Investing in Out-of-Favor Value Companies

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1 R E P R I N T E D F R O M J U L Y 1 6, Investing in Out-of-Favor Value Companies ROBERT W. FRAZEE is an Assistant Vice President at Delta Asset Management, LLC. Prior to joining Delta he worked in the Assurance and Business Advisory Services group at PricewaterhouseCoopers, LLP. He received his BS in Business Administration and Master of Accountancy from the University of Tennessee. He is a Certified Public Accountant and a level II candidate for the Chartered Financial Analyst designation. TWST: Please start with an overview of Delta Asset Management and what you do there. Mr. Frazee: I am a research analyst at Delta, so I spend the majority of my time analyzing companies, both the companies that we own and the companies that we are looking at as potential investments. I also manage our taxable fixed-income accounts. Delta was started in 1989 by two of our principals, Myron Mall and Alex Conaway. Myron and Alex worked together at a bank here in Memphis prior to starting Delta. So we ve been in business for more than 17 years now and we ve grown pretty consistently over the years. We now manage a little over $500 million in assets. About 90% of our client base is high net worth individuals, the remaining 10% is made up of pension plans, foundations, endowments, etc. We use both equity and fixed income in the management of our accounts depending on the client circumstances and needs. About half of our accounts are balanced, another 40% are pure equity accounts, and then the remaining 10% are pure fixed-income accounts. TWST: What is the firm s investment philosophy? Mr. Frazee: On the equity side, we are an all-cap value manager, meaning we don t want to put any constraints on ourselves in terms of the size of companies that we buy or even where we invest geographically. Our basic premise is that we want to identify value and then invest accordingly wherever that may take us. At times this has resulted in our leaning more toward small and mid-cap stocks. Right now we are leaning the other way, more toward large cap stocks, but that obviously can change depending on valuations. As far as what we look for in a potential investment, basically we want to find very high-quality businesses that are run by managers that we feel are competent and shareholder oriented. We want to find these businesses when they are trading on an out-of-favor basis in the market. There are a number of reasons that stocks may be out of favor such as short-term earnings pressure, cyclicality, or even execution issues at the management level. In some cases, we ve found the market to simply be ignoring a certain company or a sector or an industry. This often happens, we ve found, when the market is highly focused on another area. For instance the late 1990s are a good example of this, when technology-related companies were the focus of the market and a lot of very high-quality businesses were essentially ignored. Incidentally a lot of those businesses that were overlooked proved to be some of the best investments for the next several years following the market downturn in the early part of this decade. M O N E Y M A N A G E R I N T E R V I E W

2 Whatever the reason for the out-of-favor nature of the stocks, our primary concern is to find situations that we deem to be temporary. In other words, we do our very best to stay away from situations where there is something inherent in the business, something of a structural nature where the company is at a competitive disadvantage. The reasoning behind this strategy is based on our belief that the market is generally short-term oriented. Current information is quickly reflected in the stock price, but oftentimes the current situation is not a good proxy for the actual long-term prospects of the business. It is this type of inefficiency that we believe provides very good opportunity from an investment standpoint. In our experience, these situations provide a competitive return with generally lower risk. TWST: What is the current environment like for investing in these high-quality companies that are not performing up to par? Mr. Frazee: As you can probably tell from what I ve said, our analysis is entirely bottom-up. We don t do any macroeconomic forecast or top-down analysis. The environment for us is dictated by the valuations that we are finding in the market. Given the strength of the market that we ve had over the past few years and in particular the past 12 months, stocks in general aren t particularly cheap. One thing we ve talked about concerning this current bull market is how broad it has been. This is different from some prior market rallies. I alluded earlier to the late 1990s. That market environment was actually quite narrow in focus and really concentrated on technologyrelated companies, but if you were willing to look away from where most market participants were looking, there were some great opportunities to find good businesses that were being overlooked. Unfortunately that does not seem to be the case in the current market environment. A lot of it has to do with all the private equity activity that we are seeing. As soon as a company stumbles a bit, either it s snapped up by private equity or in a lot of cases just the speculation of private equity pushes the stock price up. So all that s to say that there are not a lot of companies or industries that are really out of favor at the moment. TWST: What changes in emphasis have you seen in your portfolio over the last 12 to 18 months? Mr. Frazee: We make no attempt to follow any benchmark in terms of being overweight or underweight in some industry, so any changes of that nature are not intentional, but are just the result of where we have identified undervalued stocks. As I mentioned earlier, our portfolio has gravitated more toward large cap companies over the past couple of years, simply because they have been out of favor versus small and mid-caps. I don t know that there have been any other significant changes to the portfolio, but I will say that the names that we ve been able to add over the last 12 months or so have been very high-quality, stable, mature companies. In a lot of cases, they are companies that were considered growth companies a few years ago, but, for whatever reason, they ve gotten very cheap. From our perspective those are great opportunities to buy some quality businesses at prices that are very attractive. TWST: How many stocks generally do you have in your portfolio? Does the number fluctuate according to market conditions? Mr. Frazee: All of our stock portfolios follow one of two model portfolios. One model may include cash reserves while the other model remains fully invested at all times. In the case of the model that includes cash reserves, market conditions can influence the number of positions we hold, as well as the percentage of cash reserves. All other things being equal, a weaker market environment would most likely result in lower cash reserves and a higher number of stock positions. The fully invested model is not as influenced by market conditions. In either case, we generally own between 25 and 35 names, so it is a fairly concentrated portfolio as compared to some mutual funds that may hold a couple of hundred stocks. We generally consider a 3% position to be a full position in a stock and we won t go over 4% in any one stock or 8% in any one industry for risk management purposes. TWST: What is the benchmark against which you measure the performance of your portfolio? What is your track record? Mr. Frazee: We benchmark to both the S&P 500 and the Russell Given that we are an all-cap manager, I think that gives us a good idea of how we are doing versus both the large cap names of the S&P 500 and the smaller cap stocks of the Russell As far as our track record, over the last 10 years, we ve been able to achieve our ultimate investment objective, which is to produce a competitive return in excess of the S&P 500, and we ve done so while assuming much less risk than the market. TWST: Can you tell us about some of the stocks that you feel are representative of your investment approach and the reasons why you were attracted to them? Mr. Frazee: One company that we have been buying recently is Bed Bath & Beyond (BBBY). We believe that this is a great company; they have a phenomenal retailing and merchandising culture that really gives them a competitive advantage over their peers. We also liked this company versus some of the other home furnishing retailers that we were looking at, because we felt they were not constrained by a certain merchandising look that could be either copied or would go out of style as consumer preferences change. In the retail space, that was very important to us. The stock has been under pressure recently for a number of reasons, one being the weak housing environment. This company is definitely impacted by the housing market since the purchase of many of their products is associated with someone buying a new home. So, given the weakness in housing that we ve seen over the last year or two, this has had a negative impact on their sales. I think there is also some concern in the market that this company s growth engine, which has been phenomenal over the last 10 to 15 years, is maybe beginning to slow, both in terms of future new store expansion opportunities and also same-store sales growth. Because of the weak environment, there has also been quite a bit of promotional activity by some of Bed Bath & Beyond s main competitors in the form of discount pricing, which has hurt them as well.

3 In our opinion these are basically temporary things that are really not related to the fundamentals of the company. Because Bed Bath & Beyond has a competitive advantage in their merchandising, we feel like the promotional activity by their competitors is not rational and it s not sustainable on a long-term basis. In terms of their growth, it probably is true that they are not going to grow at quite the same pace that they have over the past several years, but I think that the stock adequately reflects that. We ve made fairly conservative assumptions in our model about revenue growth over the next 10 years and based on our numbers, the stock They are extremely well positioned versus their competitors and they are the market leader in nearly every business that they compete in. Their geographic positioning is also very good. They ve got great exposure to some very fast-growing countries such as China and Russia. More than a quarter of their sales this past year came from developing markets. We believe that because of their positioning and their management and their competitive advantages, P&G will be able to continue to earn returns on capital that far exceed their cost of capital thus creating a lot of value for shareholders. Bed Bath & Beyond is a great company; they have a phenomenal retailing and merchandising culture that really gives them a competitive advantage over their peers. We also liked this company versus some of the other home furnishing retailers that we were looking at, because we felt they were not constrained by a certain merchandising look that could be either copied or would go out of style as consumer preferences change. is undervalued. I think the company also has some opportunities that may not be fully reflected in the stock price from a growth standpoint. They have several smaller store concepts, Harmon Stores, Christmas Tree Shops, and then buybuy BABY, which they just acquired a few months back. We feel like this was an opportunity to buy one of the best retailing companies in the world at a significant discount to what we think it s worth. TWST: Do you have another one? Mr. Frazee: Another company, one that we ve owned for several years, but that I think this is an excellent example of what we would look for in a company is Procter & Gamble (PG). Most people know P&G is one of the largest consumer staples companies in the world; they have sales in more than 180 countries. They have a phenomenal management team that runs the business with a long-term orientation and they are very shareholder-friendly. One thing that we really like to see is a company or management that has a very clear strategy that they articulate frequently to their investors. P&G s strategy is to continue to invest and grow their core brands, to work to develop fastergrowing, higher-margin businesses, and then finally to continue to grow their businesses in developing markets. They ve been very successful executing on this strategy. The company has some significant competitive advantages over their peers in terms of scale and brand building. The also put a lot of emphasis on knowing their customers and this has given them a real advantage in product development. 1-Year Daily Chart of Bed Bath & Beyond Chart provided by TWST: It s interesting that you mention both a consumer discretionary and a consumer staple company. Mr. Frazee: As I mentioned earlier, sector weightings to an index do not influence our investment decisions. We do have a number of consumer-related companies in the portfolio at the moment, but it is just the result of where we have found companies that are undervalued.

4 TWST: What about another one from a different area? Mr. Frazee: 3M (MMM) is another good example and this is more in the industrial area. They do have some consumer products, but a significant part of their business is industrial in nature. This is another very high-quality business with a great long-term record of product innovation. We got the opportunity to buy 3M a little over a year ago. The situation that created the opportunity for us was basically a management change, but also a bit of a change in direction for the company. For about a five-year period at the beginning of this decade, 3M was run by Jim McNerney. He came over from GE and put a lot of emphasis at 3M on improving operational efficiency, cutting costs and improving margins and he was successful in doing that. Unfortunately, in the process, he underinvested in some of the businesses and for a company like 3M that really thrives on innovation and creativity, I think that he probably squeezed too tight in changing dynamics in the market have reached a point valuationwise where we have been able to invest in them. Dell has been a fairly controversial story over the past couple of years. The have made some mistakes from an execution standpoint, and their competition has also improved. We ve seen some fairly significant changes in the last six months or so with Michael Dell returning as CEO. They also had a bit of a change in strategy, at least symbolically, by entering the retail channel. They have responded to some changing customer preferences and are now selling lower-cost PCs through Wal-Mart. We are beginning to see some evidence that things are turning; margins improved this past quarter, and the stock price has started to respond as well. Dell is still a very good company, and will be for a long time. I think Dell is a good example of a situation where people became so negative on the short-term issues that the stock price was implying a much worse scenario than what we thought was reasonable longer term. 3M has some consumer products, but a significant part of their business is industrial in nature. This is another very high-quality business with a great long-term record of product innovation. some places. So about a year and a half ago, they brought in a new CEO, George Buckley, who ran Brunswick before coming over to 3M, and he has really made a fairly significant change in the direction of the company. He has committed to reinvesting in research and development, he has increased their capital expenditures to increase manufacturing capacity, and I think more than anything he has encouraged the company and the employees to go back to the innovative nature and spirit that drove the company before McNerney came in. Needless to say, this change in course caused some concern in the market that either, one, it wouldn t be successful or, two, it would cause some short-term bumps in the road, which it may. But the important thing from our perspective is that we feel like Buckley is doing what s best for the long-term health of the company. Going forward, we think the increased investments will lead to greater innovation and ultimately, increased sales growth. TWST: What about the technology companies? Last year, Alex Conaway talked about Hewlett-Packard and Dell. Are you still interested in Dell or any other technology company? That s a little unusual for value managers. Mr. Frazee: That s correct. We do still own Dell (DELL) and we also own Microsoft (MSFT). I think both of those are fairly good examples of what I alluded to earlier, which are companies that were considered growth companies at one time, but because of some 1-Year Daily Chart of 3M Chart provided by TWST: Some areas that have fallen out of favor in the last couple of years have been pharmaceuticals and the financial companies. Are you interested in any of those? Mr. Frazee: We actually owned Merck for quite a while, but we are out of the stock now. One problem that we have in trying to analyze pharmaceutical companies is the difficulty in what we

5 would call understanding the business. I don t mean that in the sense of understanding what they do, but I mean it in the sense of trying to understand with some certainty how things are going to look in five years and be able to put numbers on it. The nature of the pharmaceutical business is that they have current drugs that are producing revenue and profits and then hopefully they have a pipeline of drugs that are pending approvals and that are going to be the next generation of revenue and profit generators. We ve found that we have a hard time analyzing with any degree of certainty what things are going to look like five years down the road based on whether or not certain drugs get approved. So we do not own any pharmaceutical companies at the moment. As far as financial companies, we do own three financial companies right now. The first one, Commerce Bancorp (CBH) has a somewhat unique strategy of approaching banking from a retail perspective and they put an enormous emphasis on the customer service aspect of the business. It is a higher cost operation, but it has resonated with customers and they have been able to grow their deposit base very rapidly by taking market share from larger banks where people feel under-serviced. It has been a very good investment for us and a company that we continue to hold. We also own AIG (AIG), the large insurance company, which is another very high-quality company that, as you said, has been somewhat ignored for the past year or so. I think the advantage with AIG is really in their distribution channel and their geographic exposure to countries like China and other high-growth international markets. The stock is very inexpensive and we think it offers a great return for such a high quality company. Legg Mason (LM) is the other financial company that we own right now and it is a company that we ve added this past year. People probably associate this company with mutual funds, because it obviously has a large mutual fund family, but really over the past several years, through acquisitions, the company has become a very comprehensive asset management firm. They own several very good boutique money managers and they also have a hedge fund of funds group. So it s really a well-diversified investment company that is in an area that we think over the next 10 years or so is going to see a lot of growth. We had an opportunity to buy the stock when there was some concern in the market over a large transaction that they did, where they acquired the asset management arm of Citigroup and sold their brokerage unit. From a strategic standpoint it made a lot of sense because they wanted to focus all of their attention on asset management, but the size and nature of the transaction caused some concern in the market. Long term we think this is a very good company that can continue to grow and be extremely profitable. Legg Mason is a company that we ve added this past year. It s really a well-diversified investment company that is in an area that we think over the next 10 years or so is going to see a lot of growth. We had an opportunity to buy the stock when there was some concern in the market over a large transaction that they did, where they acquired the asset management arm of Citigroup and sold their brokerage unit. 1-Year Daily Chart of Legg Mason Chart provided by TWST: You obviously must be long-term oriented since you invest in out-of-favor companies waiting for them to respond to better times. What is the turnover? Mr. Frazee: Historically, our turnover has been very low, 20% or less most years. We tend to hold companies for a long time. This is why we place so much importance on understanding the business and buying high-quality companies. We want to take the perspective of an owner of the business and find companies that we can hold for a long time.

6 TWST: What is the sell discipline? Mr. Frazee: One place where I think we add value is being very focused on valuations when making buy and sell decisions. We create a valuation model for every company that we invest in. As a company s stock price appreciates to the point where it is at our valuation, we ll begin the selling process. We typically will scale in and out of companies. Our process has evolved to this over time, because we realized that we are typically early buying and early selling. I think that our discipline on both the buy side and the sell side is very important and having numbers to base our decisions on takes a lot of the emotion and subjectivity out of the process. TWST: What do you think differentiates your investment approach at Delta Asset Management from that at other firms? Mr. Frazee: I would say that there are two primary things that distinguish our firm and our approach. The first thing is just our overall methodology and our focus on long-term fundamentals. As I said, we try very hard to take the emotion out of the investment process and look past short-term issues and identify the real long-term fundamentals of the business. I think the reason that most market participants tend to be so short-term oriented is because things over the next year or so are much easier to know with some degree of certainty, whereas the longterm drivers require a much more thoughtful analysis. We spend a great deal of time trying to really understand the business in depth, its industry, its competitors, its positioning, and its management. We try to learn everything that we possibly can about a company so that we are able to make informed judgments about the long-term prospects, and I think that analytical depth really adds a lot of value. The other thing that I think distinguishes us is our effort to minimize risk in the investment process. Whereas most managers and most investors tend to focus primarily on the return side, we give equal consideration to the amount of risk that we are taking in achieving that return. This is reflected both in the types of companies that we buy, as well as in the buy and sell discipline that I mentioned earlier. People tend to pay much less attention to risk in good market environments like we are in right now, but in a market downturn, it becomes much more important. As I mentioned earlier, our history has been that we ve been able to achieve a very competitive return but we ve done so with much less risk, and I think that s very important to our clients. TWST: Who are your typical clients and do you have close personal relationships with the clients? Mr. Frazee: As I said at the beginning, the majority of our clients are high net worth individuals and it is definitely a relationship business. I think it is very important to people that they know and trust the people who are managing their money. Our principals have been in the business for a long time and they ve been in the community for a long time. These are generally relationships that form over many years and they ve developed a great trust. We take that responsibility very seriously and we offer a high level of service, and people appreciate that. TWST: What advice would you give to investors who look at this bull market and ask you why they should invest in value companies that are out of favor? Mr. Frazee: I think it goes back to the level of risk in the investment process. I believe that the types of companies that we invest in have a much better risk/reward metric than a stock that is priced to perfection. The reason is that when a company is out of favor, generally any negative events are reflected in the stock and in a lot of cases, the market has overreacted in the short term to some negative events. This limits your downside, but if the shortterm assumptions about the company are different from what the actual long-term prospects are, there is an opportunity to earn a very good return. TWST: Thank you. ROBERT W. FRAZEE Delta Asset Management, LLC 700 Colonial Road Suite 130 Memphis, TN (901) The Wall Street Transcript, 48 West 37th Street, NYC Tel: (212) Fax: (212) Website: