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A Value Fund’s Unique Ideas
08/15/2012 6:00 am EST
Portfolio manager Marian Kessler tells MoneyShow.com about her firm’s methodology for uncovering large-cap—and some mid-cap—fund investments. She describes some of the fundamental metrics her firm uses, and shares some of the names the fund currently holds.
Kate Stalter: Today, our guest on the Daily Guru is Marian Kessler, co-portfolio manager of the Becker Value Equity Fund (BVEFX), which has a four-star rating from Morningstar. Marian, can you start out today by explaining for us the fund’s objective and your investment philosophy?
Marian Kessler: Yes, the fund’s objective is capital preservation and growth in the large-cap value space.
The attributes of the fund are really philosophy- and process-driven. We buy stocks that are out of favor, but very good quality companies, and we buy companies that are selling at valuation discounts, either to the market or to their historic norms. So we buy a combination of absolute and relative values, and we buy stocks that have stable to improving fundamentals.
The fourth attribute that I mentioned is really critical to the process in the long term, the risk-adjusted results that are really quite good.
Kate Stalter: One of the things that I’m intrigued by is that at Becker, you prefer to generate your own ideas through internal research, rather than relying on Wall Street research, which a lot of investors do. Explain that approach.
Marian Kessler: Yes, that’s true. At Becker, we pride ourselves on our independence, and that independence leads to some unique attributes.
From an independence standpoint—just our location in Portland, Oregon—we’re off the grid of group-think. We think that really benefits us from a consensus standpoint. We use internal research, hands-on integrated research. We use Wall Street basically just to gauge consensus, but otherwise we don’t use Wall Street opinions to guide our choices.
Also, our size. At $2.5 billion, we’re flexible. We can trade around existing positions, and we can add and subtract names seamlessly from portfolios, which gives us a great deal of flexibility, particularly in very volatile or crisis-driven markets.
This independence, I think, leads us to some unique attributes of the firm. First, we’re team-managed rather than the star system. That minimizes ego-based decisions, and puts the emphasis on the execution of the philosophy and process of the fund.
So we essentially equal weight positions to again, avoid manager bias in the decision-making process, and control unintended risk. There’s a thorough vetting of ideas prior to the inclusion of a name on the portfolio, which is thesis- and valuation-driven.
The relative and absolute mix in the portfolio is important, too. We’re opportunity-driven. Right now, probably 60% of our positions are in relative values versus absolute, and we spend a lot of time on maintaining the validity of sustainability of that thesis.
Kate Stalter: Can you say a little more about the relative value versus absolute? Explain how that might be different from some of the portfolio methodologies that our listeners might encounter more often.
Marian Kessler: Yes, and having worked at a number of institutional buy-side firms over my career, this is unique. It is a bottom-up process, so we’re not targeting an x-percent in relative values or absolute.
And again, a definition of relative value is a stock that is selling at an attractive valuation, generally in the lower 25% of the range over a five-or more-year basis. That would be on a P/E basis, price to sales, price to book, whatever valuation metric is important for that particular stock or sector. An absolute value is fairly self-explanatory—a stock that’s selling at a discount to the market as a whole.
Kate Stalter: I wanted to also talk a little bit about some of the holdings in the fund. You seem to be very heavily weighted in US-based companies, and I noticed a number of Dow components, names that people might be familiar with. Can you say something about a couple of the holdings in the fund right now?
Marian Kessler: Yes, actually the theme, or one of the themes that’s come out of the portfolios in the last few years, has been somewhat of a return to a domestic business model. We had been quite exposed to international growth through domestic companies, but that has changed modestly in the last few years as we’ve shifted opportunity driven to more US-centric companies.
Larger companies owned in the portfolio—we are large cap-driven, although we will use some mid-cap names where we see opportunities. A couple of new stocks in the portfolio include Southwest Air (LUV)—really our first venture, very brave, into the airline space. Southwest has very strong free cash flow, even with oil prices being where they are.
Cost savings from fleet changes in rationalization will be very strong over the next 18 months, and there are a lot of synergies from the AirTran acquisition about 18 months ago, as well as expansion into international markets where they haven’t been before. We have high hopes for this name in the portfolio going forward.
Another new name in the portfolio, also maybe not a household name—although we do own Intel (INTC), Microsoft (MSFT), Chevron (CVX), Time Warner (TWX), Target (TGT), and so on—is Staples (SPLS), which people are probably familiar with. It’s by far the largest in the office supply space.
We bought it at less than five times enterprise value to EBITDA, and it has a very consistent earnings pattern with free cash flow in excess of $1 billion annually, 11% free cash flow yield, inexpensive stock. We think European concerns, of which 20% of its revenues are from Europe, are just overdone.
So, that’s illustrative of the kind of stock that we’re looking for. We’re very balance-sheet driven. We spend a lot of time—I think maybe again a uniqueness unlike much of our value peers—looking at free cash flow and return on invested capital versus cost of capital. And not as much of a focus on P/E and price to book, which really could be moving targets, particularly in difficult economic times.
Kate Stalter: It sounds to me like you’re really describing a bottom-up research philosophy, not so much that you’re targeting sectors or industries. Would that be the case?
Marian Kessler: That’s correct. We are not top-down sector rotators, and we are not macro-driven. We are very much fundamental bottom-up, research-driven, independent, in-house-driven research by seven analysts. Four are generalists, supported by three sector-specific analysts.
We do what we call an integrated research process. We not only just analyze the fundamentals of the company, the financials, talking to managements; we check in with input providers, output users, peers, competitors, regulatory agencies—all in-house, in order to really do our checks and verification on the stories that we’re hearing from the companies. It’s very much of a “like but verify,” be very cautious, and try to be as objective as possible.
Kate Stalter: We’ve talked about the stock-selection process. Do you use price targets when you decide to sell a position in a stock? How does that work?
Marian Kessler: That’s a good question. We don’t use price targets. We use valuation targets.
There’s a subtle difference between the two. We have in mind a valuation target for our absolute value names and our relative value names, and that is really a function of what the company can deliver in terms of earnings growth.
Valuation, for example—using a stock that we’ve owned for nearly ten years in the fund, Becton Dickenson (BDX), which is a health-care supply company—we bought that when it was trading at about 13 times earnings. Today, it’s still trading at about 13 times earnings, but the stock has doubled over that period of time, and earnings have doubled.
So, the valuation is still intact, but the stock has done exactly what we wanted it to do, which was to meet its expectations on a go-forward basis, and fulfill its job on that road map that I described of stable to improving earnings. And we still own it because it’s still selling at a very reasonable valuation.
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