De Vaulx: 'As a Value Investor, We Remain Disciplined'

Gregg Wolper: Hello. I'm Gregg Wolper, senior analyst at Morningstar. And I'm here at the Morningstar Investment Conference, speaking with Charles de Vaulx, manager of IVA International Fund and IVA Worldwide. Thank you for coming, Charles.

Charles de Vaulx: You're welcome, Gregg.

Wolper: Now, one of the most noticeable things about your funds is the level of cash that they have. And I think people would want to know why is the level so high? It's not unusual for you to have more cash than a normal fund does, but the levels have gotten very high in the past couple of years. Why is that?

De Vaulx: Because, Gregg, since the lows of March of '09, the markets around the world have bounced back tremendously, thanks to low interest rates, pretty high corporate profit margins, and valuation levels around the world strike us as being at nosebleed levels. And so as a value investor, we remain disciplined. When prices reach our interested value estimate, we sell, we raise cash, and when we're unable to redeploy that cash in proper bargains, the cash just sits there. Also, at IVA, as you know, we try to provide great downside protection, and so that's another reason, besides our strict value approach why we are willing to hold cash. And finally, cash is more that just a buffer, something that doesn't go down when the risk goes down, as we've seen over the past few days. Cash is actually what you need to buy low, to then sell high. So you actually need cash to pounce when there's blood in the street.

Wolper: And one of the areas that you're most worried about is China. A lot of people over the past few years, one of the big topics in the investment world, is will China have a soft landing, or a hard landing? And so far, it's definitely been slowing down already, doesn't seem to be too much of a crash yet, but you don't think the trouble is over. You are more pessimistic than most. Why is that?

De Vaulx: Yes. Even though we're value investors and stock-pickers, we've always paid attention to credit cycles, whether it's impacting entire economies and geographies, or sectors. We have never seen a credit bubble that ended well. There's been a huge credit bubble in China, especially starting mid-'08. And to us, all the excesses are mostly at the corporate level, and so to us it's not a matter of if, but when. Now, the policymakers in China are very aware of the situation; they are trying to deal with it. There's maybe a little bit of pushing the can down the road, but there's no doubt in our minds that things will get worse before they get better, and that causes big risks to the world economy and commodities.

Wolper: Do you have any timeline in mind as to when more trouble in China will come if there is a crash, or at least a hard landing?

De Vaulx: No, but I think within probably 12 months, we should know if we're right to be as worried as we are. We're not alone--George Soros is equally worried. One thing we try and track is the junk bond market in China, and the high-yield market--the junk bond market has gotten worse, so that's a sign that the credit situation is getting worse, not better.

Wolper: And one area you go into besides cash when you're concerned about the markets, is gold. You've always owned a certain amount of gold, and now it's gold bullion and not miners. That's also unusual for a fund, so why go into gold?

De Vaulx: Well, I would not say always. In '08 at one point, we had very little in gold, we had some, very little. Why? Because we use it very specifically, with the view that more often than not, which is not to say always, gold is willing to be inversely correlated to stocks and bonds. And so because we're a long-only fund that tries to deliver returns that are as absolute as possible to have in our portfolio, and because we don't short, to have something in our portfolio that can go up when stocks go down is a wonderful tool. In fact, year to date, markets have been mostly down, and it's been nice to see gold go up, while markets have been wobbly. We prefer gold to gold miners because we think that there are... It's pure, it's less risky, there's no mining risk. Some gold mines still have a fair amount of debt on their balance sheets, so we just might as well have the real thing.

Wolper: OK. Now, we've been talking about some macro issues here, but you also pick... Actually, what you do is pick individual stocks. So tell us how you choose a company. What are you looking for?

De Vaulx: In the value tent, we are more in the part of the tent that focuses on quality. So in other words, we're willing to pay up for quality, as opposed to pay less for something that will be akin to cigar-butt investing. So when we look at stocks, either Chuck, my comanager, or myself, or our analyst, what piques our curiosity is not, "Gee, stock looks cheap, let's do the work," but it's rather, "The business seems to be unique" or, "The company seems to be uniquely good. Let's hope and pray that for one reason or another, it's cheap." And then the way we do our valuation, there's no DCF, DCF garbage in, garbage out, we rely mostly on M&A multiples, where people have paid, either financiers, or companies have paid in cash to own 100% of the business. I was listening to Rob Arnott and Mr. Asness this morning. They defined value as low price/earnings, low price/book, high dividend yield. To me that's the wrong definition of value. Value is a company that trades, a stock that trades below what someone would pay in cash to own 100% of the business.

Wolper: And how long do you expect to own a company, once you buy it?

De Vaulx: Well, if you favor the ownership of quality companies, then time oftentimes will work in your favor, intrinsic value will creep up over time. So you will make money, not only through the narrowing or the elimination of the gap between price and value, but also through intrinsic value going up. So as a result of that, that focus on quality, we sometimes hold stocks for five, 10, 15 years. The so-called compounders.

Wolper: Well, the final question, with international funds, currency can have a tremendous effect on returns. Some funds hedge their exposure totally, some don't hedge at all. You've taken the middle course, but you have a lot of flexibility. So tell us how you came to that idea of using a flexible hedging policy.

De Vaulx: Goodness. Well, some... You're right, in the international investing camp, some hedge 100%, others not at all. Our view is that currencies can be very volatile, they're known to overshoot and undershoot. Not only the foreign currency but our own U.S. dollar, which I remember overshot under late President Reagan. And so sometimes when we own say something in Germany, we try to be clear in our mind, do we own it because we think it's cheap in euro terms? And therefore, we try to capture that arbitrage between the price and value, or do we also want on top of that to be exposed to the euro? And we may not want to be exposed to the euro, maybe we don't have any strong conviction, or maybe we have a conviction that the euro may weaken, so we will hedge the euro, we'll sell forward the currency. So it's flexible, we try to be smart about it. If we were to own in Japan mostly export-oriented companies, we would understand that a weaker yen would paradoxically help the company generate a higher earning, so such companies have a natural built-in hedge, there's no need to add a yen hedge overlay on it. And to further complicate things, we dabble in gold, we talked about it, and realize that more often than not, there's an inverse correlation between gold and the dollar, so we also... That's part of the mix on factors we look at.

Wolper: Well, thank you very much, Charles.

De Vaulx: You're welcome, Gregg, always a pleasure.

Wolper: I'm Gregg Wolper from the Morningstar Investment Conference.