?
Scott Satterwhite: It was part of it. 2011, as you say, we kind of wound up in the middle of the pack in the blend category. In the value category, we were probably somewhere in the mid-30s, around in there, which is pretty typical, I guess, where we live. And it was a typical year also in terms of where we got our performance, traditionally, and really quite consistently. A lot of our outperformance in all three of these strategies, we have probably more statistical proof of it in small-cap because it’s a longer database, but a lot of that performance comes from having fewer offsets, fewer blowups, fewer problems in the portfolio that cost us less.
In 2011, that was true. It was very much an average year from that perspective, and it was also pretty average in terms of how we performed in the upside outliers. We didn’t have very many, and we never do. So it was fairly typical.
Now more specifically, you can also look at performance in terms of sectors and industries and where you are and what the market did. And relative to these other two strategies, we definitely had less tailwind from insurance holdings. A lot of our financial weight is in insurance in all three strategies. In Large and in Mid, those were big contributors. But I think in small, we have had difficulty finding quality insurance players, and it was really the quality insurance players that did well in 2011. So we didn't have that tailwind in the Small account. And then on the banks and brokers, it did help us to not be there as it did in the other two strategies, but it helped less. So it was a huge help in the other two strategies. It was a help but a lesser help [in the Small strategy].
On the other elements, other parts of the portfolio, it looked pretty similar to the other two strategies. We had great results from IT, and we had a nice utility weight, as we also did in Mid, but not Large. But we had a nice slug of utilities that helped us a lot. So in many ways it was average, but definitely on a relative basis lagged the other two. So I think it was extraordinarily good performance there and kind of average performance in small caps.
Carlson: Now, Jim, as you mentioned, cyclicals rallied very strongly, obviously, coming out of the bear market in 2009, and you all will own those from time to time when you think they are trading at the right price, and you trimmed out of those. It seems that the funds have focused perhaps over the last couple of years more intensely even than usual on higher quality as you found that to be cheap.
So, what's your view going forward? Now, obviously, as we've said, 2011 was a pretty good year for quality. Are we now at a point where you're finding things a little more attractive again on the cyclical side or not so much? Or are there particular areas where that's the case?
Kieffer: I don’t know if we can find it so much on the cyclical versus noncyclical element. I think the quality element is still there, particularly in the mega cap world, the mega cap quality names still just stand out and catch our attention relative to everything else we own. One of the benefits of running across all market caps is, when something really stands out you notice it, and the mega cap quality names right now, the idea that the Microsofts and so forth, are selling at such low valuations, really stands out as a point of attraction to us.
So, I would define it more as mega-cap quality, which is kind of a common theme among a lot of investors right now, but we think appropriately so, and that's caught our attention more than anything from a cyclical versus noncyclical perspective.
Carlson: Right, certainly, within the value fund, which focuses primarily on large caps, and also on a fair amount in mid caps, it seems that the top of that portfolio in particular has a quite a few very large companies at this point.
I wonder if you could talk a little bit about the purchase of Apple in the second quarter? As you all mentioned in your shareholder letter, that maybe seems counterintuitive for value investors.
Kieffer: I think George is our wiz on that ...
Sertl: Apple, we purchased it in the middle of last year when it was pulling back; it was in the low $300s. We thought it fits all three of our criteria great. It has a very strong balance sheet. It has about $80 billion of cash, no debt. Probably one of the best balance sheets in the world. It has one of the best brands in the world. That brand and their business model of using very little capital to run their business and to grow generates very high return on capital, high free cash flow generation. Those are things we love.
And then we were buying it at about 8 or 9 times earnings on an unlevered basis. And that's just a great opportunity for that company, and we went in big and made it a big position. It paid off last year for us. We continue to like the position. All those same traits are in place. The new products seem to be doing well, and it remains at a very low multiple. It's up a lot, but it's still maybe 10 or 11 times our view of earnings this year. It has a tremendous amount of cash--over $100 a share in cash this year, and so we still like Apple a lot. It's a big holding.
Carlson: One more question on Apple. Does it have to maintain the very high margin--obviously, it has great margins. Does it have to maintain those going forward for your thesis to play out?
Sertl: It's interesting. Apple has high margins relative to hardware companies, but a lot of Apple is a software business now. So, when you look at its margins relative to Microsoft, you wouldn’t say they are necessarily high. So, really if you blend the margin with software and hardware, it has a pretty high margin, but not as high as you might look if you just compare it to other hardware businesses. Also, they have a retail business that is, you know, one of the best retail businesses in the world and generates pretty good margin.
Retail in general has a little lower margin, but has a really high return on capital. We focus much more on return on capital than we do on margins, and we look at the blend of the margin. But we think it's sustainable where it's at. The mix will be a little different because the iPad has a little lower margin than the iPhone. So, if iPad grows a lot, it will bring down margins, but we think it will be great for profits.
Carlson: I know the Small Cap Value and Mid Cap Value funds are currently closed to new investors. Are you perhaps finding the most ideas in the Value Fund given what you've said about mega-cap companies being fairly cheap now?
Sertl: Yes, I think for some time we've thought the best risk-reward was in the Value Fund. On a valuation basis, it looks cheaper than Small and Mid when you risk-adjust it, so we think it's fairly more attractive than say Small Cap. That gap might have closed a little bit because in the Value Fund, large caps outperformed small last year, so maybe that trend is starting to close a little bit; we'll have to see. ... I think it's a flip. When we were sitting in '99-2000, small was way undervalued and large was way overvalued. 10 years later, large did very little and small had a pretty good run for 10 years. And now it's not as extreme as in '99-2000, but maybe that reverse is taking place.
Carlson: All right. Thank you very much for your time, gentlemen.
Sertl: Thank you.
Satterwhite: Thank you.