Friday, 5 February 2010

Donald Yacktman's Investment strategy and methodology. “A low purchase price covers a lot of sins.”

Donald Yacktman's Way (Part II)

Feb. 04, 2010

(GuruFocus, February 4, 2010)

This is the second and the last part of my attempt to analyze Donald Yacktman’s investment strategy and methodology. In this part, I want to deal with questions such as
  • how the Yacktmans treats the big picture, 
  • how they manage cash level, and 
  • how they reach a sell decision, and finally, 
  • I will summarize their comments on some individual stocks as examples for the methodology in practice.

If you have not done it, please read Part I before reading any further.

What about the Big Picture?

Consciously or not, investors always form their own opinion towards how the economy and the stock market might do in the near future and position their portfolio accordingly. The press is full of such predictions, and good careers have been made. The dilemma for investors is, in any given market, there are always at least two camps, the bulls and the bears, with seasoned and successful professional managers in each camp.

The Yacktmans are bottom-up guys. When asked, their initial response is that they are not distracted by big picture issues. This dialog is from the recent Q&A with GuruFocus users[2]:

Question 16. Although your focus (both) is stock-picking, do you occasionally get caught up with big pictures issues that distract you from your main goal of picking great stocks? How do you deal with it and why do you think it can happen to investors?

Don: I don’t get distracted by big picture issues but I think many others do. I think most people have trouble buying stocks that are in price decline either because of 
  • lack of knowledge, 
  • a short time horizon, or
  • emotion. 
It is important to be objective.

And the Yacktmans think trying to predict the market is not only useless, it could also be harmful, as illustrated by this dialog in the same Q&A session:

Question 4. At this level of market valuation, how do you think the market will do in the next few years?

Don: We don’t predict the market. Frankly I think that most of the time it is a waste of time. Looking at individual businesses and buying them at good value is a much better use of time. If someone correctly predicted the market 10 years ago, they would have been in cash and not our funds. Who is better off?

  • Indeed, knowing what we know now about how the market performed in the last decade, most of us would be better off to put money in cash in the past decade. 
  • But knowing what the Yacktmans know about value investing, one is better off investing in stocks.

So the Yacktmans totally ignore the macro factors in their managing money? Wrong! The Value Investor Insight interviewer was rather persistent and direct on this point. Here is a quote from the interview [4]:

Speaking generally, do views on the broader economy make it into your analytical process at all?

SY (Stephen Yacktman): We spend almost 
  • no time trying to forecast things like inflation, interest rates and the value of the dollar, but 
  • we do try to pay a lot of attention to cycles in how we normalize earnings. 
If margins are at a peak, for example, we don’t necessarily assume they’ll stay there forever. That alone kept us out of a lot of the financials that got hurt the most in the meltdown.
Potential inflation, or the lack thereof, seems to be fairly top-of-mind for investors. What’s your take on that?

DY (Donald Yacktman): Over time, we’re very concerned about the risk of higher inflation, but we expect that the kinds of businesses we own – those that can re-price their products fairly flexibly and that are heavily exposed to currencies other than the U.S. dollar – will navigate an inflationary period fairly well.

So long term inflation finds its way to Expected Rate of Return in the Yactkmans’ world of investing.

Manage Cash Level

Keeping the right level of cash is a key decision for individual investors as well as for fund managers. It is important for individual investor, it is vital for active fund managers. When market crashes, the right thing to do is to buy and take advantage of the lower prices, typically what the fund managers have to deal with is all the redemption requests. It is just an inconvenience in a fund manager’s life that one has to deal with.

Fearing of lagging behind peers and benchmarks, many fund managers tend to be fully invested. In May of 2009, during the MorningStar meeting, Robert Rodriguez was very critical towards this practice in his speech:

Did the industry try and prepare for this tsunami of a credit debacle? I don’t think so. 
  • Whether in stocks or in bonds, it seems as though the same old strategies were followed--be fully invested for fear of underperforming and don’t diverge from your benchmark too far and risk index tracking error. 
  • The industry drove into this credit debacle at full speed. 
  • If active managers maintain this course, I fear the long-term outlook for their funds, as well as their employment, will be at high risk. 
  • If they do not reflect upon what they have done wrong in this cycle and attempt to correct their errors, why should their investors expect a different outcome the next time?

Since the beginning of 2007 Robert Rodriguez, Rodriguez kept an unusual amount of cash (as much as 45%) in his FPA Capital portfolio. The Yacktmans, on the other hand,
  • had as much as 30% in cash at the market peak of 2007.
  • In November 2008, they were “all in”. 
  • They even had to swap out some high quality stocks to buy some more cyclical ones. 
  • And as of November 30, 2009, they are back to 15% again.[4]

So what drives their cash position up and down?
  • Why 15% now? 
  • And why as much as 30% at market peak in 2007?
  • Is it by design or by luck? 
Careful exam of the Yacktmans's thinking on the matter tells us that the high cash might be a build-in function of their investment methodology. Here we dig into the The Wall Street Transcript Interview[1]:
TWST: What triggers an exit from your portfolio? Do you set sell targets?

Donald Yacktman: Think of everything being priced against the long-term Treasury, and we want to see a large spread over what the long-term Treasury yield is.

Stephen Yacktman: But in the present environment the dollar is being deflated and the Treasury rate of return is very low. At some point we say, “Hey, the rate of return of an investment is not acceptable to us.” We walk away. It’s the hardest thing to do because we have to wait for something else to come along. We can’t create something out of nothing.

And in theValue Investor Insight interview [4]:

Are you much less active when markets are calm?

DY: We’re not inactive when markets are relatively calm – there’s always something creating opportunity somewhere – but we do tend to be a lot less active overall. Our turnover has fallen compared to this time last year.

We also don’t let cash burn a hole in our pocket when the number of good opportunities decreases. While we were all in last November, our cash position in the funds today is around 15%.

In another word, the cash level is a result of insisting on
  • minimum Forward Rate of Return on the investments and 
  • minimum spread between the rate of return and the Treasury yield. 
If the requirements do not meet, the Yacktmans would rather keep the money in cash.
Nowadays, with market recovered more than 60% from the March 2009 low, GuruFocus noticed that
  • Robert Rodriguez’s fund is hoarding cash; 
  • Bruce Berkowitz has upped his cash level to about 20%, more than historical normal level, which has been about middle teens.; and 
  • the Yacktmans had about 15% in cash as of November 30, 2009. 
Since you have made so far in reading my article, I feel obliged to give away this observation. These three managers are not bears or market timers, rather, they are very constructive in managing their money through different market cycles.

When to Sell

Stephen Yacktman answered this one straight-forwardly in The Wall Street Transcript Interview[1]:

TWST: What triggers an exit from your portfolio? Do you set sell targets?

Stephen Yacktman: Many people set a price target by saying, “Okay, I think it is worth $X.” Well, we don’t think that way. We look at what the forward rate of return is, stack it up against other investments and determine which one is the highest and which one is the lowest and what risk we are taking to get that rate of return. We account for things like leverage, cyclicality of earnings, and the quality of the business. An investment that is going to make it into the portfolio with the lowest rate of return would be a company like Coca-Cola that has high predictability and good management. We can just go into autopilot. It becomes our AAA bond.

A sale is triggered by two things.
  • If the rate of return is not sufficient or 
  • if there is a better opportunity elsewhere with a larger margin of safety to get a similar or higher rate of return, we’ll sell it. 
The overall market dropped and consumer product names held up and the media companies got killed. 
  • News Corp. went from the $20s to $5. 
  • That drop opened up a huge rate of return gap and encouraged us to sell some of our Pepsi and buy News Corp. 
  • We viewed that decision as going from a low teens rate of return to something that was going to make a 20% return. 
There’s no price target ever set, it’s just a function of the environment. 
  • What ends up happening, unfortunately, in an environment where everything goes up, is fewer of these returns are satisfactory and we end up more heavily in cash. 
  • It’s not that we’re trying to time the market; it’s just there’s nothing to buy.

That is the ideal world, in which every purchase is a win. What about if they made mistake and have to sell at a loss? Here is their perspective according to the GuruFocus Q&A [2]:

Question 14. How hard is it to admit a mistake on an investment thesis and what do you do to not repeat the mistake?

Don: It is important to be objective and not let our ego get in the way. As Will Rogers said, “Good judgment comes from experience and a lot of that comes from bad judgment”.

Brian: I agree. In addition, we can’t let our emotions get in the way. When a mistake has been made, you can’t cross your fingers and hope to recoup your losses. You have to ask yourself, where do I go from here?
  • On this day, what are my best options, where are my highest yielding assets? 
  • Where would this capital best be allocated now? 
  • Once you’ve experienced a permanent loss of capital, there’s only one gear from here and that’s forward. 
  • But the key in this business is to avoid the permanent losses. 
  • And as my father has often said, “A low purchase price covers a lot of sins.”

Just be careful next time you place a buy order.

Comments on Individual Stocks

As illustrations of how the Yacktmans use the concept of Forward Rate of Return, I include a summary of their comments on some of their top holdings.

Much of this material is from of Value Investor Insight interview found on website [4]. You might be better served to read the original document. The document was published on November 30, 2009 and the interview could have happened somewhat before that, so please keep the time elapsed since then when you read it.

1. News Corp. (NWS-A)

· Stock trades half of what it was at the beginning of 2007, yet the business mix and growth prospects are much better than they were back then.

· Company has eight different operating units. The most important business by far is cable network programming. Revenues and earnings in this business have more than doubled over the past five years, driven by increasing subscriber fees from cable and satellite companies, as well as higher rates on the advertising side. Plenty room for growth exists in this line of business.

· Non-U.S. operations is another engine for growth.

· Company is believed to be able to generate more than $1 per share in free cash flow. With the stock price at $11.50 (Now it is $13.67 on Feb. 3, 2009), the free cash flow yield is roughly 8.5%. (Now it is 7.3%).

· On the top of that, the Yacktmans expect a total of 6.5% annual growth on the current free-cash-flow yield.

· So the estimated Forward Rate of Return is in mid-teens per year, double what can be expected from S&P 500 (about 7%, see Part I).

· The age of Rupert Murdoch (78) is not of concern in the time horizon that matters here, especially when one paid no premium for him.

2. Viacom Inc. (VIA-B)

· This is more of a pure-play content company, which owns various cable networks, including Nickelodeon, MTV and Comedy Central, as well as the Paramount movie studio.

· As a content company, Viacom has an upside to demand higher carriage fees from the cable distributor companies over time.

· On the advertising side, Viacom’s advertising should more than bounce back when the economy improves

· Paramount is adding nothing in the valuation model as it is not generating any cash, but as a standalone company, it probably worth $5-7 per Viacom share.

· Cable networks alone will generate $2.50 per share in normalized free cash flow. That’s an 8% cash yield. Even if Viacom grew no faster than the average S&P 500 company – and the Yacktmans think it should do better – that produces an expected return of 12-13% per year.

· Internet delivery of content should not be destructive. As long as you have content, you should be able to sell it for something and make a profit.

3. PepsiCo Inc. (PEP)

· Somewhat distinct from Coca-Cola, Pepsi’s fortunes are much more driven by snack foods.

· The distribution and shelf space of Frito-Lay products create a very high barrier to entry.

· Frito-Lay now accounts for roughly half Pepsi’s overall business.

· The snack-food business is a good one. Buyers are not too price-sensitive, margins are high, and unit-volume growth is pretty strong as busy lifestyles prompt people to eat things on the run.

· The second big driver of the business will be continued global expansion.

· On a forward basis, the Yacktmans are estimating $3.85 per share in normalized earnings. They should keep roughly 85% of that, so free cash flow would be around $3.40. That’s a 5.5% free-cash yield, on top of which they are expecting 3-4% annual volume growth, primarily from increased snack-food sales and overseas expansion. Add in some pricing, largely to keep up with inflation, and the expected annual return is 12-13%, 5% better than S&P 500’s expected rate of return.

4. Comcast Corp. (CMCSK)

· Comcast stock performed poorly in recent history because there was never any cash generated. All the earnings needed to be invested for expansion or equipment upgrades.

· Operationally, Comcast is uniquely positioned because it can offer a full complement of television, Internet, and phone services. They’ve been quite successful in rolling out these bundled services in their territories and skimming off profit from phone companies like AT&T and Verizon.

· What sets Comcast apart as an investment is the fact that a lot of the enormous capital spending necessary to build that network is going away. The company now has a platform to meet customer demands well into the future at modest incremental cost.

· That will have a dramatic impact on free cash flow generation.

· Free cash flow should exceed net income by $1-1.5 billion per year as capital expenditures are much lower than depreciation and amortization. On a normal basis, we estimate free cash flow at more than $1.50 per share, resulting in a 11% cash yield. On top of that one would add inflation plus 2% or so, as they continue to take phone and Internet share. That yields an expected mid-teens return for a company that on a fundamental basis continues to perform extremely well.

· The recently announced proposal to acquire NBC Universal, even assumed overpaid, has limited impact on the company’s value and do not change the view that the stock is undervalued.

Central to the Yacktmans’ investment methodology is the concept of Forward Rate of Return, which is current free cash flow yield plus inflation and plus annual growth in free cash flow. Macro economy and business cycle find their way in the calculation of rate of return;
  • when minimum rate of return is hard to get, the Yacktmans build a large cash position;  
  • when the rate of return become less attractive comparatively, they sell the individual stock.

Finally, it should be noted that the adjective word for the Forward Rate of Return is “Estimated”. As the examples given above show, the Yacktmans do not calculate the rate to the fifth decimal (not even to the second decimal, for that matter). In investing, they also would rather be approximately right than precisely wrong.

As of now, the compass of Rate of Return points toward high quality companies at attractive valuations, and that is where the Yacktman park their money.

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