Staley Cates on Why Active Management Wins in the Long Term
Staley Cates is President and Chief Investment Officer of Southeastern Asset Management. Southeastern Asset Management is a Memphis-based, employee-owned global investment management firm founded in 1975 by O. Mason Hawkins and the investment advisor to the Longleaf Partners Funds. Longleaf’s flagship fund, Longleaf Partners Fund (LLPFX), was launched in 1987. It was followed by Longleaf Partners Small-Cap Fund (LLSCX) in 1989, Longleaf Partners International Fund (LLINX) in 1998 and Longleaf Partners Global Fund (LLGLX) in 2012.
I spoke with Staley on September 17.
Please describe your approach to value investing and the criteria you look for in a potential investment.
It is pretty simple and requires a strong business with good people and a deeply discounted price.
For the business part, we need companies with an edge that you can articulate on one page. That can be a brand or distribution network, low-cost status or some kind of moat – that over-used word. It’s got to have a true competitive advantage.
As a little aside, sometimes people will look at our holdings and think because we are “deep value” that we care more about the price discount than the value growth. But we actually demand super-high quality, which often masquerades as lesser quality. That is why we can pay a low price. For example, some cyclical businesses such as agricultural equipment or cement, have strong pricing power, dominant market share, and/or big barriers for new competitors, but at cyclical bottoms, we sometimes can buy them at deep discounts to their underlying longer term values. If it is blatant, easy-to-see quality, then one usually must pay a lot more in terms of multiples or P/E ratios.
Good people is about management’s vesting, whether their compensation is aligned with their shareholders’, and what kind of people they are. Their value-add is not soft and fuzzy but real as rain because the good CEO partners expand value way beyond what is on our appraisal spreadsheet. Within our appraisal, we assume the discount rate is the reinvestment rate for management’s capital deployment. If, for example, you have John Malone, Warren Buffett or Nassef Sawiris investing for you, that rate doesn’t apply. They get a way better return. By contrast, if there are people who misallocate capital, we don’t get the returns we thought we were going to have.
The last thing is the price. We want $.60 on the appraised dollar. Another way we talk about this is paying a very low going-in free-cash-flow multiple.
Our approach is simple to articulate, but it is very hard to execute.
One of the trends that has been drawing a lot of attention is the increase in share buybacks by corporations, triggered by low interest rates. How does that factor in your analysis?
Share buybacks are a great idea gone bad by being overdone. At its core, buybacks are just like mergers and acquisitions. A company is just buying itself instead of another company, and it should be viewed as such. The lower the price, the better. The lower the price, the lower the risk.
Yet the broad buybacks occurring today have that totally backwards. More than 400 companies in the S&P 500 are buying in their shares. That cannot be right and cannot be good because overall the market is efficient enough that not many things are cheap. The history is companies have typically bought at the wrong time, such as before a crash. When they really should be buying shares back, following a crash, most get scared and don’t.
Our answer is bifurcated based on our names, a small subset of the overall market. We are only in these investments because they are selling at a big discount to value, so most of our companies are growing value per share with their current buybacks. But we own a small subset of rare birds.
Overall, the market’s rapid buyback pace, which is approaching the previous high in 2007, has fed this whole passive-indexing bubble because the larger companies that dominate the S&P 500 are buying more shares, driving prices even higher. Systemically it makes no financial sense for every company to be buying in shares, and yet here we are prescribing it for a bunch of our investees - the ones that are still selling at huge discounts to value - because unlike an acquisition, it is a zero risk way to build value per share. An acquisition has integration risk.
Energy prices and the associated debt and equity securities in that industry have declined significantly. Are you finding securities there that meet your investment criteria?
We already own enough energy companies to be over-weighted in the portfolio, and unfortunately, have paid a performance price for being there ahead of the decline. Although interestingly, like the answer to your buyback question, you cannot generalize about opportunities. We don’t think most of the energy group is cheap. People would assume that because the related commodity prices are down so much, the names are a bargain paradise. We don’t think it is.
In our previous interview with Advisor Perspectives in 2011, we talked about using the strip [the price of oil or gas implied by the futures market], and sadly we were way off because the strip has moved much lower. But using the strip remains our go-to methodology because we are agnostic on the commodity. Most of the energy companies are not cheap based on the strip.
With a fresh piece of paper and after this big crash – not just bear market, but crash in energy – we find very little value. But like the buyback phenomenon, a few specific companies have their own reasons for cheapness that go beyond the strip coming down. Chesapeake’s (CHK) unfavorable differentials make it the most sensitive to gas price. Murphy Oil (MUR) has had a bad recent international exploration record. CONSOL (CNX) is still viewed as a coal company even though its gas assets are a much bigger part of its value. The view that coal is environmentally untouchable has a lot of people divesting regardless of price.
Those are rifle shot opportunities, but we don’t really think the whole energy group is that compelling.