Ride the cycle
March 29, 2021
Jenna Dagenhart: Hello and welcome to Asset TV's Value Investing Masterclass. We'll cover what companies and investment leaders are saying about the economy, and where active managers are finding opportunities in today's market. Joining us now with their outlooks and much more are three expert panelists, Wally Weitz, co-chief investment officer, founder and portfolio manager at Weitz Investment Management, Dmitry Khaykin, portfolio manager, ClearBridge Large Cap Value Strategy at ClearBridge Investments, and Matt Norris, portfolio manager at Ivy Investments.
Jenna Dagenhart: Everyone, thank you for being here with us. I want to start by setting the scene a little bit and thinking about the academic definitions of value and growth stocks. Wally, can you talk to us about these concepts versus the practice of investing?
Wally Weitz: Sure. Well, back in the 50s, or 60s, I remember the 60s when computing power was available to academics and Compustat tapes allowed them to put thousands of stocks together and through screens, and various programs. They had to have simple historical data points that they could use to compare all the companies and price to earnings ratio and price to book ratio were two that were really convenient. And my idea of what they did with that was to array all the 10,000 stocks in a line and in order of highest to lowest P/E, for example, draw a line down the middle and say that the ones on this side are value and the ones on the other side are growth. And that was handy. Because anybody who believes in valuation uses some rule of thumb to decide whether their companies are cheap or expensive.
Wally Weitz: We use discounted cash flow models, which are, they're more complicated arithmetic, but it's still a shortcut. But now 50, 60 years later, I think that is just too simplistic and kind of obsolete. We've always thought about defining value as the price that an informed buyer would pay for the whole business if they were going to hold it forever. And we want to buy shares in that business at a discount to his private market value, so to speak. And in today's world, where technology companies may write-off all their expenses for development of software and other programs, the comparisons of book value and current earnings between a software company and a manufacturing company that may have a plant that's being amortized over 40 years, just totally to me makes those original ideas too simplistic.
Wally Weitz: So I sort of reject the idea that there are value stocks and growth stocks. To us, it's a slow growing company or a fast-growing company can be worth buying or not depending on where the stock price is compared to its business value.
Jenna Dagenhart: Matt, given these concepts in the current environment, what's your outlook for value versus growth?
Matthew Norris: Well, I'm currently pretty optimistic on value returns, which is tough to say, as the value has lagged growth for near on a decade now after the '08 recession. But I would change the definition slightly, and I would say we should think about it more stable versus cyclical currently as we come out of this recession. So, when COVID hit, stable companies, say for instance, a Microsoft or Procter & Gamble, it didn't really affect them very much. Matter of fact, it was good for some of them. But the cyclical companies that depend on a good economic tailwind to succeed, business slammed to a halt overnight, basically.
Matthew Norris: So these types of stocks typically reside over on the value side of the ledger, and they did very poorly. And year today, the growth index is beating value index by that last count, maybe 35% or so. But as we recover from the recession, cyclical companies now we'll get that tailwind as GDP starts to get back, jobs come back in the market, while the stable companies will just still be the stable companies. So, if you have a preponderance of the cyclicals over in most value indices, I can see them catching back up over the next year or two.
Jenna Dagenhart: Dmitry, it's no surprise that the global pandemic has resulted in elevated volatility, what's been your response? And how are you positioning going forward?
Dmitry Khaykin: Yes, so volatility creates opportunities as scary as it might be in the short term. And I think I'm probably going to butcher Buffett's quote, but he said, you're going to be fearful when everybody's greedy and greedy when everybody's fearful, or something along those lines. So what we've done in our portfolio over the last couple of years is tighten up, get rid of low conviction ideas, reduce the number of holdings and double down on quality, with an idea that the expansion market being the one in its tooth redeemed for some kind of a downturn. Nobody could have predicted COVID pandemic, globally. But it's always gives us comfort to own this high-quality franchise that can compound value over time. And that's the way we approach investment world is that, we don't start with valuations, looking for cheap stocks, we really start with a business model, the franchise characteristics that we're looking for, the durability of the cash flows, the stability of their position within the market that they operate, and then we tried to buy them, attractive prices.
Dmitry Khaykin: Speaking of which, the period of sell-off earlier this year created the plenty of opportunities for us to capitalize on companies that we've been looking at and aspire it from a side where valuations before the sell-off were not as compelling. With the market sell-off and the baby being thrown out with the bathwater, a lot of really high-quality businesses was selling at very, very attractive prices. So, we've pulled the trigger on a bunch of them. Some of them include names like Lam Research, which is a technology company. They make semiconductor equipment, and it's effectively three or four companies globally that control market, very high barriers to entry. Very well capitalized company with no net debt and strong free cash flow. And we were able to buy during the sell-off at a very reasonable multiple of sort of low to mid [inaudible 00:07:28]. And there's a few more examples of that.
Dmitry Khaykin: So volatility is unsettling, but it creates opportunities. And because we are long term buy and hold investors, we take a three, five, sometimes 10-year view with an idea is that we want to buy this companies and own them for a very, very long period of time.
Jenna Dagenhart: Yeah, volatility can be your friend if you're not afraid of it.
Dmitry Khaykin: That's right.
Jenna Dagenhart: Now, Wally, how does today's market environment compared to market environments you've managed through before given your longevity as a portfolio manager and stock picker?
Wally Weitz: Yeah, longevity is a nice way of putting it, thank you. Well, in some ways, there's nothing new under the sun because people and human nature stay the same. But what seems really different this time is ordinarily we'll have a recession, a credit crunch, something that's been seen before, and you kind of know the shape of how it'll come out, you don't know the timing exactly. But with the pandemic, in March, we wondered if we'd ever go out of our houses again, within a few months, everybody was getting a lot more optimistic and vaccines were being created and the market rallied like crazy. And now here we are in the fall and some combination of back to school and fraternity parties and otherwise loosened self-restraint have a surging in, I think three quarters of the states are hitting record high new cases. I know Nebraska is one of them.
Wally Weitz: So the question of the shape of the recovery. Maybe it's different this time. And the other thing that seems really different to me is the Fed's response that really started 10 or 12 years ago in the Great Recession. They loosened credit, they pumped money into the system the first year or two and that was needed. It was more or less normal, but they never stopped it seemed and we've had quantitative easing continuously since then, and then they doubled down or triple down when the pandemic hit. And so, while we're trying to invest stock by stock, company by company, we're talking, individual companies have different levels of exposure but in some ways the market's just been swamped with all this newly created money, and that really is causing some price distortions.
Jenna Dagenhart: Matt, what sectors do you think provide the most opportunity for value investors?
Matthew Norris: Well, today, I think I'd focus on two main areas or themes. Personally, I think a lot of the financials are very inexpensive. In financials, price to book is usually a good yardstick, and you can find a lot of names under book value, but there's a catch. So most of the reasons that are making them inexpensive are somewhat out of their control, very low interest rates, regulations, currently, banks cannot buy back stock or raise their dividends, we are in a credit cycle, you can't really do anything to speed that up or fix it, you just kind of walk through the valley and come out the other side, and depending on the outcome of the election, there could be additional regulations or taxes.
Matthew Norris: So if you're going to go shopping in financial area, I guess I would encourage people to look for names that can control their own destiny more than simply crossing their fingers and hoping rates go up or that something changes. We've looked in the insurance area, a name like Allstate. We own Ameriprise, which is a wealth manager and currently is repurchasing shares, generates a lot of cash with not that much to do with it. So, there are the names but just tread lightly.
Matthew Norris: The other area I would still suggest is anything consumer facing that cyclical. So, when the economy shut down back in March, hotels, airlines cruise lines, they all, business basically went to zero in an hour. So, although those companies and the stocks darn near followed suit, they were down a large amount, and those stocks have somewhat recovered. But I think as the economy continues to come off the bottom, you can go shopping in areas like that. Again, the caveat here is pay attention to the balance sheet because you don't know how long that valley is. And if the company can't survive until the other side when we come out of the recession, it will be terrible investment. Backing away, a lot of large banks issued stock at crazy low prices, diluting shareholder value tremendously, you want to avoid companies that may have those sorts of characteristics.
Jenna Dagenhart: And in contrast to cruise lines, and some of the cyclical areas that Matt mentioned, the technology sector has really been on fire as of lately. So, Dmitry, as a value manager, are you finding opportunities there or are valuations just too demanding?
Dmitry Khaykin: It's a very fair question, especially in light of what we've been discussing that technology not really being impacted nearly as much as some of the cyclical areas of the market by the pandemic. But what we tried to do with ClearBridge, with Large Cap Value Strategy is that we tried to buy defensible franchises at reasonable valuations. And what we've learned is, and we've made our mistakes, looking for cheap stocks within technology, and it's not always a good area to be hunting for value because it would end up being value traps. But what we look for is defensible businesses and unfortunately or not technology has a lot of the areas that are defensible where franchises have high barriers to entry, high moats around them.
Dmitry Khaykin: I mentioned Lam Research being one of them. We've owned probably for a good part of a decade companies like Motorola Solutions, or TE connectivity, not necessarily household names that most investors know. But Motorola solution, even though people know that Motorola is unnamed, but it was a company that spin off the handset business. They're the company that created the first cell phone decades ago. And then they sold under the pressure of Carl Icahn, they sold the handset business, spin it off and sold it effectively to Google, which now makes Pixel based on that technology. But Motorola Solution remaining company is effectively an oligopoly, if not a monopoly in a first responder sort of two way radios, and it's a under the radar, kind of low to mid-single digit grower, with stable margins, a lot of cash flow and what they do is leveraging their relationship with local, fire chiefs and police departments and getting into the call centers for 911, for example, that's a very segmented market. There's a lot of old technologies, it's not in the cloud, and they're just leveraging the cash flow to get into that business.
Dmitry Khaykin: It's not necessarily zero exposure to cyclicality and it's obviously being funded by local budgets, but it's a name that we like and continue to own in pretty good size. TE Connectivity is a company that makes connectors. It's a spin-off of old Tyco. We've owned it probably for about 10 years also. And the beauty of that business is that about 40% of the business is tied to automotive. Automotive is a very cyclical business. So, when people stopped driving, you can't go to the dealership to buy a car. Obviously, GM and Ford and other OEMs shut production and it hurts companies, suppliers like to TE Connectivity. But the beauty of that business is that it generates cash though all parts of the cycle. And electric vehicle is a huge tailwind for the company, because the content per vehicle goes from about $65 for internal combustion engine to roughly double that with higher margins.
Dmitry Khaykin: So in addition to owning companies that are sort of in the mainstream that you think about, there are others that give you sort of this defensible business models that may be flying under the radar that are very attractive franchises that we feel comfortable for a very long period of time.
Jenna Dagenhart: And the electric vehicle trend seems like it's here to stay. For example, with California, trying to go carbon neutral by 2045.
Dmitry Khaykin: That is very true. I think decarbonization is a trend that, for various reason makes a lot of sense. Different countries have taken a different path. Even within the United States, California seems to be at the forefront of sort of environmental regulation. There are a lot of sort of startup companies that you can participate in that trend through. Being that we look for established sort of franchises, we look for opportunities where we can participate, but not necessarily bet the ranch of the entire company in that area. And the way we can play that is companies like TE which I mentioned already, we own a couple of California utilities, Edison International and Sempra. And it's unfortunate and horrible that there are all these wild wildfires, and people are dying, and they're losing their properties.
Dmitry Khaykin: The fact of the matter is that they've created this wildfire fund that all utilities contribute into, and that should protect effectively, publicly traded utilities from being effectively going bankrupt as long as they are found to be prudent in the way they run operations. But Edison international and Sempra being over time will be beneficiaries of this massive investments in renewable infrastructure, right? Because you need to deliver energy from the point of generation to the point of consumption. So, we think of those two businesses as companies that should grow earnings say about, five, seven, 8% that are trading at or below market multiple. Edison international has some uncertainty about the liability related to prior fires. But nevertheless, it's more than priced into the stock. So those are some of the areas we participate in sort of the green renewable energy. Then there are some couple of other companies we can cover.
Jenna D.: And mega-cap technology and work from home stocks continued to shine in the third quarter, and equity markets hit fresh all-time highs. But Wally, you recently wrote in your third quarter note that you suspect the economic recovery will take longer and be more on even than the markets rebound would suggest. Are people declaring victory too soon?
Wally Weitz: Well, I think so. And then that's not terrible. I'm not terribly pessimistic, and I'm not expecting another market crash necessarily. But the idea that the market could come back to new highs within three or four months. I think maybe it's a symptom of what we've come to, I mentioned before the Fed pumping money in for the last 12 years, people used to talk about the Greenspan put and they talk about the Powell put with the idea that the Fed's going to bail out stock and bond markets whenever they wobble a little bit.
Wally Weitz: We saw on the fourth quarter of 2018, they started to let rates tick up just slightly and the market went down 20%. And it seems strange to me to think that the market owes us good times all the time. And when Dmitry is talking about the wildfires, I think it's sort of analogous to, apparently 100 years ago, the Forest Service decided that they were going to put out every fire that they could find as soon as it started, and they thought that was a service to the people in the area. But it turns out that that makes the whole forest more and more fragile, so that when you do get a fire, you get the kind of explosive things that we've had in California, in Colorado and around the West.
Wally Weitz: But back in, I think it was the first quarter of 2016, the oil industry hit a rough patch and stock prices went down and oil stocks cratered. And it turned out that an awful lot of companies that seemed to have nothing to do with or very little to do with the energy patch, or energy business turned out, they did have a little bit of exposure. And maybe it was for an industrial company, 5% of their business was compressors that was used in fracking, or maybe for a hotel company, they were housing workers in remote oil fields and that sort of thing.
Wally Weitz: And it turned out that the economy was fine, and they all came back fine, but it took a little longer because of that exposure to the oil patch. And I think we have, allegedly, according to some studies, half the people in the United States were not prepared for a $400 family surprise, going into this. And they've had an enormous surprise. And the fiscal measures with the CARES Act and unemployment benefits and so on is helpful in maintaining their spending, but it's going to be awhile before the growth is really robust again.
Wally Weitz: So we look at each individual company, of course, a couple of them. We don't own Zoom, but they were fine on day one. But at the other end of the extreme with hospitality and travel, it may take five years, it may take more than that for movie houses. So, each one's different. We're trying to figure out what that path looks like. And with the risk on, risk off, flip flopping that happens in the market, both the victims and the beneficiaries can flip from overvalued to undervalued and back again, week by week and month by month, and that's the volatility that that value investors live for.
Jenna Dagenhart: Now, taking a closer look at the economy here, Matt, what's your outlook for the economy?
Matthew Norris: I'm very positive, longer term, but I don't disagree with Wally. The path from point A to point B is rarely a straight line, and there will be fits and starts on the way and the timing is unknown. But I see no real structural reason why we shouldn't return to the levels that we were at before the crisis. But again, timing, you could predict what or when but never forget both, right? There will be some changes. When you think about how the world works, if you're working from home, maybe now you buy less gasoline because you're not commuting, but you'll probably take that money and spend it maybe fixing up your house or buying different types of food to cook at home or who knows what. So, there will be a shift.
Matthew Norris: The economy won't recover to the pre-peak levels, this year or next year, I can't imagine. Different industries will recover at different speeds. If we do get a vaccine that works here, that will definitely accelerate the process. But it's still probably a multi-year process before we get back to kind of before. It's very interesting. We commented on the volatility and how that gives you opportunity. GDP growth from 2010 to 2020 seemed like it was 3% every year plus or minus a little. There's very little volatility. And I think that was a time waiting for growth stocks that could create their own growth. I'm not going to mind if we have some fits and starts because as Wally also said, that's an opportunity. We just had probably the shortest and sharpest recession in history that had nothing to do with business fundamentals, it was an outside force from healthcare. So, I don't think the economy's say overcapacity, or there's a permanent thing that needs to be fixed. We just need to slog forward and eventually emerge on the other side of the pandemic.
Jenna Dagenhart: And the recovery isn't necessarily going to be overnight?
Matthew Norris: No, it won't.
Jenna Dagenhart: Now, Dmitry, how are you monitoring the macroeconomic picture?
Dmitry Khaykin: Well, we are bottom-up stock pickers, really. We are active managers. We're not trying to position portfolio for a bull market or a bear market for a V-shape recovery, or a K-shape or a W or whatever other letter people tend to use these days, we just try to buy the best quality franchises we can at reasonable valuation. But I would echo what Matt and Wally said that, it's an external shock, some people use an analogy of a hurricane in certain areas where they see that huge V, and a very rapid sort of recovery.
Dmitry Khaykin: The massive fiscal and monetary stimulus that has been put in place over the last, call it, six to nine months is sort of trying to bridge the gap between sort of pre-COVID world to the point where the economy recovers to some extent, and businesses start opening again, and people start feeling comfortable getting on the plans and going to restaurants. And as a country, we've done a pretty good job doing that. But we're not there yet. And there's a lot of uncertainty with respect to whether the next stimulus bill is going to come in place or not, when it's going to come, and obviously election is a huge swing factor.
Dmitry Khaykin: So we feel that people who try to make predictions about macroeconomic sort of outcomes are right about 50% of the time. It's only apparent when they're right, looking in the rear-view mirror. We feel that it's hard enough to pick stocks, let alone predict what economy is going to do. And that's why it's even more important in this environment to focus on what we think we do best, which is, buy the best businesses we can at most reasonable valuations we can afford to pay.
Jenna Dagenhart: Yeah. And Wally, as you talk to companies, what are they saying about the economy?
Wally Weitz: Well, of course, it depends on the industry as we've been saying. It's a totally mixed bag depending on what business you're in. But it also depends on the personalities of the management's, because I think corporate America has learned, they've all had media training, and they've all had it beaten into their heads that they want to set expectations low enough that they can exceed them every time even if the absolute number is really lousy. So, we listen to the conference, the earnings calls, we talk to managements. We realize they don't really know, either, but we do five- or 10-year discounted cash flow models for each company. So, one of the really handy things about DCFs is not that they give you a magic answer, because we take the number that drops out with a little bit of a grain of salt, but it allows you to fiddle with the assumptions.
Wally Weitz: So we say if this part of the business comes back right away, and this other part doesn't, we can experiment with the impact and the sensitivities within the models of that and at least get an idea of the possibilities, and then we monitor to see how it's really unfolding. But the other thing about using five and 10-year DCF models is that what the next few quarters do doesn't really make any difference in our assessment of what the business value is. Now, if airlines are never going to be the same, we can't look out at the five-year mark and think everything's fine and use our old model, we'd have to throw it out. But the path of recovery is a lot less important than where it ultimately gets and how well the business does in the 5th year, the 8th, or the 10th year and so on.
Wally Weitz: Again, our idea of the business value doesn't fluctuate nearly as much as the quarterly earnings picture does in a time like this. And again, right or wrong, I mean, we're not perfect about the estimates. But if we have a sense of business value and the markets way over or underestimating that in the short run, again, we can try to take advantage of that.
Jenna Dagenhart: Gives you a pretty good sense there. And Matt, does the potential implementation of further stimulus make you worry about inflation?
Matthew Norris: Well, I do agree with Dmitry's comment, that making macro predictions is kind of a fool's errand. But since I already dug my grave talking about the economy, I'll go ahead and address inflation. I don't worry about it today, but I think that's a question you better ask yourself every six months. So, as Wally mentioned, somewhere in the last 20 years, the Federal Reserve has decided that it may not be their job anymore to control inflation and unemployment. It seems to be their job to prop up the stock market anytime that it has a bad week or month. And they did it again this time with a balance sheet that had gone from under a trillion dollars to four trillion in '08 to now something around seven trillion I believe.
Matthew Norris: But throwing money at a problem usually is kind of like putting makeup on it, it'll work for a while, but it's not going to work forever. And economic theory will tell you that throwing money at a problem is going to cause inflation down the road. Now, they didn't really do it in '08, and we haven't really seen it yet, but it's still probably too early to know. If inflation got back to the Fed's target of 2%, I wouldn't have any problem with that. And actually, that would probably benefit a lot of value sectors on the chemicals and basic materials, and some people that could use a little pricing power. But if it does get to 2%, and you start thinking, huh, now it's looking like three, four or 5%, then you better step back and kind of reassess. So, no real worry today. But yeah, don't go to sleep on that question. Keep an eye on it.
Jenna Dagenhart: Well, interesting discussion on the economy there. Well, moving on to the investment process. Dmitry, how do you define your approach to value?
Dmitry Khaykin: Yeah, so Wally talked about, sort of the history of Compustat and dividing lower half of stocks by price to book price, to price to earnings as a shortcut for valuation. It works for some people. We feel that looking at evaluation as sort of as a primary way to sort of narrow the final of your investment universe to opportunity set is somewhat flawed because things change, and they don't always revert to the mean, right? So, the competitive dynamics change in the current environment technology to cover technology at landfill already, technology can be a disruptive force that kills a lot of businesses and creates a lot of new businesses.
Dmitry Khaykin: So it's somewhat dangerous in our opinion just to look at valuations and say that cheap stock is therefore a value stock. What we try to do is we try to find competitive advantage businesses at reasonable valuation. And when we say competitive advantage businesses, we look for companies that have resilient and durable business models. And it means that they have strong balance sheets, and they have enough profitability to withstand the inevitable bumps in the road, whether they're macroeconomic, so competitive otherwise, and resilient means it's the company positioned within its end market and its stability of the end market. And it also means, how do we think about the risk of disintermediation or technological obsolescence? So, it encompasses all those different factors.
Dmitry Khaykin: And then only after that, once we feel comfortable that the franchise really has those core characteristics, then we'll look at valuation. And we are very disciplined, we don't pick a point in time and say 10 times, 15 times multiple, it's attractive. We'll look at things in a normalized basis but normalized for the cyclicality of the business when normalized for the balance sheet differences in a lot of different factors as well. And we finally we try to really heavily discount sort of something that may or may not occur in the future.
Dmitry Khaykin: So we look at the cash flows in the short to medium term, and products or services that are not in the market today and may or may not come to market anytime soon, we're not going to really bank on it. So, a good example of that would be if we look at a pharma company or biotech company and we don't own a lot of them, but we don't some, we're not necessarily going to bank on a phase one drug coming to market. We're going to do a DCF of existing products that are already in the market. And if the stock is below that value, then we'll try to buy it, and if it's not, then we're probably not going to buy it. And if there is a pipeline drug that happens to hit the market, and is a great success, it's an icing on the cake. But we're not going to make a decision to buy a stock on a binary event like that.
Jenna Dagenhart: Welly, turning to you, you've been a value investor your entire 50-year career, how would you describe your investment philosophy, and has your philosophy or investment process changed over the years?
Wally Weitz: I would say, the philosophy has not changed. The idea of paying attention to business value is something I adopted early on, because I had the very good fortune of coming to Omaha in 1973 and working for a fellow who was a good friend of Warren Buffett's, and he made sure I paid attention. So, business value as opposed to statistical cheapness, it was an early idea. How I've implemented it over the years as evolved, I think. Warren talks about how it took him a long time to listen to Charlie Munger saying that quality was important. And I listened to that and believe that, but it still took me a long time to adopt it. But probably in the last 10 or 15 years, it has sunk in. And if you looked at the overall quality of the businesses that we've owned in the last 10 years compared to the first 10 years, you'd wonder how we're still here.
Wally Weitz: But another thing is, with technology, I assumed that since I'm not mechanically inclined, and I had no idea how a disk drive worked, and that sort of thing that I couldn't invest in technology stocks, and I heard Warren say the same thing, and I thought that's good enough for me, and I ignored him for a very long time. But as we collected some younger and smarter and more imaginative young analysts and portfolio managers that gradually convinced me that it was possible with some technology companies to really have a good idea of what they'd look like in five years and 10 years.
Wally Weitz: If you have a product cycle of six months, and some other competitor can put you out of business, that's not for us. But by probably, I guess, this was 11, or 12 years ago, we bought Google, when it finally became clear that that was a superior medium for advertising. And we we’ve owned TV and radio and cable stocks for decades, and had paid a lot of attention to advertising, but Google was eating their lunch. And gradually over that last 12 years or so, we've been willing to, we may find out that we really can't project the way we think we can. But you look at our portfolios now, and they're much more likely to have Visas and MasterCard’s, and Googles and Facebooks, and not have the Forest products and energy companies and cheap but mediocre financials that I sort of lived on in the 70s, 80s, 90s. So, the tactics have changed but the idea that business value matters lives on. And I mentioned accounting earlier.
Wally Weitz: Some of our other analysts, Jon Baker, in particular, has been really good about basically showing me how some companies can spend all their profits and more in their early years of their business, becoming entrenched and locking in customers and the concept of lifetime value of a client or a customer is the intangible. Back probably, 20, 25 years ago, Buffett wrote a few paragraphs in an annual report about intangible goodwill and it was basically, at that time, he would say it was, the Coke brand was on our books for $1. But when you think about, a life insurance company pays out the whole first year's premium to the salesman, but hopefully keeps that contract on the books for a long time. And so, getting away from pure P/E, and getting away from thinking more about overall enterprise value to cash flow has probably made me a lot less interested in highly leveraged companies today than I would have been 20 years ago. So, the tactics change, but the concept and the philosophy are the same, I think.
Jenna Dagenhart: Well, it sounds like you got to Omaha at a good time there. Matt, could you describe your investment process?
Matthew Norris: Certainly. I think it's very fascinating, and also kind of fun to listen to Wally and Dmitry, and we will all describe our process differently, yet, there are certain basic underlying themes, I think we would probably all raise a glass to that we all agree in. So, we start by looking for an undervalued stock. And our favorite metric is normalized free cash flow to enterprise value. So, if my checkbook was big enough, and I could buy all the stock and all the debt of a company, that free cash flow would be my salary or the return. And that, to me is the same as what Wally said back at the beginning of, what would a reasonable man pay for business if he was going to buy it and run it? And a computer can spit out 20 ideas in five minutes with that, but the computers don't know, was there an acquisition? Did management just change? Is there a new competitor, or is there a disruptive force? Which Dmitry talked about.
Matthew Norris: We then create a discounted cash flow model, and we asked ourselves, okay, if we truly believe this stock is undervalued, there's probably a reason, something's wrong, or there's a concern in the market, and it needs to be fixed. So, Sears was a cheap stock for 20 years, and we never touched it, because of what Dmitry talked about, disruptive forces. Amazon came in, online shopping came in, and Sears had no response, and they just slowly melted away like an ice cube until they were gone. So, there are companies that have those problems that won't get better. So, if you can find a cheap stock that's just cheap temporarily with a reason to get better. And thinking of some of the other names, we own Lam Research also here, and these names fall in cycles, semiconductors and semi-capital equipment, they fell during the COVID pandemic, it gives you a chance to buy really a business that's going to grow and be around the rest of my life at a cheap price.
Matthew Norris: So cyclical reasons can be the reason, it might be something macro, it might be a management change, or frowned upon acquisition, maybe you have to know that the company will get over whatever it is that's making everyone dislike it today.
Jenna Dagenhart: And the computer also can't 100% wrap its head around ESG considerations. Dmitry, can you give us an example or two of how you factor ESG into your research and your stock selection process?
Dmitry Khaykin: Yeah, so ClearBridge has been an ESG investor for 20, 30 years. And it's changed what it means to be EGE invested today versus 10 or 20 years ago. It used to be SI, sustainable investment, nowadays it's ESG. So, the semantics changed. But the end of the day, what you're trying to do is you're trying to buy companies that are not only worried about the bottom line, but they're trying to do the right thing for their employees, for the constituencies, for the employees, for their customers, for their communities, and treat people the way they're supposed to be treated. And the approach that we take with Large Cap Value Strategy is by focusing on this competitive advantage businesses. The upside of that is that by being more profitable than most of their peers, you have plenty of firepower to not only deliver to the shareholders, but to deliver to all stakeholders. And a couple of examples to use is let's say Home Depot. It's a company we've owned for over 10 years now. And I do a fair amount of work around the house.
Dmitry Khaykin: I like to do a little electrical work, a little carpentry, whatever. And there's a Home Depot and there was a Lowe's and I'm not pooh-poohing one at the expense of the other but it's striking how well Home Depot handled COVID. Not only from the standpoint of making sure that customers are safe, right? They cut number of hours, they have people at the door clicking how many people come in, there are lines of footsteps everywhere is to make sure that you keep six-feet of distance, they make sure that everybody who comes in wears a mask, a protective kind of screens in front of the people who work behind cash register. And they did it and they pay extra sick leave, extra compensation to the employees on the floor, given the fact that they take in risk by being interactive with their customers.
Dmitry Khaykin: So again, their profitability is materially better than most of their competitors, they can afford to do it. The other good example is Deere. Deere is a big agriculture construction equipment company, right? If you live in a farmland like Wally does, green equipment is probably something we've all seen many times in the field. Deere generates about 25 billion of revenue. About a third of the global ag market is Deere's. The next three competitors are slightly above that. So, they have a scale advantage. They have 5000 distributors globally. They have dominant share in US and Latin America.
Dmitry Khaykin: So what that affords them to do is that affords them to focus not only on making heavy metal machines but focus on precision agriculture. So, the precision agriculture, it's a very heavily R&D focused area, requires a lot of software investments. And what it allows them to do is it allows them to reduce usage of water and harmful chemicals, while improving the yield for the farmer. So, it serves dual purpose. Helps the farmer makes the bottom line and helps the environment by reducing the use of water and harmful chemicals.
Dmitry Khaykin: They made acquisition a couple of years ago called Blue River. It makes basically cameras that are put on the bottom of the sprayer and planters and the camera and basically can over time with AI learn to differentiate between the crop you're trying to grow and the weeds that you're trying to kill. And instead of spraying sort of all around the area with pesticides or herbicides, you can effectively do it much more targeted and let's say for a cotton crop, you reduce use of harmful chemicals by about 90%. And at the same time, you improve the yield for farmers by 10 to 15%.
Dmitry Khaykin: So that type of differentiation, so it's clearly ESG jewel that serves multiple purposes, and extends the competitive advantage of companies like Deere. But it's an integral part of the process. It's not something we outsource to third party; we have access to MSCI and Sustainalytics and all these other third-party sources. But it's something that we rank all our companies, our analysts rank all our companies when they use geometrics. They differ from company to company or sector to sector. And we engage with companies on issue matters the same way we engage with their companies on any other fundamental issues. It's a way to control risk, it's a way to control management and tensions and so on and so forth. So, it's something we've been doing for a very long time, and it seems to be catching a lot of attention these days, but it's been ingrained in our sort of research and culture for many, many years.
Jenna Dagenhart: Matt, any thoughts on your end about ESG?
Matthew Norris: No. Historically Ivy was not really a big ESG shop or it wasn't a big part of our process. But in the last few years, we've jumped on board. I mean, it's all the rage these days. And we've got a new CIO, who's very, he wants that to be a part of the process. I guess, all value managers are cynics to some degree. And I have seen these studies that show if you had ESG as part of your process, you've done better or the rankings, which we all know are kind of the quantitative rankings take with a grain of salt, but it seems everyone I know is now adding ESG to their process. So, once everybody's doing something, sometimes loses its efficacy.
Wally Weitz: One other thing, I think before it was even labeled ESG, and in the old days, it was socially responsible investing, no liquor, tobacco and firearms. And this kind of considerations always been around but it is hard. I think we'd all agree, when you try to quantify and really prove that your ethical or moral, it's such a qualitative thing, and I'm guessing all of us when we talk to our companies and try to get a sense of the people. Maybe you get a better sense of if they're spirits in the right place through indirect questions. And when you try to figure out what they're really trying to build over the next five or 10 years, and what that'll mean for their employees and their customers and that sort of thing.
Wally Weitz: I think you can infer whether they're meeting the spirit or not. And one thing that, actually, it's funny. Managements have gotten very skittish about talking to money managers and analysts, because of Reg FD, and that sort of thing. But when we can convince them that we couldn't care less about the next few quarters, we're really interested in their five and 10-year outlook, sometimes that's so refreshing that they'll actually open up, and let us see what's really on their minds as they do their business. And I think that's where we get the clues on ESG, as well as, whether we like them as managers.
Jenna Dagenhart: Well, thank you, everyone, for letting us look under the hood with your investment process and for sharing your thoughts on ESG. Before we wrap up the discussion, I want to spend a little time now on active versus passive. Wally, are today's index led investment environment and highly mechanized investing landscape having a large negative impact on price discovery?
Wally Weitz: Well, price discovery always seems like a funny term to me. But I think I would agree if this is what the question's about. That indexing leads to price distortions relative to business value. The mechanics of index investing indicating that a buy order or a sell order on a given day goes to each of 500 stocks, if it's the S&P, in direct proportion to their market cap makes, it could only be coincidentally, congruent to the business value. So, I think what's maybe distorting it even more, I've talked a couple of times about the excess creation of money by the Fed and being pumped into securities markets. It may go into treasuries, or it may go to the CARES Act, but it seems to end up in the stock market, or a lot of it does. And between the gaining of share of passive investors and all that extra money, there's distortions that have been going on for years now.
Wally Weitz: I fought it pretty hard, and I think our performance showed it in 2015, '16, '17 maybe. And I think now we're willing to hold the great businesses, even when it gets to 100 cents on our appraisal dollar. So maybe that's a concession to the game theory of investing. But the indexing, if you think about, if we're at 50% of money being in passive hands and growing, at some point, at 50, or 60, or 70%, in passive hands, if somebody decides that it's time to sell, there's nobody to sell to, and we could really have some stock market fireworks if the remaining active managers like us step aside, and let them. And we saw a taste of that in the five or six weeks and this spring and the occasional flash crash. But it's something to try to understand, and we're getting our arms around how much the brute force of cash flows in the short run and the short run can be years apparently, can cause us to have to adjust how we actually deal with our portfolios.
Jenna Dagenhart: Matt, you use active management to help investors meet their long-term goals. What's most exciting to you about taking an active approach to investing?
Matthew Norris: Well, I think there's two things with us, and its risk and its customization. Looks like Wally talk about index construction. There is risk out there. The Russell 1000 Growth, which is not an index I'm completely familiar with, but I think 25% of that is in the five biggest names. And someday when the wind starts to blow from the different direction, and people do want to sell, the largest cap companies get the money, and they get the money taken out of it.
Matthew Norris: If you look back at the 2000 tech bubble, the Nasdaq fell roughly 60% from January 2000, to the bottom in March of '03, but the Equal-Weighted S&P was down about 20. So, you can help control the risks for your client by not having 25% of your portfolio in for big names. As companies as those names may be, the risk to those names is that they probably eventually get overvalued, and then when a correction comes, there are some worst performers. So, we try to be a little more equally weighted in most of our portfolios and guard against that risk.
Matthew Norris: The other thing I like is customization, we run a number of different value approaches. One example is one concentrates on the value names we'd normally pick with an extra eye toward the big data they can offer. So, you can participate in the performance over time of value investing, but also creates you cash flow. And there's customers that prefer that, that's what they want. So, there is the ability to kind of tweak and customize, while a standard index fund I guess is, I really have nothing against them, but they're one size fits all and you better hope that it fits you.
Jenna Dagenhart: Yeah, that's a great way of putting it. And Dmitry, you're clearly an active manager at heart, doing some boots on the ground research at Home Depot for your home improvement projects. Why is active management important to your portfolio and how do you think about the ways that you line up and don't line up with your benchmark?
Dmitry Khaykin: Yeah. Look, there is a trend in favor of ETFs and index funds, and it's a trend that's above and beyond the control of anybody on this call, right? It's a mega trend that'll continue for as long as it does. We have no way of stopping it. We as active managers are not obviously big fans of that. But it's democratizing investments, right? Effectively, it allows an educated investor to participate in the market, in a broader market, or narrow slices of the market, depending on the index you participate in, and so it's cheap. And what you get for the cheapness is basically everything that Matt and Wally have mentioned already, you effectively get exposure to the market, you get beta. But by definition, you're not going to get all [inaudible 00:57:58], right? Because if the index or ETF is actively following a particular type of the market or slice of the market, you're just going to get to keep up with it for a very inexpensive price.
Dmitry Khaykin: As active managers, what we're trying to do is we're trying to generate alpha, meaning outperform our benchmark. We're in a relative performance game. Our benchmark as Russell 1000 value, and we're trying to outperform the benchmark by making active bets. And by active bets, I mean, we're not trying to look like an index, when I tried to look like a ETF, we're trying to look different, by making decisions to invest in areas where we feel we'll be able to generate outsized returns relative to our peers and then relative to our benchmark. And it's varies depending on what sector you're looking at.
Dmitry Khaykin: There are parts of the market where there is plenty of differentiation amongst companies that operate in that market, and those sectors include industrials, for example, it includes communications, it includes materials even, even though we shy away from commodity chemicals, for example, there's plenty of companies that are differentiated enough, and those are the sectors that we feel very comfortable making and technology obviously, we spend a lot of time talking about technology. We're very comfortable making pretty active bets in size. And for us size means position sizes up to 5%, probably even though technically we can go higher, but we try to limit that at that level. And there are some other parts of the market which are more exposed to variables outside of our control. And those would include sectors like financials and energy.
Dmitry Khaykin: Those are driven by big macro variables like oil price, for example, for energy or interest rates for financial sector. We don't pretend as I mentioned, we're not macroeconomists, we don't bank on interest rates or inflation as we discussed earlier going up or down. And then those part of the market, we just tried to have exposure, so that if there is inflation, we participate in that inflation, the benefits of that inflation. But at the same time, we're not sacrificing the quality focus that we have at the core of our strategy.
Dmitry Khaykin: So whether we're talking about energy company, or we're talking about money center bank, like JP Morgan, we always try to buy best capitalized, best managed, least leveraged company. If it's a manager company, we're looking at the lowest cost resource base. If it's a bank, for example, we will look for deposit base that is a competitive advantage in a diversified revenue stream. So that's the way we think about sort of broader positioning versus an active management versus our sort of benchmark.
Jenna Dagenhart: As we conclude this panel discussion, Matt, is there anything you would add?
Matthew Norris: No. We've kind of, excuse me, I think we've addressed it. But I do believe when you think of the index as a whole, with a bigger proportion of cyclical companies typically residing in the value side, I'm not in charge of chopping the companies up into each bucket, but that's just how it falls out, then a continued recovery in the economy should benefit those and I think some money will find their way out of some of the growth stocks and into some of the cyclicals over time.
Jenna Dagenhart: Well, everyone, thank you for your time. It was great to have you.
Matthew Norris: Thank you.
Wally Weitz: Thank you.
Dmitry Khaykin: Thanks for having us.
Jenna Dagenhart: And thank you for watching this value investing masterclass. I was joined by Wally Weitz of Weitz Investment Management, Dmitry Khaykin of ClearBridge Investments, and Matt Norris of Ivy Investments. I'm Jenna Dagenhart with Asset TV.