Christine Benz: Hi. I'm Christine Benz for Morningstar.com.
What stocks does one of Morningstar's head fund researchers recommend, and what mutual funds does one of Morningstar's top stock gurus recommend?
Here to discuss that question is Mike Breen. Mike is associate director of mutual fund analysis for Morningstar. And Pat Dorsey is also here with me. Pat is director of equity research at Morningstar.
Guys, thanks for being here.
Pat Dorsey: Thanks, Christine.
Mike Breen: Thanks for having us.
Benz: So we thought this would be kind of fun to mix things up a little bit. Pat, you pay attention to the fund universe, and Mike, you've been a stock-picker for as long as I've known you and even before then.
So, Mike, let's start with you. When you look at individual companies, what are the key criteria that you are looking for?
Breen: It took me a while to figure out that I needed to follow the KISS, "Keep It Simple Stupid," technique, possibly because of necessity, but also from watching top managers over the years and realizing the ones that kind of aggregated things back up to a higher level and didn't get lost in the weeds worked really well. And some of my best picks were done that way where, ironically, we were just trying to avoid losses and concentrate on avoiding the downside as opposed to depending on some sort of catalyst to occur.
We were fortunate to own Anheuser-Busch in 2007, just really as a place to park money. It wasn't going to go down, and then it got acquired at a big premium and it was a big winner. And so, I've sort of simplified over the years, and so really looking for quality characteristics at the fundamental level: cash flows and clean balance sheets primarily.
Benz: Okay. So, let's talk about one of your ideas. J&J you said has been hitting your radar as a high-quality name that you think is selling at a fair price?
Breen: I actually own it already. ... It's got lot of attributes that we look at when analyzing fund portfolios. In our software you can put column sets of fundamentals across free cash flow yield, P/E, net margin, ROA, and at sort of an absolute level debt-to-capital that I'd like to see, on a stock I would buy. And I noticed in looking at portfolios of fund managers that it was hitting on all of them at extremely good levels, on fair price, lots of free cash flow, no debt.
So a very defensive, safe pick kind of in that Anheuser-Busch mode from a couple of years ago. We're very confident that it's got protection on the downside. The risk is that maybe the profitability and some of the things are at peak levels, but I think that's baked into the price trading at 10, 11 times expected earnings. I mean, those are pretty trustworthy earnings.
Benz: So, Pat, I know that's one that your team likes quite a bit too.
Dorsey: Yeah, we're big fans. I mean, in fairness, I don't think J&J is going to get taken out like Budweiser would; that would be a bit of a big nut for anyone to swallow.Read Full Transcript
But I often liken a J&J to a health-care mutual fund. I mean we've got this giant portfolio of consumer products--Band-Aids, No-Tears shampoo--that doesn't require a lot of reinvestment, but then kicks off a lot of cash, which they can then throw back into higher-growth areas like orthopedic devices, which they own the largest division in the world, DePuy, that makes artificial hips and knees, that sort of things, as well as their biotech and pharmaceutical franchises.
You know they've had some issues lately, but this is one of those few firms in the world that has its culture of disciplined capital allocation. If you remember a few years ago, they walked away from the Guidant acquisition that had since pretty much sunk Boston Scientific. You don't often see big companies get into a bidding war and then step away. Usually too many egos are involved, and so, "Well, we've got to finish this deal; we've got to win." But they said, "No, the price is too high. We won't get a return. We'll step back." I like that in a business.
Benz: So, Mike, your other pick, maybe the quality isn't there so much, but you think it's kind of too cheap to resist right now. So let's talk about that one.
Breen: Yeah. It's a company called Collective Brands, and in full disclosure of Vince Sellecchia, who is the manager of the Delafield Fund, it's one of their holdings, and I've been talking to him about it and caused me to do some research on it.
It's really a quite simple story. It's shoe stores, Payless ShoeSource, Saucony running shoes, Keds, a bunch of different brands. They have a new CEO who has been in there for a little while with a good track record. Very cheap, trading at 0.3 time sales, much below the industry, but it's a good franchise, and they're going to use their cash flow, which they have tons of it, to retire debt.
So, not an exciting business, low margin – not the greatest business, but definitely way too cheap now. I'm pretty confident that got some protection on the downside, and as things work out over the next year, we'll have a chance to sort of ... they're really a deep-value play, and just sort of have it return to a more normal level.
Benz: So, Pat, how about you on this shoe company?
Dorsey: Well, it's definitely a deep-value play. I think our fair value on it is like $22 a share, stocks are $13-ish, $14 right now: very, very cheap. And oftentimes, although we do focus a lot on quality companies, what we call wide-moat businesses at Morningstar, a lot of times you can get some of your biggest pops in terms of future growth in cash flow from the businesses that go from as, one manager recently said to me, crappy to semi-crappy. And this is sort of a business that's probably going to go from crappy to semi-crappy…
Breen: Don't sell it short... It's moderately crappy.
Dorsey: ...But you can make a lot of money owning businesses like this. The brands are good. They've just probably been underinvested in over time, I would imagine. And I guess the only thing I would say is you want to have a business like this on a bit of a tighter leash than a J&J.
Breen: And for me, the way I treat these holdings: J&J would be a much bigger position; this is speculative, it's smaller. So I don't think there is a lot of risk, but it is a lot riskier, so you want a smaller stake in it. If something does go wrong that you didn't see, you don't get damaged as much and then has a decent amount of upside.
Benz: So, Pat, I want to turn to you and talk about what you look at when you are thinking about mutual funds. I've always been impressed about how you do pay attention to the mutual fund universe. Let's talk about, first, why you do that?
Dorsey: Well, I mean these folks have been running money for a long time, and they've generated returns over time. And I think if you don't learn from them, you're kind of a fool in some ways. I'm always shocked, for example, at how many investors don't pay a lot of attention to, say, [fund managers'] shareholder letters. Budding investors, especially, because having hired 150-plus analysts over the years--you ask them what do you read; not many of them have really read shareholder letters. I don't get this because they are free.
Dorsey: Your ROI has got to be good. There is no "I," right?
Benz: Some people are stocks or mutual funds, and never the twain shall meet.
Dorsey: Well, it's just a weird thing, because I mean it's sort of like, if you wanted to be a pro basketball player and Michael Jordan said, I'll give you a free one-on-one lesson for an hour, you'd probably take him up on it, but yet nobody reads shareholder letters from folks, whether it's from Warren Buffett, or David Herro at Oakmark. I don't understand it. I think you can learn a lot from the great folks.
Benz: So, let's talk about a couple of your fund ideas. One is kind of a tried-and-true quality-oriented pick, let's talk about that one.
Dorsey: Well, Sequoia Fund. I mean this is a fund that's sort of well known to those inside the industry, because it's ... the firm Ruane, Cunniff... where Warren Buffett told folks who had invested in his partnership that dissolved in the late '60s, he said, well, I think these guys are pretty respectable, you should put your money over there if you still want someone to run it, and that sort of morphed into the Sequoia Fund over time, which was closed for a long, long time. There was actually a secondary market in the shares, if I'm not mistaken. And I think about three years ago, it reopened. And so, this is a fund that's in the top decile of performance over one, three, five, 10, 15 years; charges you are whopping 100 basis points; and is one of the most shareholder-friendly cultures I have ever found, and in the vein of "Keep It Simple Stupid," I mean, what more do you want.
Benz: So the other idea, Pat, is also value-leaning fund or deeper-value fund.
Dorsey: Deeper-value I would say, yeah.
Benz: And it really got creamed in 2008.
Dorsey: Oh, yeah.
Benz: So, let's talk about this fund and what you like about it?
Dorsey: Yeah, so it's Dodge & Cox [International], and Dodge & Cox is a shop that's been around for, I think, what, 80 years now, 90 years, and they've launched four funds during that time period, so…
Benz: Pretty minimalist, which is unusual in the mutual fund world.
Dorsey: Exactly, which is great, which is what you want to see, right? I mean, again a very shareholder-friendly culture, a firm that I would have a high level of confidence that would look in 10 years like it looks today, which is I think what you want in a fund company, which your trusting to be a steward of your assets.
What I really like about their foreign fund is that it gives you a lot of exposure to faster-growing areas of the emerging markets. They've got about 20% of the portfolio in emerging markets versus about 5% for the average sort of non-emerging markets specialty fund. And they also own a lot of companies like HSBC or BHP Billiton, which might be domiciled in developed market countries, but most of their demand and most of their economic returns going forward are going to be driven by what happens in emerging markets.
And if you look at the portfolio and if you just look at it versus the lot of kind of standard, like say foreign large-blend/large-value funds, looks nothing like it.
And what I really like about that fund, 65 basis points, very, very inexpensive relative to most foreign funds, and again the returns have been fabulous. So it's again, "Keep it Simple Stupid," what more do you want?
Benz: So Mike, I know those are going to be two funds that you like as well?
Breen: Yeah, absolutely, and I would have to agree that you've got a brilliant analysis on Sequoia since I covered it, and you're matching what I say about it. But, yeah, you hit the nail right on the head.
One of those shops that's very defensive, quality companies, and so their trailing short-term numbers are going to look about as good as they can right now because that encompasses 2008, and when we're covering it in 2006 we will get complaints from some shareholders that it was only making 10% or 12% per year for the last three years, because other people were making more and then 2008 comes and instantly it's still making that amount and everyone else is making less. So you can kind of book that.
And one of those things where they had the courage or their conviction to put a big chunk of their money in Berkshire Hathaway and then in arrears everybody looks and says, well, for 20 years anybody could have put 20% in Berkshire Hathaway...but nobody else did. So, if you look back 20 years ago that looked crazy. So, great fund, great manager. I talk to Bob Goldfarb pretty regularly, and very sensible way of analyzing stocks, not pedantic or overly quantitative or anything like that.
And then Dodge & Cox is interesting as well. The international fund has been out as long but the domestic funds uses similar strategy, and even when they got hit in 2008, their trailing 10-year number was still really good. So, not to excuse that one year, but if you are a long-term shareholder, which is the way they run money, you didn't even get hurt in the grand scheme of things if you had been in for 10 years, you are still miles ahead. So very confident in both of those shops going forward. They seem like kind of funds people can own and stick with pretty sensible strategies.
Dorsey: Exactly. And one thing I should point out about Sequoia that I have always respected about them is that they have sort of been willing to take kind of the value philosophy and push it forward.
Breen: Absolutely, Fastenal, which you guys cover…
Dorsey: Fastenal, Precision Castparts, there's a lot of names in there, which I think some sort of died-in-the-wool value managers might turn up their noses at, but frankly it's worked well for them, because they, I think, really followed the Charlie Munger philosophy that there are some businesses that are worth paying up a little bit more for, then you ride those for a long time, and it compounds value, and I give them a lot of respect for that.
Breen: And Munger says, if it compounds capital at a high rate, you can't really overpay for it. So people, the classic value guys would look at those companies and say I can't buy this at a P/E of 22, but if it's growing 30% a year compounded for a decade, that's actually cheap. So sort of "price is what you pay, value is what you get" type of thing.
Benz: Thanks to both of you. This has been great to hear your insights on your respective universes.
Dorsey: Thanks for invitation. Appreciate it.
Benz: Thank you. Thanks for watching. I'm Christine Benz from Morningstar.com.