Mason Hawkins and Staley Cates on Today?s Opportunities for Value Investors
O. Mason Hawkins and G. Staley Cates are two of the most respected value investors. Based in Memphis, TN, their firm, Southeastern Asset Management, is a $35-billion, independently owned, registered investment advisory firm. Southeastern Asset Management also advises the Longleaf Partners group of no-load mutual funds: Longleaf Partners Fund, Longleaf Partners International Fund and Longleaf Partners Small Cap Fund, as well as an Irish-based UCITs fund for non-US investors, Longleaf Partners Global Fund. Hawkins is the firm’s chairman and chief executive officer and Cates is its president and chief investment officer.
I spoke with Hawkins and Cates on March 4.
Your shareholder letters often refer to the portfolio's discount to appraised value. Can you share with us some of the methodology you use to determine appraised value?
[Hawkins:] Business appraisals are the core of our being. We have three methodologies that we have applied for over 35 years. They were the genesis of Southeastern Asset Management, and we have inculcated Graham and Dodd principles into these three approaches.
The first approach is balance-sheet oriented and determines what a business would be worth upon liquidation. It sums up the assets, subtracts the liabilities after adjusting for today's values versus historical cost accounting, and then divides by shares. This evaluation comes up with what we believe is a conservative net asset value.
The second methodology is an attempt to assign a value to the business' free cash flow generation. There are many parts to this methodology that have to be calculated conservatively. The first is the current coupon of the business – its free cash flow generation per share. Free cash flow by our description is net income plus all the non-cash charges- depreciation, depletion, amortization, and deferred taxes - minus required or maintenance capital spending and working capital charges.
We are attempting to derive the free cash flow coupon that you could put in your pocket as an owner while allowing the company to remain competitively positioned.
We project cash flows out about eight years – usually never more than the past growth rate. We use a terminal multiple in the eighth year, based on 0-2% growth going forward. We then discount the terminal value and the eight individual years of cash coupons at a discount rate, which today is typically not less than 8.5%. That result gives us a value for the company's ongoing future cash flows. I want to emphasize that we use this second appraisal method for businesses that are truly franchises, are competitively positioned, and have predictable future streams. You don't want to mislead yourself by incorrectly applying this discipline to businesses with uncertain future cash flow.
The third methodology, comparable sales, is basically a check on the first two. We have recorded the metrics of going-private transactions, mergers and acquisitions, liquidations, etc. over the 35-year history of Southeastern Asset Management. These actual comparable transactions are logged, and we are mindful of and adjust for the interest rate environment when those transactions occurred. Obviously, merger metrics in 1981 or 1982, when long-term Treasurys were 15% or so, are not comparable to merger multiples today, when 15-year Treasurys are around 4%.
We compare those comparable sale yardsticks to the net asset value appraisal or the DCF appraisal. Normally we use the lower of those two.
At Southeastern Asset Management, we are our largest client because of our collective personal investments in the Longleaf Partners Funds. You see your boss in the mirror each morning, and you're not trying to trick that person. You want to be very conservative with your appraisals.
As you know, we endeavor not to pay more than 60% of that conservative appraisal, trying to create a big margin of safety of value over price, as Ben Graham described. We pound that price discipline into everybody via his books, Security Analysis and The Intelligent Investor.
Those three methods describe how we go about hanging a number on a business. Obviously there are certain companies where we don't have either the proper view of the future or the adequate facts to do an appraisal. It is very important to pass on opportunities when you can't calculate a conservative assessment of the business's value.
Let's talk about some of your holdings. With Dell Computers, do you see any catalyst that will permit the profit margins and the return-on-assets (ROA) at Dell to improve from where they are now? Are improvements in those metrics important to your investment thesis?
[Cates:] Let's take the return-on-assets separately from the margins. We do not see return-on-assets improving, nor do we care in the least that it does. Right now Dell has over $4 billion in free cash flow - net, after tax, and after all CAPEX. This will be the third year the company has generated that. Dell has $23.5 billion of total assets ex cash, and therefore an operating ROA of 17%. Of the $23.5B, $6B is goodwill and intangibles, making the free cash return on tangible assets 23%.
One misconception is that Dell is not a “high-return business,” or that ROA needs to improve. We strongly disagree with that. Those returns I just talked about are way higher than at most companies.
The other interesting thing is that you actually just called it “Dell Computers,” which highlights why it is cheap. People still view it as desktop and notebooks, even though those are dying a slow death. Those represent probably a fourth of corporate value and a third of earnings.
The good segments – storage, servers, services, and software – account for the majority of value and an overwhelming percentage of future growth. Dell has its basis in computers, because computers created the free cash, which led to the 20,000-person distribution network, which is why they can now buy a storage company, widely distribute its products, and take revenues up in multiples the way they did with EqualLogic.
Margins will drift upward just because of product mix. Think of PC margins as mid-single digits. HP does the same. In PCs you are basically a reseller for Windows and Intel. With storage, servers, and services, that is not the case. You have much, much higher gross margins. You have obviously higher SG&A. Net it all out and you have significantly higher all-in operating margins than you do in the computer business.
Dell will get a product mix benefit going forward. Rising margins will not be from heroic cost-cutting, because the company already implemented those when Michael Dell came back.
Dell has over $6.00 of net cash, including approximately $1.50 in finance receivables, and a stock price around $15. I mentioned the $4 billion of free cash flow, and it will be actually more than that. With a little under 2 billion shares outstanding, Dell will generate over $2 per share of free cash flow. You are paying approximately $9 per share ($15 price - $6 cash) for the operating business – basically a 4.5 P/E on real cash earnings, if you will, for a return-on-assets in the high teens or a return-on-tangible assets in the 20s.
That is why we are there. It is cheap because of this perception of what they do versus what they actually do.