Strategies for finding value investments

Mar 10, 2014 @ 12:00 am

Runtime: 9:17

Artisan International Value Fund Portfolio Manager Daniel O'Keefe talks about the risk/reward strategy that kept his firm out of bank investments in 2008 and helped identify companies with the strongest discount to intrinsic value in 2013.

Video Transcript

[MUSIC] This week on Wealth Track, the two time winner of Morningstar's International Stock Fund Manager of the Year Award explains how he and his colleagues built the artisan international value and global value funds to prosper in all market conditions. Artisan's Daniel Keith is next on Consuelo Mack Wealth Track. [MUSIC]. For us and our clients value investing is about finding businesses that meet four different characteristics. So we want something that is cheap relative to its long term intrinsic value. We want a high quality business, so a business that has some competitive advantage that has the potential to grow. That's defensible. We want a strong balance sheet. We want a strong balance sheet, not only because it's a repository of value in, in difficult times, but it's also a repository of value in, in good times as well. We can talk a little bit more about that. And then finally we want a management team who is working in our interest, actively engaged in building the value of the company on a per share basis. So if you think about all of the risk reward elements of those four characteristics, how do they play out in difficult environments, and how they play out in, in strong environments like what we saw in 2013. So the risk/reward is, is you're constantly balancing those and, and these four characteristics, you think protect you in, in down markets and, and enable you to participate in up markets. Is that kind of what this recipe does for you? It, it, it, it makes sense intuitively that they would protect you in a down market. Right. A strong balance sheet A discounted valuation. A high quality business. All of those are intuitively defensive characteristics. But we, we manage our portfolio in a way that, hopefully, we can, we can participate in, in strong markets as well. And the way to understand that is to think about what's going on with the discount to intrinsic value. So, in 2008, we, we protected capital because we had great businesses, we had strong balance sheets, we didn't own banks, we didn't own commodities in emergent markets, areas that were very hard hit. So we held up well in 2008. And, and let me stop you there, because a lot of value investors did own banks, especially. Yeah. So why did you stay away from banks? So, banks were at a low price to earnings multiple. So were they cheap? They were statically cheap. Right. But were they truly cheap. Well when we looked at banks, necause we didn't own any for years leading up to the financial crisis. We acknowledged the low PE. But we looked at the risk. Okay, cuz this business is as much about risk as it is reward. We looked at the risk and we said well, the leverage is 20 times. The businesses have been growing their loan books without interruption. They haven't taken any reserves against potential credit risks. There's a lot of risk in there, okay? So, a low priced earnings multiple doesn't necessarily indicate true value because those earnings are arguably peak and because they're so levered, if something bad happens then you stand, you stand to, to get wiped out. So, you look at it and you say well, is, is it truly an attractive risk-reward scenario, where if you're right, you can make a ton of money or decent returns but if you lose, you can lose a ton of money? We focus on the ability to lose a ton of money and that's why, that's why we stayed away. So that's different from focusing on something where you, you see not only where you see significant long-term undervaluation, and that, that undervaluation is underpinned by the tail winds of a strong balance sheet or the tail winds of a defensible business model, the tail wind of a management team working in your interest. That would be where we would, we would get very excited we would say, okay it's not only undervalued, but you have all of these other characteristics work in your favor as well. So do, what you were doing describing me as you said these are a lot are defensive characteristics so you can understand why they would be you know, reward you, protect you. Yeah. In a, in a down market. Yep. But then in the upmarket and certainly in, since the bottom of 2009 for instance. It's, it's in a, many cases it's, it's been the lower quality stocks and the higher stocks in small cap and that have done better than the quality companies. Yeah. So, so how come you didn't [LAUGH] [INAUDIBLE] in 2013 as well and... Well what we did, what we did was after we held up well in, in 2008... Right. We looked at our portfolio as we always do. We looked at our portfolio and we looked at where are the discounts intrinsic value. What is the discount in the intrinsic value of the overall portfolio. That's something that we track. Mm-hm. Because it will tell us something about the future perspective return. And, since we own things like Walmart and Johnson and Johnson, for example, that didn't decline as much. The discounts that we saw in the portfolio after 2008 were not as attractive as the discounts of many other businesses that were trading out on the market that got really murdered. Right. And so, what we did was we, we reallocated capital from stocks where the discount was not so great, into where the discount was huge. Okay, and so, that lever, accessing that lever, widening that price to intrinsic value creates the opportunity for significant future returns. So, so, for instance. For example, we bought Google in 2008. And Google is a great example of what we do, because it gets to the heart of the distinction between something that is merely statistically cheap and something that is fundamentally undervalued. So Google, at around 12 times our estimate of earnings when we purchased it was not necessarily the cheapest company in the universe. You could buy plenty of stocks at... Yeah, that's right. Nine or ten times earnings. But Google is a better of value, over long period of time, at 12 times earnings, than in average or mediocre company at nine times earnings. Even though its a higher multiple, why is that? Because it has huge operating margins. It operates in a long term secular growth market. It has significant competitive advantages, and it's worth 20 plus times earnings, whereas an average company at nine times earnings, yes, the multiple is lower, but what is it worth, 12 or 13? Would you rather buy something at 12 that's worth 20 and growing, or something at nine that's worth 12, that may or may not grow? When you and I talked before the interview, you had said that it's really tough to find good values out there now. So, I mean, you know, to give me your assessment of, of the companies that your looking at and and that how they're valued right now? Well a very wise man once told me now is always the most difficult time to invest. And I think that, that is, that is certainly true today. What we see is we see markets that have gone up a lot. And certainly in 2013 earnings grew in the high single digits. And many cases stocks were up 20, 40, 50 percent. So there's been a huge re-rating of securities. And that re-rating has generally extinguished. The, the undervaluation that we saw years ago. We were buying great companies at low multiples of depressed earnings five years ago. Right. And now we have multiples that are high in historic terms, or average to high in historic terms, on earnings that have rebounded in our, at a normal or strong level. So, just intuitively, they're just, the bargains have been, have been wrung out of the market. You're running a global fund, which can invest in the US and you're running an international fund, which is non-US, obviously overseas. Yeah. So is it you're looking at the US market, which is an extremely well infringe than than the international funds out of. You know, you've got the emerging markets, which actually emerging market people are saying are, are pretty cheap right now. Is that, so do you find yourself migrating looking more at emerging markets for instance or? Well, we are looking, and you're right. Emerging markets right now are at a generally low multiple. And a record, you know, over at least, over the last seven or eight years, a record discount on a PE basis Mm-hm. To the developed world. Something like four, four points on the multiple. And so, that, that gets our attention, right? So, we look, and the comments that I made about the average valuation in the developed markets are very different from the emerging markets. In the emerging markets, you have an average PE of let's say eleven. Mm-hm. And that is comprised, at least our research tells us, that's comprised of some really, really good companies trading at high multiples. And some really kinda low-quality leverage businesses trading at, at low multiples. And so, we haven't found anything that's cheap and high-quality. We can find [CROSSTALK] Oh, interesting. Cheap and low-quality at a low multiple, or we can find expensive and high quality to high multiple, but we can't get an attractive combination of, of price and value which is we said before is an important component of what we do. [MUSIC]


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