Outperforming in Up and Down Markets

Greg Carlson: Hi, I'm Greg Carlson. I'm a mutual fund analyst with Morningstar. I'm joined today by the two managers of Artisan International Value and Artisan Global Value, Dan O'Keefe and David Samra. Thanks for joining me today, gentlemen.

David Samra: Thank you for having us.

Daniel O'Keefe: Thank you. It's nice to be here.

Greg Carlson: You two won the International-Stock Fund Manager of the Year award for 2013 from Morningstar, and this is not your first award. You won for 2008. It's interesting that you've won in two very different environments. Obviously, in 2008, it was a terrible year for stocks. Your funds held up a lot better than the competition. Similarly, in 2013, the funds outperformed in a very strong year for stocks.

Before talk about the drivers of performance last year, maybe we can talk about the strategy for those folks who are less familiar with it.

Daniel O'Keefe: I think your observation about the strong performance in both the down market of 2008 and a strong market of 2013, for example, is an interesting way to approach how we think about investing and the characteristics we're looking for--because those characteristics really explain the strong performance in two very different market environments.

We're looking for four characteristics: We're looking for an undervalued business, something that's cheap relative to its long-term intrinsic value, but we're looking for that attached to a very high-quality business, a strong balance sheet, and a management team that allocates capital and works in the interest of building long-term shareholder value.

Those characteristics immediately can be thought of as being beneficial in tough market environments, because of the defensive qualities. A strong balance sheet protects a business in a weak economy. A good management team is building value. A defensive business, a high-quality business, is competitively advantaged. And an attractive price, of course, is probably the most important margin of safety and one that most value investors talk about. That helps explain why we outperformed so well in 2008--because of some of those defensive characteristics.

But in 2013, how were those characteristics able to help us participate and, in fact, outperform in a very strong market? I think the key to understanding that is the way that we use the discount to intrinsic value and how that lever of price-to-value is manipulated inside the portfolio.

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What we do is, we look at our securities, and we track the discounts to intrinsic value because that reflects the future expected return. And when the market sells off, as it did in 2008 after we did not decline as much as others, we reallocated the portfolio into larger positions where those discounts were much larger, and we continued to do that through the recession and through the period of skepticism that followed in '09, '10, and '11. We continued to work a large discount into the portfolio and take advantage of that offensive characteristic of a discount: a high future expected return. And I think that helps explain why we were able to do well in both a difficult market and participate also in a very strong market.

Carlson: Just to add onto that, it probably bears mentioning that these moves tend to be fairly gradual or limited in nature. You're not turning over the portfolio a great deal, and the portfolios themselves tend to be fairly concentrated, with about 40 to 50 stocks.

O'Keefe: That's right. The dollar turnover tends to be higher during periods of market volatility, because again we're looking at the portfolio, and we're saying, how can we drive a larger discount into the portfolio to drive a larger future expected return over the following periods? So, we will be taking capital from stocks where that discount to intrinsic value has narrowed, and we will be allocating it where that discount is wider, and that's what creates a dollar turnover. If you've seen over the last few years, our turnover has been coming down. It was very high during the very volatile periods, and it has been declining as the market has been less volatile, basically as the market has been going up.

Carlson: David, as Dan has talked about the strategy, the historical profile of the fund is that it's typically done better on a relative basis in those down markets. It's participated well in up markets, but not necessarily beaten all comers as it seemed to do in 2013--particularly Artisan International Value beat every single other fund in the Foreign Large-Blend category, and that's a big category. Can you talk about what the drivers of performance were in 2013, perhaps in terms of particular names? It's a bit of a diverse bunch.

Samra: It is a diverse bunch. But interestingly, it does marry with what Dan was speaking about in that, as part of anybody's efforts in value investing, your objective is to both generate returns and manage risk. As we switched in 2008 from managing risk to looking forward to saying, from these levels, we can generate some very significant returns, we made some investments in some very good businesses, very high-quality assets, larger market caps than what we as value investors traditionally have access to. And many of those businesses have gone through a period over the last few years, which continued into 2013, where they revalued significantly from low multiples to high multiples. Some of those businesses on the international side would include Compass Group, Reed. We had a couple of European banks, which as you can imagine, were hurt very significantly during the downturn. That would be Lloyds and ING.

We took advantage of weak pricing in the property and casualty insurance marketplace, and we played that both on the underwriter side and on the insurance broker side. Businesses such Aon and Arch Capital benefited very nicely on the global side. We also own shares in Marsh McLennan, which did very well.

In industrials last year, in particular, we have a couple of businesses that are associated with business activity in Europe, in which today's markets are expecting a pickup, and that would be Panalpina, a freight forwarder. You can think of them as sort of a travel agent for moving large cargo from one place to another. As economic activity picks up, you'll have much more cargo moving around, and Panalpina's share price did very well last year. As did Adecco, [which] is a temporary employment-placement firm. Activity for temps has been picking up, and the profitability of that business has started to improve. All of that has driven the portfolios.

What we should also mention is technology, because in both Global Value and in International Value, we've had several technology names that have driven returns very nicely, including MasterCard and Google. In international, we've had Baidu. And in both funds, we've had TE Connectivity. And many of these stocks have moved up considerably in 2013.

Carlson: And David, could you talk a little bit more about Baidu, because that, to me, is a bit of an atypical name. I don't expect to see a Chinese search engine company in your portfolio.

Samra: Sure.

Carlson: You don't tend to own much in emerging markets typically.

Samra: We don't tend to own much in emerging markets, and we certainly don't tend to own a lot of businesses that grow very rapidly. Interestingly, we know this industry very well because of the work we've done in Artisan Global Value with Google. Google is the world's largest search engine. Baidu is simply a knockoff of Google, and China's largest search engine. So, we know the industry; we know the business very well. We know with a decent degree of certainty what the future of that business is going to look like.

And in each search engine around the globe, including Google, including NHN in Korea, and now, including Baidu, there is a transition going on as people move away from searching on a desktop to searching on their mobile devices, and that transition causes disruption. How are the new search clicks going to be priced? How effective will they be in driving sales? How much will the advertiser pay for those clicks, and what does it mean for the growth rate for that business, and are the incumbents going to have the same market share in search that they did on the desktop? And in each case, Google, NHN, and now with Baidu, the share price came down significantly during that transition, given the uncertainty.

We took advantage of that. We bought the shares at a very depressed price. The company has very high levels of profitability, a very strong balance sheet, which are two of the things Dan mentioned are very important to us. Between the cheap stock, the strong balance sheet, and the good management team, and in addition to this, we've got a very, very good long growth profile. Baidu fell right into our wheelhouse of the types of investments that we're looking for.

Carlson: Dan, I guess the hard question now is, where do we go from here? Where are you guys finding ideas now? I know both portfolios have a little more cash than usual--somewhere around the 10% mark.

O'Keefe: We're actually at or near record levels of cash in both portfolios, 12%-13% plus. And as you would expect, that reflects our interpretation viewed through the lens of available opportunities in the marketplace. In other words, we're finding more opportunities to sell than we are to buy, and the natural result of that is that cash levels rise within the portfolio. We have a maximum of 15% cash for both portfolios.

So, we are in a reinvestment period. We are actively searching to reinvest the proceeds of the disposals that we're making at full prices. The environment is generally fairly priced. This is a very interesting time period in our careers, because at many times when markets are high and valuations on average appear fair, there are often obvious pockets, significant pockets, of undervaluation.

In other words, the S&P today is around 15 or 16 times earnings, and sometimes in history when you have a fair multiple of 15 or 16 times, that's a function of some stocks being overpriced and other stocks being underpriced. Today, we feel like the majority of stocks we look at are sort of clustered around fairly priced. So, it's difficult to find new investments, and we've come off an abnormal period where, as value investors, we were able to buy at very attractive prices the Googles, the MasterCards, the Compass Groups of the world. And those great opportunities are not here today with us anymore, unfortunately.

We're having to go back to what we call the normal state of value investing, which is trying to find one-off situations, special situations where a company is going through a problematic period, a restructuring. There is some type of obvious problem that has caused the valuation to become very attractive, rather than a universal depressed valuation, which allows you to almost have your pick of the available universe.

So, it is a somewhat difficult environment for us in terms of reinvesting, but we're actively engaged. We're slowly moving the portfolio out of fairly priced securities and into new ideas, one stock at a time.

Carlson: Thanks to both of you for joining me today. We really appreciate it.

Samra: Thank you.

O'Keefe: Thank you, Greg.