Thu, 21 Jun 2012
BBH Core Select manager Tim Hartch says focusing on easy-to-understand businesses, particularly in the financials and consumer defensive sectors, helps his team avoid negative surprises.
Jason Stipp: I'm Jason Stipp for Morningstar. As the market continues to serve up negative news, investors can't be blamed for being a little bit skittish, but some managers have shown their resilience in difficult markets. One of those is Tim Hartch of BBH Core Select. He is joining me today here at the Morningstar Conference. This is a Silver-rated fund that has a great long-term history of performance and also was a top performer in 2008 in the large-blend category.
Thanks for joining me, Tim.
Tim Hartch: Thank you.
Stipp: You folks are bottom-up stock pickers, so you look at individual securities and you find your opportunities where you find them. This can lead to a portfolio that has some different looks than the S&P 500; it has different weightings than that index. One of those weightings as of your most recent portfolio was in financial services, an area of the market obviously that suffered in 2008. I'm wondering if you can talk a little bit about the opportunities you're finding in financial services.
Hartch: We have an ownership approach to investing generally in large-cap businesses, and that ownership approach implies trying to identify businesses where you have a certainty of a positive outcome over a long time period. It also means we want to have not only the margin of safety in the price but also in the quality of the businesses. Within financial services we actually think there are a number of companies that really are extraordinary franchises that are currently very attractively valued.
Stepping back just more broadly about financial services, particularly the banking sector, there is a perception I believe that still the sector is under significant stress. That's true that there are regulatory challenges, but the U.S. banking sector is extraordinarily well-capitalized. Back in 2008, it was about 6% tangible equity to assets; today it's almost 9%. It's never been higher in the last 60 years in terms of being better-capitalized, and the other main challenges for banks are credit losses. Those have consistently gotten better, if you think about the problem loans four or five years ago with the average loan being approximately four years, the duration of average life of a loan, most of those are behind the industry. So you see the credit statistics continuing to improve.
So we think just at a macro level that there is a perception about the industry being in a more difficult position than it actually is. The U.S. banks have really gotten through the crisis, and then there are certain banks that really have emerged as winners coming out of the crisis. We own two: Wells Fargo and U.S. Bancorp. They are both deposit-driven franchises, so they have great deposit and liability structures. For example, Wells Fargo is a business that has more than $900 billion of deposits, and the cost of those deposits is only about 20 basis points. So, that plus an extraordinary capital position, the ability to generate capital, both U.S. Bancorp and Wells Fargo have that capability. They're very well-positioned in today's environment, and so we think they're attractively valued with a large margin of safety both in the quality of the business, and the price.
Stipp: So, those two names, I think, you would say are more traditional, old-school kinds of banks, where they take in the deposits, pay out a certain interest rate, and there's a spread there. We've seen with other banks, however, that they can be much more difficult to analyze. J.P. Morgan, for example, which was a very strong bank throughout the crisis recently had an issue, obviously with its London office. So when you're looking at banks and trying to figure out their risks, some of the bigger banks with the more opaque operations, do you stay away from those as part of your process and risk control in banks, looking at those easier-to-understand financial-services companies?
Hartch: We believe simplicity is a virtue, and it's particularly so in financial services. Both U.S. Bancorp and Wells Fargo have basic banking businesses at the core of their franchises. They're not traditional money center banks. They're more superregional banks, though in the case of Wells Fargo it's in all 50 states, but they operate really as a traditional bank almost like a community bank in each of their markets. So it is easier to understand how they are earnings their money and what their potential risks are.
So, I think that's correct. We do focus on businesses that are easier-to-understand, and we are less likely to have a negative surprise.
Stipp: Do you think that those banks and other financial-services holdings would be less susceptible to the systemic risks that seem to be on a lot of investors' minds right now, especially with talk of European contagion and things like that.
Hartch: I think that is the primary macro concern at the moment for the banking sector, the European situation and the potential for bank problems and sovereign debt issues throughout Europe. The two banks that we own that I mentioned, Wells Fargo and U.S. Bancorp, have very minimal exposure to Europe. It would be more counterparty risk with respect to certain other banks and financial institutions if there were a large failure. But as I said they're very well-capitalized and they are extremely focused on limiting any potential losses with regard to the European situation.
I think it's more of a sentiment issue that's depressing the current valuations, and that's actually a benefit for us as long-term owners because both of these businesses are now generating a lot of cash and have ability to buy back stock. When you are doing share buybacks, a low multiple, a low share price is actually a big benefit. Both banks are trading at meaningful discounts to our estimates of intrinsic value and have very low absolute multiples.
Stipp: Another sector where you have a sizable weighting is the consumer defensive area. Would you say that your attraction to some of those names is a byproduct of your focus on quality companies.
Hartch: The short answer is yes. We have very specific criteria that we use to identify which kinds of businesses we want to own. We look for essential products and providers of essential products and services, a loyal customer base, a strong competitive advantage, and an attractive industry structure. And within the consumer sector, there are many businesses that have good brands, good distribution, particularly globally that would fit to those criteria. So we have a wish list of the businesses that we want own and there are a number of really world-class consumer business is on that wish list.
Stipp: Have any of those been under pressure recently and maybe offered you a buying opportunity, or why have you been able to pick up some opportunities in that area? What has the sentiment been that allowed you to get good valuations on those names?
Hartch: They’ve done very well in recent years, they’ve consistently performed well I am talking about businesses like a Nestle and most recently Wal-Mart. The share prices have done reasonably well, and that reflects very good operating performances. We haven’t added a number of new names, the most recent probably would be Target of the retailers. But we think they're at reasonable valuations and they're very stable businesses. If you look at the opportunities, I'm thinking of the consumer packaged-goods companies, the businesses we own like a Nestle, like a Diageo, have extraordinary positions in emerging markets around the world, the growing markets. If you look out five to 10 years, again that ownership approach based on the fundamentals of where the business is going to be in the future, they are well-positioned. The major challenge at the moment is the difficult consumer environment in Europe and to a lesser extent in other developed markets like the U.S. But I think that's largely priced into the current levels.
Stipp: I want to talk a bit about the opportunity set you're seeing. Your cash stake as of your most recent portfolio was around 9%. Can you put that in some context? Is that high? Is that low? And what does that say about the opportunities you're seeing in the current market?
Hartch: It's higher than it's generally been in the last few years. It's generally been around 4% or 5%, but I wouldn't read too much into it. We did exit some positions on valuation. We have a very disciplined process for exiting a company as it approaches our intrinsic value estimate. We try to buy at 75% or below the intrinsic value and then to exit as it approaches our intrinsic value. In the case of Visa and Ecolab, these are two recent examples where they've reached our intrinsic value estimates, and we've exited. So I do think that we'll find more opportunities and be able to invest the cash that we have.
Stipp: My last question for you, I started this interview by mentioning some of the macro issues that investors are reading about day after day. You are a bottom-up stock-picker, and I know that you're a fundamental investor and are looking at business franchises. But yet we do know that the macroeconomy can affect companies, at least in the short term. How do you think about some of the broader issues that we're seeing in the economy now as you're analyzing the individual companies that you hold? And is there ever a swing factor for economic concerns in the decisions that you make on individual companies?
Hartch: Well it's impossible to divorce the macroeconomic environment from the individual businesses, so we're always analyzing those companies in the context of what's happening to their own customers who could be consumers or could be government payers in the case of health care. And those are significant macro factors that affect our businesses. But more often than not we have found that being too swayed by those macroeconomic factors is a negative. It can actually sort of paralyze you. So we try to really focus on what's happening at the individual businesses and the feedback from the executives who manage those businesses, and we really seize on opportunities when the negative macro sentiment creates valuation opportunities.
Right now, for example, we have a large position in Novartis, which is a phenomenal health-care business that has had some temporary challenges in some of its smaller businesses and always has regulatory challenges from the payers. But the firm has a really superb franchise in its eye-care business, Alcon. Its pharmaceutical business is doing quite well. So when you look with the cash flows that the business generates, it's really trading at a bargain price, a significant discount to our intrinsic value. So that's how we hope to take advantage of those macroeconomic environments when the negative headlines are creating opportunities in individual businesses.
Stipp: Tim Hartch from BBH Core Select Fund, thanks for joining me today and for your insights on the current market and the opportunities you're seeing in your fund.
Hartch: Thank you very much.
Stipp: For Morningstar I'm Jason Stipp. Thanks for watching.