Vulcan’s approach to value investing

  • |
  • 14 mins 01 secs
How can you be a value investor who doesn’t look for cheap stocks? C.T. Fitzpatrick, founder of Vulcan Value Partners and now a stock picker for Alliance Trust’s global equity portfolio, explains how he looks for high quality businesses that have inherently stable values, despite rarely being cheap.

Channel

Alliance Trust
Alliance Trust PLC

https://www.alliancetrust.co.uk/

Alliance Trust PLC
River Court
5 West Victoria Dock Road
Dundee
DD1 3JT

Phone: 01382 938320

PRESENTER: I’m joined now by the latest edition to the fund manager line up here at Alliance Trust, C.T. Fitzpatrick. He’s the CIO and founder at Vulcan Value Partners. C.T., tell us about the business.

C.T. FITZPATRICK: So Vulcan Value Partners is a company that I founded in 2007. It is the exclusive vehicle for everyone who works at Vulcan to invest their own personal capital in publicly traded equities. We mostly invest in large cap stocks. We have a global perspective. We look for businesses around the world. If there’s something to remember about Vulcan I think that is unique is we’re value investors, but we don’t look for cheap stocks. We look for businesses that have inherently stable values. These businesses are rarely cheap, but we follow them anyway, and when they do become discounted we’re ready to invest in them, and those form our portfolios. And we’re very fortunate to have likeminded investors who share our time horizon and who believe in the margin of safety, and also appreciate the fact that since it’s our exclusive investment vehicle that when we do well our clients do well; when our clients suffer we suffer more.

PRESENTER: You mention the margin of safety, what do you mean by that?

C.T. FITZPATRICK: Well, the margin of safety is all important in value investing, and it’s really what value investing is all about. It’s the idea that you can reasonably value some businesses. And that if you pay less for them than they’re worth, the distance between the two, if you will, the gap, is like a shock absorber. Things happen that you can’t forecast. There are trade wars, there are recessions, financial crises; there are all sorts of things that happen that no one can really predict. And if you have paid too much for a really good business, you have a lot of risk. If you pay fair value for a good business and these unforeseeable things happen, you have in our opinion an acceptable risk. But if you have a margin of safety in terms of value over price, it’s like a shock absorber, and you can get through the tough times and take advantage of market volatility instead of being taken advantage by it.

It’s also very important to invest in companies that have stable value. So they can be statistically cheap at a point in time, but will they be stable? And will their values remain stable over our five-year time horizon? When you can find a business like that, and there is volatility, you can take advantage of it and improve your margin of safety, i.e. improve that shock absorber by buying businesses whose stock prices have declined, but whose values are stable or have even risen.

PRESENTER: And what exactly do you mean by the margin of safety?

C.T. FITZPATRICK: Vulcan focuses on value stability. That is really important to us. We are big believers in the margin of safety. That’s what attracted us to value investing in the first place. And you ask yourself how can you improve, how can you get better? And the answer is, using an American baseball analogy, you’re not going to get better by trying to hit more home runs, but you can get better if you don’t have any strikeouts. And so in order to have what we would call a sustainable margin of safety over our five-year time horizon, and that is our time horizon, five years, we think it is all important to make sure that you limit yourselves to companies that have inherently stable values. So we are value investors, but we don’t look for cheap stocks; instead we look for businesses that we would like to own should they ever become discounted, and we wait patiently and follow them so that when they become discounted we can have an opportunity to buy them with a margin of safety.

PRESENTER: What’s unique about your value investment style?

C.T. FITZPATRICK: It’s a lot easier to value some businesses than others. The companies that we invest in have high and recurring levels of free cashflow. They have very strong balance sheets and they’re therefore easier to value than other companies that are very difficult to value. It’s very difficult to value a bank for instance. The assets are opaque. It has high leverage. If the asset values decline marginally, the equity value will decline a lot. And on the other hand most of the companies we own have net cash on the balance sheet.

So we can value cash, we’re going to get that right. And when you translate the asset, the gross asset values of the companies that we invest in, our equity values are very stable. And so if we’re wrong by 10% say on the value of an operating asset of a business we own, and we’ve got net cash on the balance sheet, well we’re only wrong by maybe 8% on the value. And if it’s trading at a substantial discount to that number, say 50% of our estimate of fair value, that’s a lot easier to do than it is to say buy a highly leveraged financial institution or industrial that doesn’t generate a lot of free cashflow, and then when your asset values move a little bit, your equity values move a lot.

And so it’s very hard to have a sustainable margin of safety in the latter and a lot easier to have it in the former, and that’s why we do what we do. But just to answer your question a little more fully, we take free cashflow, and that can be very different than IFRFs or gap reported results, we take free cashflow. We measure it. We determine how risky the free cashflow coupon is. We determine very conservatively how fast it can grow. And we use those inputs to value the business. We adjust for net cash on the balance sheet, or net debt if they have net debt. We make adjustment for pension accounting. Because we don’t trust it, we treat pensions like debt. And we put it all together.

We check all that against comparables, and our work is almost always conservative compared to the comparables. And we just use them as a reality check to make sure that the assumptions that we’re using are not overly optimistic. So if we can buy a business at a steep discount to the assumptions we’re using to value it, and the business has done better than we’ve assumed in the past, and that intrinsic value estimate is conservative compared to comparables, and we can pay say half of what it’s worth, we think that provides a reasonable margin of safety.

PRESENTER: So how often do you look at a stock and think the market’s got the pricing of this completely wrong?

C.T. FITZPATRICK: There are a lot of companies where we think the market has it right, and there are a lot of companies where we think the market is way too optimistic. So I want to be humble about the market. We’re contrarian in our thinking, but we’re hopefully thoughtful contrarians, and not be contrarian just to be contrarian. So we really ask ourselves a lot of hard questions about if something is discounted, why is it discounted? What are we missing? And we don’t just automatically assume the market’s wrong.

PRESENTER: Typically how many stocks do you run in a portfolio?

C.T. FITZPATRICK: In our focused strategy, we manage between seven and 14 names by mandate. We won’t own less than seven and we won’t own more than 14. And that is an admittedly non-diversified strategy. And it’s not appropriate for all investors; however, a lot of investors and a lot of our clients are very diverse. They have numerous managers, they have multiple asset classes, they own lots and lots of individual securities, and we really don’t add much value for them by delivering a highly diversified portfolio of say 100 names. Because we just don’t move the needle on the diversification, they’re already diversified. Well, if you’re in that position, and you can then have your highest conviction best ideas, it enables two things to happen.

One it allows us to limit ourselves to the very best highest quality companies and buy them at a discount. And markets are not so inefficient that you can always have a highly diversified portfolio of really good businesses that are really discounted. You can have a diversified portfolio of businesses that are not very good businesses that might be statistically cheap, or businesses that are good businesses but are overvalued; however, if you’re willing to give up diversification and have a focused portfolio, it is possible to have a portfolio of really good businesses that are really cheap. And if you add that to an overall investment strategy where you’ve already got lots of other managers and lots of other assets, you don’t really give up anything in terms of diversification, but you add the ability to compound capital with a substantial margin of safety, virtually in any market environment.

If the markets are overvalued you can find a few names. If markets are really discounted, like they were after the financial crisis, you can buy some extraordinary businesses that you want to overweight, that you would not be able to overweight in a regular portfolio. So that’s why we do it the way we do it. It’s really where we want to overweight our own personal capital.

PRESENTER: And once you’ve purchased a stock, how long are you prepared to hold onto it until it delivers?

C.T. FITZPATRICK: We’re very patient. As I’ve mentioned earlier, every decision we make is through the lens of the five-year time horizon. Now, our time horizon is actually longer than five years, but we ask ourselves would we be willing to own this business for five years if the market shut down and there was no liquidity and you couldn’t get out. Maybe something, we might have more of a private equity mindset in terms of how we look at that. And if the answer is no, we wouldn’t be comfortable doing that, it doesn’t qualify for investment, so it sets a very high bar. So we’re very patient. It’s very rare to find these amazing businesses at steep discounts. So what would cause us to lose patience if you will?

We define a mistake not as a company whose stock price is down, but whose value hasn’t grown or had declined two years after purchase. Now let me caveat that just a little bit, that is a potential mistake. When that happens we’ve stopped, reassess everything, revisit our investment case, and see if the assumptions that we’re using the value the business in the first place are still valid. And if they’re not, if the business’ competitive position has declined, if they’re simply not generating free cashflow, although we thought they could, a lot of times those things run in combination, we will sell the business whether we have a profit or a loss. But if we re-evaluate the business, and maybe there’s been a recession and that’s the reason the free cashflow coupon hasn’t grown, and that’s why the value hasn’t grown, but the company has been able to hold its value steady in a declining environment, then we would not sell it. We would continue to remain patient and continue to own it. But that’s what would cause us to see if we should still hold that business over five years.

PRESENTER: And given your investment style, does that mean you tend to gravitate towards certain sectors and avoid others?

C.T. FITZPATRICK: Basically any business that does not generate free cashflow we have no interest in owning whatsoever. So we start with that. If it does generate free cashflow it might not be sustainable. And it might be cyclical. And it might not be qualifying for investment. Just because it generates free cash, it’s where you start; it’s not where you stop. So businesses that don’t control their own destiny, businesses that are commoditised or that are dependent on the price of commodities, those are the kind of businesses that we would avoid. We don’t like financial leverage. Most of our businesses have very inefficient balance sheets. They have net cash on their balance sheet. We think that’s a good thing. We do invest in some businesses that have modest amounts of debt, but it’s modest in relation to their ability to generate free cashflow. But generally we don’t like financial leverage.

PRESENTER: Do you invest your own money in the funds?

C.T. FITZPATRICK: Yes; in fact everyone at Vulcan Value Partners is required to invest in publicly traded equities exclusively through Vulcan. You cannot work at our company and invest anywhere else. So we think that’s really important, because it aligns our interest with our clients. And it’s quite frankly if we want our own money. One of the reasons we started Vulcan was so that I could put my personal capital and my family’s capital into the ideas that we own for all of our clients.

PRESENTER: All that research you do on stocks, do you tend to buy it in, or have you built it all yourself?

C.T. FITZPATRICK: We generate it ourselves. I mentioned slightly earlier that there’s a tagline about Vulcan: we’re value investors but we don’t look for cheap stocks. We look for businesses that have inherently stable values; that we would like to own should they become discounted. And so it’s all, we start with that, and it’s all sourced internally.

PRESENTER: So what exactly are the resources that you’ve got behind the portfolios?

C.T. FITZPATRICK: Well, I’m very fortunate to work in a really highly motivated, highly talented group of people. We are a research-driven shop. Roughly half of the people in our firm are involved in research and the other half are supporting the research effort. Everybody understands that research is at the centre of everything we do, and the entire company is built to insulate the research team and allow us to find the best ideas we can find from around the world. We travel around the world. We talk to CEOs, CFOs constantly. We’re always comparing one company to another, looking for the very best ideas around the world, and we’re trying to have constant improvement in what we’re doing. We’ve made heavy investments in our infrastructure that improves our trading efficiency. We can talk about ideas, but if you can’t execute them on the trading desk you’re just talking. So we have a highly integrated team that works together as a team to deliver the best risk-adjusted return for our clients that we can possibly do.

PRESENTER: So what sort of resources have you got behind the portfolios?

C.T. FITZPATRICK: I think MasterCard is a great example of a company like that. We bought MasterCard over a decade ago during the financial crisis. When we bought the business we were modelling that its earnings would decline, because obviously we were going into a recession. And the company’s value was extremely stable, even throughout the financial crisis. In fact when we first bought the business in the fall of 2008 its stock price declined precipitously going into 2009, bottoming in March of 2009. In the interim the company reported earnings, and instead of earnings being down as we had modelled, they were actually up, which was amazing in that environment. The company generated a large free cashflow coupon, and our value was actually up materially in the teeth of the financial crisis, while the stock price had gotten even cheaper. So we added to our position of MasterCard and it became one of our largest weights in the portfolio.

In 2009, the stock was up roughly 100% from the bottom, and it was still discounted, because it had become so discounted before and the value continued to grow. So MasterCard’s weight has fluctuated in our portfolios for over a decade. When price rises faster than value we have less of a margin of safety and we lower the weight in the portfolio. When value rises faster than price, or price declines, which is rare for MasterCard but it does happen, then we add to our position in MasterCard. And so even though we’ve held the business for over a decade, its weight in the portfolio has fluctuated according to discount.

PRESENTER: What do you expect a company to do with all the free cash that it throws off? Should it be paying that out in dividends, or reinvesting it in the business?

C.T. FITZPATRICK: It really depends on the opportunity set that the company has. And capital allocation is really important to us. It’s one of the things we demand of all of our investments. Companies that generate free cashflow can have their values per share grow faster than the underlying value of the business if that free cashflow coupon is invested wisely. Alternatively, if it’s reinvested poorly, the share of the company can decline. So it’s very important. And whether or not they pay it out in a dividend, or reinvest in the business, or make acquisitions, or repurchase their stock should the company’s shares be discounted, as they always are when we own them, those are really important decisions. And there’s not one right answer, it really depends on the opportunity set. But the mindset of management should be to think with an owner mentality, put shareholders first and allocate capital to the highest and best use for shareholders.

PRESENTER: As a long-term investor, what’s your attitude to voting your shares?

C.T. FITZPATRICK: Well, we take proxy voting very seriously. We look at all the proposals and try to determine whether or not what is being proposed is in our own clients’ best interest. We’re very fortunate that we invest in very well managed companies, and generally we’re able to be supportive of management; however, when we’re not we will, if we see something we don’t like we don’t just blindly follow management suggestions, and from time to time we do have to vote against them, but generally we’re in the fortunate position of not needing to be activists.

PRESENTER: What’s the most important lesson that you’ve learned since launching Vulcan Value Partners 12 years ago?

C.T. FITZPATRICK: I think the most important lesson is humility. There’s a very thin line between confidence and overconfidence and even arrogance. You don’t want to become wed to your assumptions and wed to your ideas; when the facts change you need to change with them. I think it’s very important in addition to that to follow principles as opposed to rules. Principles are flexible, and you can learn and grow as an investor. The concept of margin of safety and reducing risk is all important. But the way in which you do that needs to be flexible, and you need to allow yourself to grow and get better over time.

PRESENTER: C.T. Fitzpatrick, thank you.

C.T. FITZPATRICK: Thank you.