Wadhwaney: Focus First on Balance Sheet Strength

Kevin McDevitt: Hi, I'm Kevin McDevitt from Morningstar. We're here at the Morningstar Investment Conference. I'm joined by Amit Wadhwaney from Moerus Capital.

Amit, thanks so much for being here.

Amit Wadhwaney: Thank you very much. Good morning.

McDevitt: So you have a very unique process and approach to investing, and one of the things that's most striking is that you focus first on balance sheet strength rather than on forecasting earnings as so many managers do. Why do you take that approach?

Wadhwaney: Well, the idea is actually very simple. It's also I think a reflection of our humility in that we don't believe anybody can forecast economic variables, macroeconomic variables, with regularity correctly again and again and again. So if you're going to do that as a part of your process, you run the risk of risking your partners' and your fellow investors' capital.

What we thought about was, why do we not use the fewest assumptions possible, especially about the future and use that as an integral part of building our understanding of our business, value in the business, and thinking about whether one should invest in the business or not. This in turn, of course, leads you to the next thing. What do you use as the peg on which to hang your coat on?

Most importantly the one thing you do know about the company is facts about it in the here and now. Thinks like the balance sheet, the state of the world in which it operates, the business it does, how it's doing, the current state of the economy in the world at large. We use that as a basis for understanding the business, valuing the business, assessing the risks, and so forth.

McDevitt: OK, so if you're talking about valuing a business, but you're not looking at forward cash flows or forward earnings, how are you valuing the business using a balance sheet?

Wadhwaney: Well, the easiest way to, if I can describe it in the simplest terms, you parse the balance sheet. On the left hand side of the balance sheet is to desegregate all of the assets that you can separate, valuing each of those individual assets as conservatively as possible, again using the fewest assumptions.

When I say conservative, conservatism really stems from two things: the assumptions we use and the methodology we use. Our methodology typically tends to veer toward liquidation valuation in that you think, What will I get if I was to sell these assets today? What would the cash proceeds be here and now?

Typically that tends to not pay much of a premium for the future and your future expectations. As a result of that, you tend to want to put very, very conservative, I could argue bedrock, valuations for a business.

McDevitt: Do you think that if you're using that kind of an approach, if you're focusing on liquidation value, do you feel like that kind of biases you or perhaps points you more toward companies that have more tangible hard assets than perhaps either their balance sheet has less in the way of goodwill or maybe more intangible assets like brand value? Are you more focused on those hard asset companies?

Wadhwaney: Oh, absolutely. There is no question. There is a tilt in that direction. This is not to say that it's not just purely bricks and mortar that we talk about. We also work with financial assets. Bond portfolios, equity portfolios, holdings in other companies could be a part of our valuation.

There's no question there's a tilt toward companies that do have physical assets or financial assets, but also companies that have contractually guaranteed streams of cash flow because if you have those, it may not be reflected in the balance sheet as such, but it is nonetheless an asset and should be a part of the valuation that you have. There is clearly a tilt. Goodwill is not something we tend to pay up for. It's just not what we do.

McDevitt: Can you give me an example of one of those companies that perhaps has that income stream coming in, but again, it's showing up on the balance sheet as something you could value?

Wadhwaney: Currently we don't have many of those companies. The recent company we actually do own which has something like that, it's actually the financial services industry. It's an investment manager. It's one which may or may not be exhibiting here today. It's Franklin Resources for example.

McDevitt: They do have a table right over there, yeah.

Wadhwaney: Franklin does have a table here. Oh, OK. The thing about Franklin is it's a company that has a pristine balance sheet. It's got a stream of revenues. However, I can't say they're contractually guaranteed. Again, assets come and go through the front doors every day, so you can't say that it is. That said, strip out the cash, you're probably paying 6, 7 times the operating earnings for that business, which I think is pretty good for a very high-quality investment manager.

McDevitt: OK.

Wadhwaney: Again, it's not a contractually guaranteed stream of earnings.

McDevitt: Sure, but at the same time though you feel like it's annuity-like. It has that quality to it.

Wadhwaney: To some degree, yes. Very much so.

McDevitt: When investors think about it, I think when most investors think about balance sheet health, they think in terms of debt, how much debt is on the balance sheet? You go beyond that. Talk a bit about what other liabilities other investors might miss.

Wadhwaney: A couple of things. Let me just talk about debt for half a second because you have to think about debt not as a number, an abstract number on the balance sheet. Let's say you have a debt balance of $300 million outstanding. You have to think in terms of one, covenant, debt covenants. If for example the debt comes as a severe contractually your assets are mortgaged against the debt and you've got to worry about it.

Again, you can have a covenant-like debt, which of course would let you slip through the process of bankruptcy. However, you also should think about interest rates that you're paying. If you're a lucky European company, a big European company with a brand name like a Nestle, you might actually wind up issuing debt at negative interest rates. You've got to think of interest rates, the term structure, and so forth.

What's important about debt is debt is only but one liability on the balance sheet. Also most companies have commitments, contingencies and such, which are off balance sheet liabilities. Lease commitments for example, capital expenditure commitments for example, litigation commitments for example, environmental liabilities for example. There's whole bunch of those liabilities that you've got to always take into account when you value a business, because if you don't, one of these days one of these things can come back and bite you.

Finally there's a final liability that most people tend not to consider. Most businesses in running a business on a day-to-day basis, have to spend. This is a recurring cost of business like operating expense. You've got to capitalize that. That's one. There's a separate additional amount that you should think about when you think about businesses which are capital-intensive. These are usually large dollar amounts and the company may or may not have committed to spend the money, but in many cases the spend is not optional or discretionary.

You've just got to spend to keep your steel mill running for example. Your furnace has to be realigned. You probably don't have that on your balance sheet or off your balance sheet as a contingency. You've got to take all of these into account. When you think about debt, I mean, the big sort of overarching thought should be, debt is not usually engaged in with frivolous intent. There's a reason why people take on debt.

Hopefully people do it with some degree of wisdom and some sort of premeditation. For example, one of our companies issued debt--it's a European company, it's a Greek company actually. A Greek real estate company which issued debt roughly at 3% in euros, turned around, with the proceeds, bought property in Athens yielding low teens gross cash flow yields, which I think is actually a pretty decent use of debt. So debt has to be considered in a sort of holistic fashion, not just in isolation as a number, but in the context of the business.

Of course one last thing. Businesses can be cyclical. Have cyclical cash flows. So you should always think in terms of your debt in the context of the cyclicality or sustainability of the cash flows the assets generate.

McDevitt: Amit, thank you for your insights.

Wadhwaney: Kevin, thank you very much.

McDevitt: Thank you for watching.