Shannon Zimmerman: For Morningstar, I am Shannon Zimmerman. I'm here today with Mike Clarfeld of Legg Mason ClearBridge Equity Income Builder and several other strategies, and we'll talk about those in a bit. But let's focus initially on Equity Income Builder, and you are comanager there with Hersh Cohen, who I think has been managing money since the Carter administration, right?
Michael Clarfeld: Yes. Hersh has been managing money since Carter, maybe even earlier than the Carter administration.
Zimmerman: Maybe before the administration.
Clarfeld: Maybe before the administration, yes. Hersh has done phenomenally well over a very long period of time.
Zimmerman: That's true at this fund and then also Legg Mason ClearBridge Appreciation (Cohen stepped down from managing this fund in 2010).
Clarfeld: Exactly. With a disciplined approach that we think that stands test of time. And the disciplined approach that Hersh has always run and how we run this fund today is focusing on high-quality companies that can compound returns at attractive levels over the long term. And we believe that approach is really one that works throughout all market cycles. We actually feel like those types of stocks that fit that approach are particularly attractive today, making this a very good time for our investing approach.
Zimmerman: Let's talk about a couple of names in particular they were the top two holdings of the fund. ExxonMobil which is sort of a classic large value; the fund is in the large value category at Morningstar. And you expect to see ExxonMobil in a fair number of portfolios, but not Apple. But Apple is the number-two holding. How can that be?
Clarfeld: So, a good question. Actually let's start with Apple since that one stands out more. What's interesting you mentioned large value and traditionally you wouldn't expect potentially Apple in a large-value fund. You also probably wouldn't expect Apple in an income fund at least not until recently. We've owned Apple for about two years, and really what drove us to Apple where several things.
All of our analyses start with balance sheets, and Apple's balance sheet now is arguably the strongest in the entire world. Apple has close to $100 billion in cash. I mean these are mind-boggling numbers. When we bought it, it wasn't $100 billion, but it was probably $30 billion or $40 billion or $50 billion.
All of our analyses always starts at balance sheet, so Apple has really a truly fortuitous balance sheet, tens of billions and now $100 billion in net debt. Then we look at the business and our investment approach is really focused on high-quality businesses. So, there are lots of different ways to find names to invest. Some people run screens and see what screen is cheap, and that's one way, and that's good way of doing it. But it's not we do. What we really do is find best-in-class businesses that we think will be successful over long periods of time.
When we looked at Apple, what we saw was that it was in a very large and very quickly growing marketplace with a vastly superior product, and that actually given the whole app phenomena and the app marketplace, the App Store, the more people who use Apple [products], the more developers who want to make products for Apple. There is actually a network effect where more people using the product actually made it stronger.
Zimmerman: Did you own Apple before it began paying a dividend?
Clarfeld: We did. That's a good question. We actually bought it before it began paying a dividend because we believed that it had certainly the wherewithal and ultimately would institute a dividend. And we also think that sometimes the mistake people can make with equity investing is sort of if you wait until the dividend's already been announced, it's something like the horse is already out the barn, and the stock's already moved a lot. We believe being good investors is sort of hopefully a little staying ahead of the curve and getting there earlier.
Zimmerman: And you anticipated that Apple, with all that cash sitting on the balance sheet, at some point would pay a dividend?
Zimmerman: Like Microsoft did before, right?
Clarfeld: That's right, and it's a trend actually we're seeing in technology a lot right now which is really powerful and really great for equity income investors like ourselves. If you look back just even five years ago, it was taboo to pay a dividend in technology because people thought, if a tech company was paying dividend that its growth days were over, and it was sort of a mature company.
Zimmerman: It had a different audience for shares, so to speak.
Clarfeld: Exactly, and what we're seeing today is that vast majority of tech companies now actually pay dividends. So Microsoft, Apple, Intel. Cisco Systems recently announced a meaningful increase. Oracle has a dividend, small, but growing. So really the two large holdouts we see today are just Google and Amazon.com. We don't expect probably either one of those in the real near term to do it, but it's gone from being sort of a stigma to be a dividend payer to actually there's a really a lot of high-quality dividend payers now with real yield in the space which is great for us.
Zimmerman: So folks who are looking at a portfolio like this [might ask], "This is a large-value fund. What is it doing owning Apple?" Well that's why, and also I know from our previous conversations that you and the team are absolute-value specialists. So you're looking for companies that are trading at a fairly steep discount to intrinsic value. What's the discount that Apple has right now to its actual value in your estimation?
Clarfeld: Well, that's a good question. Intrinsic value is certainly something [important] with folks. With a company like Apple, it's more of a free-cash-flow-based analysis. And what we see is that on a cash flow basis, on an earnings basis, Apple has always traded actually very cheaply. So, even though it was having this tremendous growth, I mean, you could go back a year or two ago and Apple was growing literally 75%-80% year over year. I mean these are really staggering numbers and trading at 12 or 13 times earnings. And even today what we see is we don't think that Apple continue to grow probably that sort of 75% growth rate.
Zimmerman: But we didn’t think that five years ago either.
Clarfeld: That's right. It has gone a lot longer. But we continue to think that it can grow at very handsome rates, and that in the low teens it's an attractive place to be investing, which is a low-teens multiple on the stock.
And I think the other thing that's interesting is Apple keeps redefining itself or redefining its addressable market. So its first hit product was the iPod, then the iPhone, now the iPad, and the markets keep going. And so there are also rumors it's getting Apple TV and things like that. We continue to think they would grow in the addressable markets, as well.