A Long-Term View
11/13/2008 12:01 am EST
Daniel J. O’Keefe, portfolio manager of Artisan International Value Fund and portfolio co-manager of Artisan Global Value Fund, is taking a long-term look and finding opportunities in undervalued companies.
Q. Daniel, during this period of global economic crisis have you been a steady buyer of equities in Artisan Global Value Fund (ARTGX)? If so, why and what have you been purchasing?
A. As almost all our stocks are falling further from their fair value targets, the hurdle for new investments keeps moving up. So, a good portion of our buying has been in existing holdings. For example, Bank of New York (NYSE: BK), a holding in Artisan Global Value Fund, has been extremely volatile. Not a traditional bank, BK makes most of its revenues and profits from capital markets, related fee income, and a significant money market business. BK has not been immune to the credit concerns of the markets, but its exposure to low quality commercial paper has thus far been manageable. We have taken advantage of these concerns to add to our position.
Purchases we made in the third quarter include Tyco Electronics (NYSE: TEL), a leading [Bermuda-based] manufacturer of electronic connectors used in everything from cell phones and computers to automobiles. This is an attractively valued business with high margins, attractive returns on capital, and good cash flow generation.
The balance sheet is strong and management is very sensible in deploying the free cash flow. The stock price has fallen dramatically as investors anticipate the impact of a recession on Tyco’s earnings. While we believe that Tyco’s earnings will decline, we think that at less than eight times earnings, any decline is more than adequately discounted in the price.
We also added a position in the preferred stock of Arch Capital Group (NYSE: ARCH-PB). Arch is a Bermuda-based property and casualty insurance company. Most insurance companies have been very hard hit recently due to investor concerns over potential write-downs in their investment portfolios. We believe Arch is conservatively invested and very well capitalized.
While the common stock of Arch looks extremely attractive, trading at about five times earnings and a discount to book value, we find the preferred stock alternatives to be irresistible. They are higher up in the capital structure than the common stock, and due to their depressed share prices are now paying us a double digit dividend yield.
Q. Would you advise individual investors who are not currently participating in markets to sit on the sidelines until there’s a clear indication that we’ve hit bottom? Do you have a projection for the bottom?
A. We take a long-term ownership view of equities. So, taking a top down view of the market and trying to call a bottom is not something we spend a lot of time thinking about. We seek out high quality businesses in the marketplace that are trading at a significant discount to our estimate of intrinsic value. We do believe that the global economy has entered a recession, but also believe that equity market valuations have more than fully discounted this scenario into current prices. These valuations look very attractive and provide the prospect of generating attractive returns once the economy begins to recover.
Q. You have the leeway in your funds to buy quite a significant percentage of emerging markets securities. Are you buying any right now, and if so, would you give us a sampling? If not, why not?
A. We are looking to build a portfolio of businesses that retain four characteristics: a discounted price relative to the business’ intrinsic value; a strong, defensible business model; a management team that creates value for the owners; and a healthy balance sheet. We are fairly agnostic about where a company we may invest in is domiciled. However, in emerging markets the ability to determine some reasonable estimate of intrinsic value is often undermined by a whole range of obstacles, including corporate, legal, and regulatory structures that promote and protect business value. Therefore, we have historically had a hard time finding businesses that meet substantially all of those criteria in emerging markets.
Given our risk-averse nature, we require a price where even in some of the most extreme possible outcomes, we believe a reasonable rate of return can be achieved. This year we have clearly seen an aggressive decline in emerging markets, so we are looking there. However, stocks in all markets have declined quite significantly and all else equal, if we can generate adequate returns with our investments in the developed parts of the world, there is no point in taking the added risk.
Q. Which do you consider the key indicators of a strong company?
A. A financially strong company will produce a high level of free cash flow and have little debt. But there is also another important point to consider. In tough times like we are experiencing right now, those businesses with strong balance sheets may be able to strengthen their competitive positions and generate returns for shareholders at times when competitors might not. Businesses with strong balance sheets can do this by using capital to take market share from weakened competitors, by buying up weaker companies or by repurchasing and canceling shares when valuations are low.
Q. In your equity selections, you seem to favor companies with significant insider holdings. Is there a specific percentage guideline that you tend to follow?
A. We do not have a specific requirement, but we like to see management teams that are aligned with us as shareholders. We like to see rational option programs in place and we like to see management teams compensated in a way that encourages growth in shareholder value.
Q. You have noted that price is much more volatile than value, yet many investors often focus their attention on price. Which of the value indicators do you favor?
A. Our assessment of value is a function of the businesses’ underlying long-term intrinsic value. Intrinsic value is determined by free cash flow generation, net asset value, or the value of the business to a strategic acquirer. We compare that intrinsic value to the price that is quoted on the stock exchange. Often times, the market will become concerned about near-term issues and sell a stock down to a level that is well below intrinsic value. We use such opportunities to acquire shares. When the market is more optimistic and pushes a stock price up to its long-term intrinsic value, we are likely to be sellers.
Q. Do you currently have any favorite sectors or regions of the world where you are actively searching?
A. Looking back several months ago through the end of the third quarter, there was a lot of difficulty in the market but it was narrowly-focused on specific sectors, namely financials and anything housing-related. After the third quarter ended, a lot of the liquidity issues in the market came out, the credit markets essentially froze and everything started to fall at the same rate. At this point, we decided that there was a great opportunity for us to really focus on the highest quality, best businesses available. We no longer had to focus our efforts on only financials or consumer-related areas because everything started to get cheap. In this type of environment, we believe that you can really build the next several years of outperformance by concentrating on the best businesses, the best balance sheets, and the best franchises.