Former Oakmark Manager Sanborn as Defiant as Ever

In March 2000, Robert Sanborn was at the bottom of the heap. One of the most vocal proponents of value investing, his Oakmark Fund (OAKMX) had posted an especially weak return in 1999 and early 2000. The fund suffered enormous shareholder redemptions, and ultimately, Sanborn lost his managerial post. In some quarters, including the Morningstar.comConversations board for his fund, Sanborn was regarded as an old-school investor who just didn't get the new economy. More than two years later, former Sanborn picks such as Philip Morris (MO) have rebounded sharply, and the dot-coms that he shunned have taken a pasting. We sat down with Sanborn, who now runs a hedge fund, to discuss his current views on the market.

Morningstar: You're a bottom-up stock-picker. But in the big picture, how do you have your fund positioned?

Sanborn: It's really been the same for me since 1999. In general, small caps are still more attractively priced than larger caps. I would say, lower-expected-growth stocks are still more attractively priced than higher-expected-growth stocks. While that basic relationship hasn't changed, the opportunity now is nowhere near as good as it was in March 2000. You know, Cisco (CSCO), which I've shorted, was at $80 then and it's at $15 now. The thing that's amazing is that even at this price of $15, it happens to trade at five times revenues. What the hell was it doing at $80? It was trading at 25 times revenues and is a large-cap company.

I would say that it's getting tougher to find value in the long side, but I still prefer small- and mid-cap stocks. My average long stock has about a $5 billion market cap; my average short has an average market cap of about $70 billion. Within each side of it, I have small, medium, and large cap, but that's the average. Since I first started here in July, I'm up 28% because of that positioning (gross, not net of expenses). I can still find shorts fairly easily still and I think that the opportunity is greater there than on the long side. But I think in the big-picture sense, I think that you're looking at earnings growth in the S&P 500, say, fairly low, mid, single digits, you know, 5%, 6%, 7% over the next five or 10 years. And that's coming off an inflated base because of shoddy accounting.

I take it from that you're not seeing much value in the big name tech stocks. What do you think about some of the pharmaceuticals?

I think that area is a value trap. I think that a lot of value buyers are interested in the drug areas because they perceive it as being a superior business--which I think it has been. Among big companies, since 1972 only two of them have posted compound earnings-growth rates over 15%, Philip Morris and Merck (MRK). That is the sign of a great business.

But you still aren't interested in Merck?

Merck has a market cap of $119 billion and basically has no debt, but its revenues are $48 billion so it's trading at about 2.5 times revenues; the P/E is about 20. That doesn't strike me as cheap. I think that the drug business has changed. In this country, the government and managed-care companies are now paying for a very large percentage of drug bills, and they will keep costs as low as possible.

I think that what attracted people to a stock like this is that it's so far off its high. It peaked in late 2000. What happened is the stock jumped from $65 to $95 in the summer of 2000. Growth buyers were fleeing tech like crazy because they wanted to escape the fundamental weakness there, so where's the only place for them to put money to work? You can find a P.F. Chang's China Bistro ; you can find a Bed Bath & Beyond . But if you're a growth investor who wants to put big money to work, you go to health care. So, in my opinion, that move was totally artificial; a total artificial move of growth buyers fleeing the wreckage of tech in late 2000 so that they can show their clients that they don't own Cisco. But people anchor on this. And the basic dynamics of the industry have changed pretty significantly.

What is a fair value for a company like Merck? Do you really think that it should have a below-average multiple?

First of all, I find the average stock to be overvalued. If the market is overvalued, then just because a stock is relatively cheap isn't enough to get me interested. Corporate profits as a percentage of the economy are pretty low right now. That would tell me that probably profits are below trend, to some extent. So if a drug stock is trading at 20, and the P/E of the market is somewhere around 21 to 23, then I think that by and large drug companies are trading at a slight premium relative to other firms' P/Es on normal earnings.

I still think that there are far more opportunities in the mid-cap arena at this point than there are in the large-cap sector. And again, drug stocks are almost always going to be large cap. And by and large there was so much money artificially put into large-cap stocks in the late 1990s, that still has to be bled out to some extent. You give me a drug stock with a really good product pipeline, a valuation of 1.5 times sales, and a multiple of 15 times clean earnings, I'm pretty interested. But at 2.5 times revenues and 20 times dubious earnings, these companies aren't on my radar screen.

What do you think is dubious about drug companies' earnings in particular?

Drug companies have more flexibility and more discretion than most businesses in allocating costs. They can defer R&D and other types of spending pretty easily. So, I'd say by and large, their economics are probably slightly worse than people think.

You've mentioned some overvalued stocks like Cisco. What do you think that the most overvalued stocks are right now?

Well, I'll give you some of my shorts: large caps, including Walgreen (WAG). Take-Two Interactive Software (TTWO) is another example: They've had major problems with the SEC and their revenue recognition practices. They make Grand Theft Auto, a fun game if you like ultraviolent games. I think that it's a one-hit-wonder. My favorite one is IDEC Pharmaceuticals , which has a ridiculous valuation and very limited prospects. I've been short General Electric (GE) since the first day the fund started; it's overvalued in my opinion. It's not a very aggressive short, but I am short. GE's not greatly overvalued, but relative to similar mid-caps, it's overvalued.

A lot of people remark that GE's revenues are dried up, yet the bottom line keeps growing. Is GE manufacturing earnings?

Oh, definitely. There's no way that collection of businesses generated the results that they did over the past five years, in real terms. There's no way. Those businesses aren't that good. They're either taking huge risks in the GE Capital subsidiary or their accounting is aggressive at best, or some combination.

What about Philip Morris? It's one that I'm curious about because you owned it for many years. Is that still a favorite of yours?

It's one stock that I don't happen to own now because it has gone up so much. I liked it at $18, $19 per share, but it's around $55 today, plus it has probably paid $10 per share in dividends since it was trading at that low level. So it's a different stock than it was at $18.

Isn't a company like that risky at almost any price because of litigation risk? Look at what has happened to companies with any asbestos taint. Those companies mostly quit making products with asbestos years ago, yet many of them are now being forced into bankruptcy. And they never made products that killed as many people as have cigarettes.

That is all true, what you said. But that's not the way to look at it, in my opinion. The way to look at it is, you can do one of two things: you can basically say, "I as an investor will never get involved in something like litigation." Well, I think that that's wrongheaded. I think that there's a price for everything. Let's look at the Philip Morris situation. Here's the key thing about the litigation that I don't think people fully understand: the amount of money that they've spent on litigation is very low. The most was on the state settlements. Let's just say that right now, there's a litigation settlement that raises the cost of Philip Morris cigarettes $100 billion. What would Philip Morris do to recoup that? It would raise prices. They could double the price of tobacco today. They'd lose some smokers, but cigarettes have the most inelastic demand of any product in the free world that is legal. And there is very little competition.

Shifting gears, you earlier mentioned your affinity for mid-caps. At Oakmark Fund, you owned a lot of mid-cap industrials. Is that still the case?

That's a big area for me now and has been for some time. It's done really well for me. These are industries that have attracted very little capital over the last five to 10 years, so there aren't a lot of emerging competitors. That to me is very significant. The venture-capital industry, I believe in 1999, the venture capital asset class was up 146%. So what happened? In 2000 and 2001, VC firms raised more money than in the prior 10 years. That money did not go to compete against Maytag , and did not go to compete against Fortune Brands . It went against Cisco, E-Toys, and the like. Mid-cap industrials are in industries where capital is coming out of them, thus improving the profitability of the industry. Even though that area has done very well since March 2000, they were driven down so low between 1996 and March 2000 that I think if you look from 1996 to now, they're still reasonable. I still think that is the most reasonable sector in the marketplace.

The size of my fund is also an advantage. With just $100 million, it's not that hard to invest in mid-cap industrials. It's easy. I believe that a lot of the established value managers are taking in a lot of cash. That's forcing them inexorably into large-cap stocks. I still don't think that that's where the attractive values are. It's in mid- and small-cap areas, despite the fact that it's getting a little overheated.

I saw the list of the small-cap value funds that have closed that (Morningstar produces), and it's unbelievable. They must be getting tons of cash. I do believe that when all's said and done, my longs--these mid-cap industrials, etcetera--will be pushed much higher than where they're at now. There's still inevitably more money in growth funds than in value funds. I think that is going to shift. And it's not going to take a lot of money to move these stocks.

It's the exact opposite of what was going on in 1998 and 1999. The stocks that I owned then-- such as Fortune Brands--I was the typical owner of those stocks and I was selling every day. The other owners were similar types of investors, they were selling every day and the money was going to Janus, and they were buying every day. So I believe that process--over the next few years, you're going to see the culmination of the reversal of the 1990s. And if you watch CNBC, which I try not to watch, in 1999 you would have never even heard stocks like Masco (MAS) mentioned. And I do think that at the end of the day, these stocks will be moved way beyond what they are worth. I'll be long gone, and I'll probably miss much of the move up after that, but I'm not going to try and time it. The Fortune Brands and the Mascos of the world could double easily from here. They could get overvalued, but they're not at this point.

In addition to the valuation argument, what you're saying is that this dearth of capital going into this industry means that these businesses should be able to earn above-average returns on invested capital in the future?

Exactly. And these are companies that by and large were buying back their shares aggressively. At the end of 1999, two thirds of my companies were aggressively buying back shares. That was a very, very smart move. So not only was new capital not entering these industries, but the companies themselves were decapitalizing through share buy-backs. I do find that when I talk to the companies, they're not telling me that they're seeing signs of capital heading into the industry and retarding returns. I think that every single one of my longs is number one or two in its industry. And a lot of them are natural consolidators. They're consolidating the weaker companies in the area.

What's an example of a company that you think is doing a really good job as a consolidator?

Fortune Brands. Fortune Brands is basically four businesses. In the spirits business, they own Jim Beam; it's a cash-flow situation. In golf, they're natural consolidators. The company's Titleist unit is the natural consolidator of that business. In the cabinet business, where Fortune Brands also has a major presence, the company is consolidating that business aggressively. In my mind, that's a value-added move. It's very interesting.

What about a part of the market that has performed relatively well recently--financials?

I actually am very light in financials. I worry about financials in general. I believe that there will be major pockets within the financial-services industry that have to pay a heavy price for the excesses of past years, and you've not really seen it yet. You've got your Consecos (CNC) of the world, maybe, but I think that you're going to see more of that. I think that with the leverage there, the fact that the economy isn't booming, and a lot of leeway with accounting--makes me kind of worried about the whole area. The only representation that I have in the financial-services industry is that I'm short a couple of stocks. I have no longs there.

What are you shorting?

I'm short AIG (AIG). I'm short on Ameritrade  also, which has been a good choice for me. And I'm short FirstData , which is a great company that has done very well, but the valuation is excessive. So, I'm short three financial-services companies, and I'm not long on anything in the sector. If you look at the Oakmark Fund, when I managed it, I liked financial services. I tend to like them. But at this point, I think that avoiding them is the right move.

What about health-care services? You had some exposure to that area at Oakmark Fund and took some lumps.

I was early. I did drug stocks in 1994 and basically toward the end, I did Hospital Corporation of America. I had a couple of HMOs at the bottom that did really well, but I would have sold way before they peaked, frankly. That's been an explosive area. The only health care that I have now is that I'm short a couple of biotechs. I have no longs.

A lot of value investors told us in the late 1990s that they had concerns about valuations for tech stocks. But some of them now have told me that, looking back, they didn't realize how inflated these actual operating earnings were during the bubble years.

I don't buy that. I think that's baloney. Number one, if you look at economics in general, at the way that companies work, at the way that capital gets attracted to hot areas and that eats away returns, I think that it was pretty clear that there was a bubble economy at that point in time. Whatever Cisco claimed they were at back in 1998, a lot of it was because their demand was in bubble mode and it was far, far, far above trend. A lot of people go back and try to rationalize; they say, "Well, if I would have known what those numbers really were, I would not have owned those stocks." I don't buy it; I think that is a cop out. The great majority of the overstatement of the earnings, if you look back, didn't come from accounting. It came from the fact that demand was in a bubble mode--an unsustainable, not replicable mode--where you had venture-capital money going to people who had nothing but an office and a Web site. That money was going to those people, and I know people that were selling to them. I know people that would get orders for multimillions of dollars in equipment and the buyer wouldn't even ask for a price quote. So I believe that the vast majority of the overstatement of earnings in 1998 and 1999 was because of that.

Before leaving Oakmark Fund, you took a beating, both in the press and on the Conversations boards of Morningstar.com. I know from our past conversations that you were shorting Internet stocks in your personal account. And they just kept going up and up. It had to be tough there for awhile.

You know, if you have conviction--and I have very, very strong conviction--all that outside stuff doesn't matter. I personally started shorting Internet stocks in probably 1998, in very late 1998. I gradually got more and more aggressive. At one point, my biggest short was Yahoo . I shorted it at $200 (presplit). Before I did it, I asked myself, "How much pain can I take?" I decided on one fourth of my net worth. I did the math and came out at $500, which was very lucky on my part. I told the traders that I can't lose the nest egg; close the position at $500. One day it closed at $500 1/8. I said, "I'm out. This is the stupidest move of my life." The next day it opened at $499. Lucky for me, it went down to $499 and I never covered it. Then it went straight down to $20.

So that was tricky, but it worked out really well for me. I had about 25% of my net worth short at that point, which was pretty aggressive. I really thought that we were close to the end for the dot-coms there in that first quarter of 2000. The Super Bowl in 2000 was a joke in terms of the advertising. I remember one company--it might have been MicroStrategy (MSTR)--that spent $4 million on one Super Bowl ad. In that Super Bowl, I think that three fourths of the ads were dot-coms or related. Then the first quarter of 2000 had a lot of just really crappy IPOs in the sector, real garbage. I went to a lot of IPO luncheons. I've found that there's a huge revisionism about that period. People say that everyone knew that it was a bubble, etcetera. Forget it. That's all BS. I was at the luncheons where the buyers were all over these companies; they just wanted every share that they could get. They believed. I thought that we were coming to the end, I really did.

What about the Nasdaq now? I realize you're not going to invest in many of those companies, but how low do you think it could go?

I think that the Nasdaq could go down another 30%, 40% and still arguably be expensive. So much of the rise was unjustified. When it was at 5000, it was a joke, not real in my mind. For someone like me, the real trick is just to smile at occurrences like that.

Still, your returns were pretty poor in the late 1990s, even when compared with other value managers'. Do you think that you could have or should have been more flexible during that time?

Going back to 1999, knowing what I knew then, I would have done nothing different. Sure, if I had known that Cisco was going to $80, I would have wanted to own Cisco at $50. But the move from $50 to $80 wasn't real or predictable. During those years, it wasn't so much that I had bought a lot of losers--I had an absence of winners. In 1999, the S&P was up 25% and the Nasdaq was up 40%. But, I believe the average stock in the NYSE was down pretty substantially. It's the exact opposite right now; what's been going on since fall 2000 is that the averages have been going down pretty heavily, but the average stock has been going up.

Bob Markman (manager of several funds, including Markman Aggressive Allocation ) was a friend of mine in the early days. In December 1999, I was on a conference panel with him. I was at zero that year, and Markman, who managed 100% U.S. large-cap growth, was up 50%. He gets up there to speak before me and says, "For the last one-month, three-month, six-month, one-year, three-year, five-year, and 10-year periods, U.S. large growth has beaten every asset class." So I get up there and say, "Well, that's interesting. If you were up here 10 years ago, in December of 1989, you would have said the same thing about Japanese stocks." I said that it's a very dangerous strategy and that I'd be willing to bet that within two years, what I've lost this year, I'd recoup. So I would have done nothing different. Nothing.

Do you feel like you were ill-treated by the media?

No, not really. I don't mind that. I know the media's business. To me, media was merely a way to get the message out. I knew the media was going to bite me. In 1994, I was in a front page article in The Wall Street Journal, quoted as saying, "Look, everyone loves me now, but is going to hate me down the road, and frankly I think that more money will come out of this fund at some point in the future than out of any other fund in the history of the world." It was probably true. I know what the media is, so I expected what I got. Didn't bother me at all.

Not even a little?

I was one of the few voices in the wilderness. I probably deserve more credit than I got. But I'm not in it for the credit. I'm in it for the money. I have pretty thick skin in that way.

Anything else?

Life is beautiful.