R E P R I N T E D F R O M J U L Y 1 1 , 2 0 1 1 Long-Term Value Investing in Large-Cap Global Companies TODD S. LOWENSTEIN, CPA, joined HighMark Capital Management, Inc., in 2001 and is the team leader of the HighMark value equity strategy group. He manages approximately $1.5 billion in assets under the HighMark Value Momentum Fund (HMVMX) and the HighMark Large Cap Value Fund (HMIEX) strategies. He has held prior positions at J.P. Morgan in mergers and acquisitions and as the Senior Manager of the information, communications and entertainment group at KPMG LLP Mr. Lowenstein received a . Bachelor of Arts in economics from the University of California, Santa Barbara, and an MBA with an emphasis in strategy and finance from the University of California, Los Angeles, Anderson School of Management. SECTOR — GENERAL INVESTING TWST: How would you describe your investment philoso- TWST: Please begin with a brief introduction to HighMark phy as it pertains to these two funds?Funds and tell us a bit about your role there. Mr. Lowenstein: Our goal is to achieve attractive risk-adjusted Mr. Lowenstein: High- Mark Capital Management has been returns over an investment cycle by outperforming the index by 200 tomanaging money since 1919 with about $17 billion in assets under man- 300 basis points after fees, while assuming less risk. Generally speaking,agement today. We have core capabilities in equities, fixed income and we consider ourselves patient, contrarian long-term investors and reallymultiasset mandates servicing clients across the institutional, retail and focus on the business behind the stock. Our overarching philosophy andprivate wealth spectrum. In terms of organizational structure, we are or- mission is to seek out undervalued companies with low expectations thatganized as investment boutiques with many distinct strategies yet lever- have been overlooked, misunderstood and mispriced by the market forage the entire organization’s breadth and depth of intellectual capital for temporary reasons. We search for opportunities or catalysts to unlockresources. We currently have 66 investment professionals averaging over underlying asset value or improve profitability over time. The centerpiece21 years of experience. of our work is to stay anchored in conservative business appraisals, look- The value equity strategy group that I lead has five profes- ing across a full market cycle and attempting to purchase securities atsionals, and we manage two separate products: a relative value strategy material discounts to underlying intrinsic value, which provides us with abenchmarked against the S&P 500 called Value Momentum (HMVMX) margin of safety before committing capital. Because the future is so un-and a deeper-value strategy benchmarked against the Russell 1000 predictable, we require this margin of safety to protect us from adversityValue Index called Large Cap Value (HMIEX), which we just recently and provide some level of downside protection relative to the upside op-took over from an outside subadvisor. Our team is very experienced and portunity we see down the road.consists of a dedicated group of like-minded value investors with di- There is an old Ben Graham saying that captures the essenceverse and complementary backgrounds and skill sets, and which carry of this: If you take care of the downside, the upside takes care of itself.the necessary temperament to execute this strategy. Combined assets We are very focused on avoiding permanent impairment situations andunder our strategy are approximately $1.6 billion, and that’s across find that success in investing is highly correlated with avoiding mis-mutual funds, pension accounts, high net worth and nonprofit entities. takes and letting the forces of compounding work their magic under aOur relative value strategy has been around for over 25 years and is low turnover approach. We think this mindset, when coupled with atruly a unique strategy that has produced consistent, disciplined and disciplined process, stacks the deck in our favor compared to most mar-dependable investment performance in both good times and bad across ket participants, who seem to take more of a shorter-term, high-turnoverall market cycles and economic environments. posture toward investing. M O N E Y M A N A G E R I N T E R V I E W
MONEY MANAGER INTERVIEW ——————— LONG-TERM VALUE INVESTING IN LARGE-CAP GLOBAL COMPANIES TWST: Drilling down a little bit, can you walk us through Being contrarian in nature, we seek out opportunities to de-your processes of identifying potential stocks and selecting the ones velop a variant view, especially when the market has overreacted to badthat you want to include in the funds? news, overly pessimistic expectations or underappreciated potential that Mr. Lowenstein: The first step we undertake is to screen the can push stocks below their true net worth. It’s important to stress we aremarket for pockets of cheapness. We cast a wide net in our search for not simply buying cheap stocks for the sake of cheapness, although weinvestable opportunities and undervalued stocks, typically screening the like cheapness. We are trying to establish value and understand how the “Our overarching philosophy and mission is to seek out undervalued companies with low expectations that have been overlooked, misunderstood and mispriced by the market for temporary reasons. We search for opportunities or catalysts to unlock underlying asset value or improve profitability over time.”relevant benchmark as well as expanding into some small-cap, midcap companies will ultimately be recognized for improving fundamentals orand foreign stocks. Using what you might consider as traditional value- unlocking asset values and potentially being rerated by the market overscreening metrics, we search for companies with low multiples on earn- time. Ultimately, we establish a position if significantly undervaluedings, book value, EBITDA, free cash flow and sales. with an attractive risk/reward profile, and we feel there is an opportunity The second step is to focus on only the most mispriced and for consensus opinion to change about the company prospects when itattractive risk/reward candidates available and which meet our internal has been unfairly punished or simply misunderstood.rate of return and downside risk criteria. Generally, we’re looking for TWST: What sectors have emerged, especially during thea three-to-one upside-to-downside risk profile over a three- to five-year economic recovery from the recession, as being more likely to in-holding period before investing. So what that translates into for us is a clude the kinds of stocks you’re looking for?minimum 12% annualized expected internal rate of return, a maximum Mr. Lowenstein: I will preface my comments by stating we30% downside price risk and a 40% don’t have any heavy top-down sec-discount to our takeout, or private Highlights tor bets at the moment. However,market value appraisal. The third we do have some strong views andstep is fundamental research where Todd S. Lowenstein discusses his relative value important themes that have shapedwe conduct extensive due diligence strategy in large-cap multinationals. Mr. Lowenstein our portfolio positioning in this eco-on these companies in order to stress- uses a contrarian, bottom-up approach and a long- nomic climate. Our base case righttest the investment thesis and prop- term holding period, and he engages in conservative now is that we’re in a low-growth,erly handicap all the risk factors business appraisals. He says selectivity is key in the below-trend type of economic envi-involved. Our research efforts in- current macroeconomic environment. Mr. Lowenstein ronment. History suggests when youclude understanding the industry also discusses some of his top portfolio holdings and have a financial crisis of the thisstructure, business-cycle dynamics, the reasoning behind his selection. magnitude and the ensuing delever-the competitive landscape and com- Companies include: AFLAC (AFL); Baxter International aging process that occurs, it takes apany positioning, cyclical and secu- (BAX); Jardine Matheson Holdings Ltd. (J36.SI); ABB considerable period of time, esti-lar trends unfolding, and underlying Ltd. (ABB); Heineken N.V. (HEIA.AS); Vodafone Group mated to be five to seven years, tobusiness strategy of the industry plc (VOD); Diageo plc (DEO); Henkel AG & Co. KGaA fully recover to past-trend growthplayers. We examine past trends in (HEN3.DE); Nestlé S.A. (NESN.VX); Siemens AG (SI); rates. Government policy hasgrowth rates, margin levels, earnings Daimler AG (DAI.DE); Royal Dutch Shell plc (RSD-A); stepped in and attempted to fill thepower, asset utilization, free cash Anglo American plc (AAL.L); Vinci (DG.PA); Berkshire void with aggressive fiscal andflow generation and returns on in- Hathaway (BRK-A); Microsoft Corporation (MSFT); The monetary policy in a feckless at-vested capital potential for sustain- Home Depot (HD); Walgreen Co. (WAG); Honeywell tempt to stimulate demand and easeability and how it might change in International (HON); United Technologies Corporation the pain. The problem is that, by notthe future. We also assess the capital (UTX); Comcast (CMCSA); UnitedHealth Group (UNH); allowing markets to clear on theirstructure of the company — whether Lockheed Martin Corporation (LMT); Chevron own and with the highly distortiveit’s appropriate for the characteristics Corporation (CVX); Intel Corporation (INTC); Wells effects and unintended conse-of the business and where we are in Fargo & Company (WFC); Time Warner Cable (TWC); quences of short-term consumptionthe business cycle. Generally, we Nokia Corporation (NOK) and Google (GOOG). initiatives, all that seems to be hap-will talk to the company manage- pening is a higher-debt-burden levelment, competitors, Wall Street analysts and our network of contacts in comprising future growth potential and a lengthening of the naturalorder to properly frame the situation as well as try and get a sense of healing process rather than letting nature run its course.the consensus opinion and whether it might be wrong and what expec- According to Reinhart and Rogoff’s exhaustive research worktations are likely priced by the market. on past financial crises and government debt burdens, when you get to
MONEY MANAGER INTERVIEW ——————— LONG-TERM VALUE INVESTING IN LARGE-CAP GLOBAL COMPANIESabout 90% debt-to-GDP levels, it shaves about 1% off your potential caps are at extreme levels of cheapness — both in absolute terms, rela-GDP growth rate. Undoubtedly, this will be a serious headwind to a du- tive their history, and also sell at a meaningful discount to small capsrable economic recovery, full employment and absorption of excess ca- whereas they used to sell at a premium. We think there is a strong casepacity. With that economic backdrop, a rising economic tide will not lift for mean reversion here as valuation spreads widen again over time asall boats, so investors need to be selective and discerning to outperform. the investors wake up and migrate back to where the value is in the mar-In this kind of environment, we look for three things to capture opportu- ket. Meanwhile, these megacaps are not only inexpensive but also havenities and avoid pitfalls. First, for years we have believed the center of attractive investment attributes, with both offense and defensive charac-gravity has shifted from west to east, so you want more exposure to in- teristics that should play well in an uncertain and uneven economic en-ternational and emerging markets, but not at any price. We want more vironment. They have strong balance sheets, wide-moat competitiveexposure there, directly by owning foreign ordinary or ADR companies advantages, large international sales exposure, benefit from consolidat-and indirectly through multinational companies with a high percentage ing weaker industry players with low-cost financing available, and areof business in those regions. overcapitalized and thus poised to return more excess capital to share- “For years we have believed the center of gravity has shifted from west to east, so you want more exposure to international and emerging markets, but not at any price. We want more exposure there, directly by owning foreign ordinary or ADR companies and indirectly through multinational companies with a high percentage of business in those regions.” In our mutual funds, we can own up to 20% of our portfolios holders in the form of higher dividends and accretive buybacks.in foreign ADRs or ordinary shares and have always had strong expo- Examples of stocks we own in this category include Berkshiresure, because we analyze industries on a global basis and have seized on Hathaway (BRK-A), Microsoft (MSFT), Home Depot (HD), Walgreengreat investments by being so broad in our view of industries. Examples (WAG), Honeywell (HON), United Technologies (UTX), Comcastof stocks we own in this category are Jardine Matheson (J36.SI), ABB (CMCSA), UnitedHealth (UNH), Lockheed Martin (LMT), Chevron(ABB), Heineken (HEIA.AS), Vodafone (VOD), Diageo (DEO), (CVX), Intel (INTC) and Wells Fargo (WFC). Finally, we are alwaysHenkel (HEN3.DE), Nestlé S.A. (NESN.VX), Siemens AG (SI), attracted to turnarounds, restructuring stories and special situations, soDaimler (DAI.DE), Royal Dutch Shell plc (RDS-A), Anglo American we seek them out. These stories tend to be less correlated with the marketplc (AAL.L), and Vinci (DG.PA) . Second, we think there is consider- and more correlated with their own problems.able value in unloved large-cap multinational companies. These stockshave underperformed the market for over a decade as their multiples 1-Year Daily Chart of The Home Depot 1-Year Daily Chart of Vodafone Group plc Chart provided by www.BigCharts.com Chart provided by www.BigCharts.com Often event risk occurs, which carries complexity or causes confusion, which can beset a company or an industry and thus createhave compressed over 50% during that time frame, while the fundamen- pockets of opportunity for value investors to capitalize on. Here we aretals have been pretty solid. But rates of growth slowed, somewhat disap- trying to understand the turnaround roadmap plan and the quality of thepointing the growth-investing crowd that owned them. These companies assets to determine how profitability can be restored and/or assets mon-were essentially stigmatized by the curse of high expectations, given the etized to drive higher shareholder value over time. This could involvehigh multiples and high expectations they carried, and now have been shrinking the company to reset it for a new lower-growth trajectory, assetderated to such an extent that that are truly bargains with virtually no sales or spinoffs of noncore divisions, optimizing the portfolio of busi-downside risk and a much more attractive combination of low valuations nesses, changing the capital structure, executing the business plan betterand low expectations. Moreover, from a broader group perspective, large with new management, or simply slowing growth investments and re-
MONEY MANAGER INTERVIEW ——————— LONG-TERM VALUE INVESTING IN LARGE-CAP GLOBAL COMPANIESturning excess capital back to shareholders. We are extremely patient and TWST: Are you making any significant sector bets at thewilling to wait, even if the results are quite lumpy in nature as long as moment?progress is occurring and the values our work uncovered are being real- Mr. Lowenstein: We’re not making any big bets right nowized through the passage of time. from a sector standpoint. We’re pretty sector agnostic actually. Nothing What is nice about these stories if the business can be reposi- stands out as extremely cheap or expensive that we might want to maketioned for its highest and best use, and profitability and returns are re- a big shift. Most of our sector positions are driven by bottom-up stockstored to their potential and close-to-peer-group levels. Typically a selection at the moment. We believe that after the big recovery in thererating of the company follows, so you can make money two ways: on economy and markets over the past year or so, stock selection will be thean earnings recovery and multiple expansion. In short, from a total return dominant factor going forward, which has historically been the case instandpoint, you can still make money even in a low-growth environment. the expansion phase of the cycle we are in right now. The easy money has been made and now handicapping fundamentals and the appropriate 1-Year Daily Chart of Lockheed Martin Corporation valuation of those business values will be key. It’s a stock-picker’s mar- ket that is right in our sweet spot. Our investment process allows us the flexibility to move to where the best value opportunities are being created, whether that is ab- solute value — valuation spreads are wide, obvious what is cheap, rela- tive value, valuation spreads are narrow, quality is cheap — or somewhere in between, depending on market conditions. As a general rule, from a portfolio construction standpoint, we do use of a combina- tion of top-down and bottom-up viewpoints to shape the portfolio. Our biggest overweights are in industrials, energy and con- sumer staples. We thought these companies were poised to benefit from a global manufacturing renaissance going on on a worldwide basis. The global ISM, PMI and trade numbers were booming until the recent Chart provided by www.BigCharts.com shocks and ensuing slowdown from the Japan earthquake and tsunami, “Our biggest overweights are in industrials, energy and consumer staples. We thought these companies were poised to benefit from a global manufacturing renaissance going on on a worldwide basis.” TWST: You mentioned your interest in the emerging mar- which caused major supply chain and logistics disruptions worldwide,kets. In which specific markets do you see the best investment op- extreme weather events, oil price spikes, and uncertainty and risk resur-portunities at this point? facing in European sovereign debt markets. Notwithstanding the Mr. Lowenstein: Seemingly, most of them are engines of European situation, which likely has a long tail to it, we believe most ofgrowth for the entire global economy. They have been gradually embrac- others factors will prove fleeting, with activity levels reboundinging capitalism, free trade, rule of law and growing at very attractive rates strongly and reverting back to better trend levels in the second half of thewith low debt levels relative to underlying growth. And they don’t have year. Our biggest underweights are the defensive areas of the market likethe debt overhang that developed markets are suffering from today. The telecom services and utilities.investment controversy surrounding these emerging markets is whether TWST: Would you give us a couple of examples of your topthey can transition from an export-led economic model to more of an holdings, and tell us how those stocks are representative of your in-internal-consumption model, which may be challenging given they have vestment approach?so heavily relied on overconsumption from the West to sustain their Mr. Lowenstein: Let me give you a few examples. Microsoftgrowth. is a stock we think is safe, undervalued and underappreciated. It has been Consequently, I think you want to be careful, selective and a chronic underperformer recently. The stock is really cheap trading at 10discerning on gaining exposure. We invest in very backdoor way. We times p/e, eight times less its massive $50 billion cash balance, 50%own some direct exposure through a company in Hong Kong called discount to its software peers, 22% discount to the market with over aJardine Matheson, which is an extremely well-run conglomerate with 10% free cash flow yield, while putting up pretty sustainable double-exposure to all of Southeast Asia and is a play on the rising Asian con- digit earnings growth amid a strong product-upgrade cycle.sumer. Most of our exposure really is from multinationals that are doing So we think there is an extreme disconnect here. They havebusiness all over the world — in China and India, Southeast Asia, Africa, strong, durable crown jewel franchises in their Windows, Office andEastern Europe and Latin America. So most of our companies have sig- Servers & Tools businesses, which we think are completely overlookednificant exposure to those geographies. at this point. We think the market has put a disproportional emphasis on
MONEY MANAGER INTERVIEW ——————— LONG-TERM VALUE INVESTING IN LARGE-CAP GLOBAL COMPANIESrecent investments where they’re losing money or breaking even, such as lets, we think they can coexist with PCs, but there will be somein Bing search, phone, Xbox, which is really a small part of what they cannibalization mostly to the netbook segment and to a lesser extent todo, yet command all the attention. What is really underappreciated is that the laptop segment as well.they are well positioned to capture opportunities as the software market TWST: Another example of one of your top holdings?migrates to the cloud, primarily through their Azure cloud-platform of- Mr. Lowenstein: Another example is Time Warner Cableferings. The market views this more as a risk to their business model (TWC). This was an overlooked spinoff that found its own identity andrather than an opportunity and is not willing to give them the benefit of really is firing on all cylinders. They are the second-largest cable opera-the doubt on any level of success. They have dedicated an inordinate tor in the United States today. The stock has been a winner but is stillamount of research and development towards this transition and are re- very cheap on most metrics, carries close to a 3% dividend yield, and wepositioning the company to seize on this shifting landscape. Their assets anticipate their shareholder-friendly capital allocation policy will drivein place, prowess and initial success have been overlooked thus far. But further gains in the stock. It’s a sticky subscription business model withas they build business momentum and win, new business investor senti- pricing power, declining capital intensity and leverage, declining com-ment could shift. We think they will make a successful transition. petitive threats, and growing free cash flow generation. We think they have a cost and scalability advantage in broadband technology versus the 1-Year Daily Chart of Microsoft Corporation incumbent telecom operators, and the share gains they’ve achieved rela- tive to the telecom operators are going to continue. They have the ability to upgrade their state-of-the-art cable plant capacity at very low cost through software upgrades and reclaiming analog spectrum for conver- sion to digital formats, enabling them to avoid expensive physical plant upgrades and truck rollouts to customers. Capex as a percentage of rev- enue has fallen consistently and now stands at about 15%, from over 20% a few years back, and is expected to fall further. Recently, they’ve garnered over 70% of broadband additions in most recent quarters. The upside from all this is that you’re going to have a lot more free cash flow generation growing at double-digit rates. And management has been very good about returning that back to shareholders through dividend hikes and buybacks. By our estimates, Chart provided by www.BigCharts.com the free cash flow yield could jump to 17% in 2015 versus 8% today “Cable providers are truly infrastructure providers supplying the invaluable plumbing to enable Internet connectivity. The broadband business is the key asset, more so than the television or phone offerings” Also, their next-generation phone offering has gotten strong 1-Year Daily Chart of Time Warner Cable Inc.reviews and their new Nokia (NOK) partnership was a good move topartner with a strong manufacturer and gain instant worldwide distribu-tion capabilities. Any success in these two areas is not priced into thestock and represents free options on the business. So the market is prettyskeptical, essentially pricing in a no-growth terminal value at this kind ofvaluation level, which we think offers a compelling variant view versusthe consensus outlook. Another thing we like about it is that it has got a strong balancesheet, with no net debt, $50 billion in cash, which is close to 20% of itsmarket cap, a AAA balance sheet and generates $22 billion in free cashflow a year. There is also a big misperception that they’re a bad capitalallocator. We went back and found they’ve returned over the last 10 yearssomething like $100 billion to shareholders, and yet have cumulative Chart provided by www.BigCharts.comlosses on new business initiatives of about $20 million in some of thesestartup enterprises they’re engaged in. So it’s not as bad as it looks. And based on our projections of the dual benefit of falling capital intensitysome of those enterprises are actually turning the corner and transform- and balance sheet deleveraging. We think TWC has underappreciateding into viable, profitable franchises, like in the case of the Xbox seg- opportunities to grow into new adjacent markets such as small-, me-ment. We also think investor concerns about other risks are overstated, dium-size businesses, which are a $20, $30 billion market opportunitymostly related to threats from Google (GOOG) apps, the Chrome operat- and have grown over 20% in 2010 — and expectations for similaring system or the demise of the PCs versus tablets. With respect to tab- growth this year. So why is it so cheap? Again here, the key investment
MONEY MANAGER INTERVIEW ——————— LONG-TERM VALUE INVESTING IN LARGE-CAP GLOBAL COMPANIEScontroversy for the company is fear of over-the-top disintermediation from a benchmark. We define risk as permanent impairment of capital.risk from the Internet. That risk is not quite materialized yet. It’s hap- That’s what we’re trying to avoid. We really define risk in three differentpening in niche areas, but it’s very de minimis today. We think it’s ways: one is business-model risk, second is balance sheet risk and themitigated by what is considered to be a symbiotic relationship between third is valuation risk.content providers and distributors, and we think the fate of cable will In avoiding business-model risk, we try to invest in businessesnot be the fate of the music business. that have staying power and don’t have the risk of being disintermediated Cable providers are truly infrastructure providers supplying or their competitive advantage being diminished over time, and limitthe invaluable plumbing to enable Internet connectivity. The broadband exposure to hypercompetitive industries where the economics are onlybusiness is the key asset, more so than the television or phone offerings, average. We like companies that have limited competition, that operatehas pricing power and the ability to use usage-based pricing to optimize in more oligopoly-type structures where the actors tend to be a little moretheir spectrum capacity. So we think that risk is overstated. We think rational.most of the regulatory concerns that were overhangs on the stock have The second risk is balance sheet risk. We try to avoid compa-abated and been resolved in the industry’s favor. We also think they have nies that are highly financially leveraged, where bankruptcy risk, refi-the ability to buy back from anywhere from a third to half their market nancing risk and liquidity risk are present. Most companies do havecap over the next five years if things play out as we think, which will some leverage, but most of the companies we own have limited levels ofdrive up per-share value for investors. debt, generate lots of cash, have a lot of financial flexibility in terms of TWST: What are some of the most significant headwinds lines of credit, working capital and can self-finance themselves in thefor the large-cap stocks you’re monitoring right now, and what’s event of dislocation.your risk management strategy? The third risk I mentioned was valuation risk. By seeking Mr. Lowenstein: There are so many risks out there. What’s out undervalued companies with low expectations, we feel we cangood about the current environment is that people are worried about so protect ourselves from overpaying for companies and multiple con-many things, there is no shortage of headline risk these days. traction risk. We always try and be mindful that a good companyParadoxically, the worst time to invest is when there is no apparent risk, doesn’t necessarily mean it will be a good investment, nor does a badbecause premiums on risk assets get bid down below warranted levels company mean it will be a bad investment. It’s the price you pay thatand risk begins building — you’re just not aware of it while the good determines your investment success. Therefore, we are extremelytimes roll on. While there are risks, most investors are painfully aware of price conscious, which also limits your downside risk. We also con-them, and that news is seemingly discounted into stock prices at some trol risk at the portfolio level and at sector level as well by investinglevel because it is so widely known throughout the 24-hour news cycle. in our highest conviction ideas and have appropriate position sizingOne big risk is the potential of a hard landing for China, which would relative to the risk/reward profile we see. “Paradoxically, the worst time to invest is when there is no apparent risk, because premiums on risk assets get bid down below warranted levels and risk begins building — you’re just not aware of it while the good times roll on.”impact the growth of the global economy and have derivative impact in TWST: Would you tell us a little bit about your sell disci-areas highly dependent on Chinese growth. So if China were to have a pline, and what might actually trigger you to reduce or eliminatehard landing and only grow the low 5% growth rate, that would be a your position in a stock?recession over there. Multinational large-cap companies would not be Mr. Lowenstein: First, when stocks have appreciative points,immune to this slowdown or an accident in the Chinese banking system where they’re approaching our fair value estimates as we define it, wefrom overinvestment in infrastructure projects when exports fell during will begin to harvest profits. So we’ll generally begin to sell down athe recession. position when stocks approach 80% to 90% of our fair-value estimate. Another significant risk is another leg down in the housing So usually for us, when the expected return on a stock is below 8%, that’smarket. Some people are expecting maybe another 5% to 10% downside usually a trigger for us. The second criteria for selling a stock would berisk, which would be manageable. However, given the foreclosure over- if there is excessive risk. If we think our thesis is broken and no longerhang and the shadow inventory that’s out there, some think it could be valid because of new unforeseen circumstances, faulty analysis, bad as-worse. Obviously, financial and housing-related industries would be di- sumptions or overly optimistic estimates of business value, this will leadrectly impacted, but also the state of the consumer psyche and confi- us to reanalyze our position and consider selling out of the stock. We willdence might be materially impacted, which would undermine consumer also consider selling a stock if more attractive opportunities arise.spending. Now, if we had a lot of inventory flood the market and housing TWST: Is there an example that you can draw on fromwent down more like a 20% correction, the negative wealth effect would recent history of a stock you sold?be punitive, and we could plausibly have the risk of another recession. Mr. Lowenstein: We recently sold our AFLAC Inc. (AFL) Broadening out the topic of risk, I think it is important to de- position due to a full valuation, risks in the investment portfolio and in-fine how we view risk. We don’t define risk as volatility or deviations creasing financial leverage. Although we like the company long term
MONEY MANAGER INTERVIEW ——————— LONG-TERM VALUE INVESTING IN LARGE-CAP GLOBAL COMPANIESwith its competitive advantages and margin expansion potential in Japan, TWST: What does intrinsic value mean to you? How dothe shares appeared to be fully valued given its risks. European financial you define it?regulators appear to require more capital, and Lloyds and Bank of Mr. Lowenstein: People talk about this term a lot, and itIreland recently exchanged hybrid debt into equity, booking a gain at the means a lot of things to different people. We take a very holistic approachexpense of bondholders. This risk causes continued losses in AFL’s to valuing a company because valuation is part art and part science, andportfolio, and we believe regulators may require more capital. To combat frankly involves a high degree of judgment. So we look at intrinsic valuethis, AFL issued debt at the holding company, which it booked as capital four different ways really. The first way is what we call a going-concernin its insurance subsidiary. By increasing financial leverage by $1 billion valuation. This is really an income statement approach looking at thein 2009, AFL avoided imminent dilution but increased the risk of future steady-state business. We assume no structural changes, then assess therestructuring. A dilutive-equity raise, ring-fencing of securities at a loss, underlying earning power and return on capital potential over a five-yearhigher capital requirements and higher interest rates in the Japanese holding period under normalized conditions. So it’s basically a reversionSamurai market may reduce their normalized ROE to 18% to 20%. With to mean concept. We ask ourselves where the company is in the businessa lower normalized earnings power, shares appear fairly valued at 2.6 cycle and determine whether it is overearning or underearning comparedtimes book value. to their normalized, midcycle potential: What will it look like when it Baxter (BAX) was also recently sold because we thought there mean-reverts? Ultimately, we try and determine what the market will paywas mounting evidence that pricing was becoming excessively competi- for the underlying earning power and characteristics of that business.tive in plasma and plasma derivatives like IVIG. We didn’t think this was The second approach is what we call net asset value, NAV. It’s really awell understood by investors and felt any disappointment in the outlook balance sheet approach, looking under the hood and determining the ap-for future growth would pressure the stock. BAX had enjoined solid praisal value of the assets, both the quantity and the quality of the re-volume and pricing dynamics over the past five-plus years, enabling sources. And then evaluate the long-term wealth-creation potential bytremendous margin expansion and EPS growth. unlocking what might be latent value. Often we’re seeking to uncover hidden assets the markets 1-Year Daily Chart of Baxter International have overlooked or failed to recognize. The reality is companies are constantly employing and redeploying assets. They rarely stay the same. They are always in a state of change, undertaking refinancings, changing in capital structure, mergers and acquisitions, LBOs, spin- ning off a subsidiary, stock buybacks, maybe an equity tracker, utiliz- ing NOLs and maybe a real estate sale-leaseback transaction. Essentially, here we are looking to buy assets at $0.50, $0.60, $0.70 on the dollar by taking an inventory or appraisal of assets and then handi- capping the optionality for change to reposition those assets and the capital structure for its highest and best use. The third concept is free cash flow. This is truly owner’s earnings assessing how much distributable free cash flow is really available for things that will enhance shareholder value like divi- Chart provided by www.BigCharts.com dends, buybacks, debt repayment, growth investments or strategic “We take a very holistic approach to valuing a company because valuation is part art and part science, and frankly involves a high degree of judgment. So we look at intrinsic value four different ways really.” Although we believe demand to be stable, albeit decelerating M&A. Generally, we look for a cash-on-cash return of 8% to 10%in some markets, the supply of plasma and recombinant products ap- yield growing over time and 300 basis points over the five-yearpeared to be materially higher than necessary. The market appears to Treasury rate to compensate us for risk. Here we ask ourselves, Whathave become oversupplied, especially in Europe. We had also heard of can you take out of the business and put in your pocket as an owner/a competitor dropping prices significantly to take market share. Since shareholder? The fourth concept is private market value, where wethe ex-U.S. markets are much less rational, and BAX’s ex-U.S. expo- determine the takeout value of the enterprise to either a strategicsure is just as high as its U.S. exposure, the risks to the company’s buyer or financial buyer in an arm’s-length, controlled transaction. Inearnings and margins were too great to justify its 14 times forward the end, we kind of pull all these four methods together, and usuallymultiple. Longer term, we still like the company and believe it has the they converge on a range of value we can get comfortable with. Andpotential to treat Alzheimer’s with IVIG, but these positive develop- that’s why we call our definition of intrinsic value. Then we try toments may not materialize before data is released in late 2012, so we buy a really steep discount to that value to give us an attractive risk/found better value elsewhere. reward profile and a margin of safety before we invest.