Value Search and Research
Hotchkis and Wiley Large Cap Value Fund
Author: Alexander Vantchev
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|Hotchkis and Wiley’s Large Cap Value Fund maintained its top quintile rank in the equity income category and handily outperformed the market in the 2003, when neither value stocks, nor large cap stocks were a sizzling hot item. Its manager Sheldon Lieberman told Ticker what it takes to find those large caps that can only go larger.
||Hotchkis and Wiley Large Cap Value Fund|
Q: What led you to register a fund in this particular format and investment philosophy?
The fund came into existence in 1987, but the firm goes back to 1980. It was founded on the large-cap value product, which the fund is patterned after. The fund is run exactly in the same way as our institutional separate account business is run. Ever since the inception, we had a strong focus on the value philosophy, which cuts across all of our products.
Q: And what is your definition of value?
There are two steps to our process. We begin by screening on the large-cap side basically all the publicly traded stocks with a market capitalization of $1 billion and above. We screen on some very specific valuation criteria – low P/E, high dividend yield, and financial strength. We run our screens once a week, and end up with a subset that ranges anywhere between 200 and 500 names. The real work begins at that point. We overlay our internal research process on that subset of stocks in an effort to narrow it down to our ultimate portfolio of anywhere from 50 to 80 names. And in our research we define value in a very specific way. The majority of stocks we invest in for our clients are stocks that are currently out of favor in the market, they are unloved by other investors, but those are stocks where we see future prospects being much stronger than current prospects.
Our whole thesis is investors tend to extrapolate the current prospects out for very long periods of time. So, if you have a company that is out of favor currently, it tends to get oversold. So, we buy into the weakness, but only when we see through our research process that the future looks more promising.
Other areas we look for is companies with good, solid free cash flows and are reinvesting in higher returning business, where the return on equity is higher than the current levels. Typically, they generate return on equity below the broad market level and you see a tendency in those types of stocks in general for a reversion upward toward market levels. The opposite is true with companies that are over-earning which tend to attract investors and they get overbid because of that. Again, investors tend to extrapolate out the current prospects. In those cases, they may look good, but investors make the mistake of being shortsighted, they don’t see that these companies cannot possibly continue to over-earn indefinitely, and so they end up overpricing the companies and they get disappointed.
Q: I can see in your top ten holdings at least four or five companies that had some sort of trouble, mainly with reporting or accounting recently – Sears, EDS, Computer Associates, Waste Management. How did you tackle those issues at the time?
Sears is a great example. But EDS is actually our most-recent position that we have added to the portfolio. You remember, it was at one time a high flyer trading over $70 a share. It did not interest us at all at that point. It has now come down to a level that looks attractive to us. They are the second largest provider of IT services in the world and they are only one of the few that can service some of the big multi-national firms that have significant IT requirements, so they are in a good position there. What has really happened for them was that in the last couple of years their free cash flow has come down significantly. And this is an area we think is going to improve most likely beginning in 2004. When we looked at the details of what was going on, we saw a number of very large Navy contracts that prior management had put into place. Those were onerous contracts that most likely would not be profitable. But they were very front-end loaded in terms of cost, there was a lot of capital expenditure that went into these and no revenue coming out. They worked through the front end of those contracts and we think these contracts are going to become cash flow positive beginning next year.
What we focus on in our whole research process is what we call normal earnings. These are long-term earnings that cut through all the cyclicality issues, the core earnings power of the companies that we are buying into. And in the case of EDS, we have a core normal earnings number of about $2.60 a share. So, based on that, this is a stock that is currently trading at about eight times normal earnings. The current earnings are much lower, and so the market is again pricing out these current prospects, and we think, again, there is a story of improvement here going forward.
Q: So, you also don’t bet on the market share leader, there? Is IBM too pricey?
They tend to be too pricey. It is not that we wouldn’t buy them, we like brand. Brand is important. We have Sears, Metlife, J.C. Penney. We spend a lot of time on balance sheet and cash flow issues. And a lot of times the market may be concerned about liquidity. We look at these companies and we plough out their maturing debt structure, we model out their cash flow over the next five years to see if they have the cash flow coverage to meet their debt obligations. If we feel comfortable with it, we’ll end up taking a position, but there is a lot of importance placed on financial strength for us, because we recognize we are buying companies that in many cases we have to wait a period of time before things turn around, and we want to make sure we have companies that are in a position to do that.
Q: But that is also the period when the price is right?
Yes, until that value is recognized. But we are patient investors. Our average turnover in the portfolio is 25% a year.
Q: We seem to be at some sort of a crossroads now, at the end of 2003 and the market can’t seem to make its mind up. What are the newcomers in the value universe from your perspective?
One example is now we own technology in the portfolio and two or three years ago we had none. EDS is an example, Computer Associates is another. These names didn’t qualify back in 2000, but they have come down in price so significantly that they qualify. This is a whole sector that was not available to us until recently. If you look at the financials, we have always had a position in financials, but it has changed. Early on, in the early 1990s, we were in the money center banks and then we went from there into some of the regional banks and played the consolidation there. Then, over the last 3 years we have been heavy in insurance to play the demutualization.
Q: And how did you find value in the insurance companies?
Metlife, for instance, came to market with an abundance of excess capital. That made a lot of sense as a mutual company, because you don’t have shareholders, but policyholders and they just want to make sure that their benefit payment is going to be there. They had $1.5 billion of excess capital. We bought it, because the management said they are going to take that money and buy back stock and they bought back a ton of stock from 2000 to 2002. At the same time they said they are going to cut $150 million a year in cost and they have done that. Now, the stock, when it went public, had a return on equity of about 9%. The market in general for that industry has generated about 16% ROE. So, for Metlife, we said there’s a company with brand, with scale, and with a plan in place that they should be able to achieve that over time. Three years later, the stock is generating about 12% ROE and it has more than doubled in price. We still hold it, because we think there is more upside, we think they are going to continue to improve their return on equity.
Q: What other changes in the value field do you expect for the next one or two years and how do you position your portfolio in this regard?
I think the one thing that has changed a bit and in fact it affects everyone, there are fewer opportunities in general in the marketplace. The market in general is pretty fairly valued. While on the value side, three years ago, there were a plethora of names that were available, that were just screaming buys. Now, it is getting harder to find a name. So, what we have done, and you see it in our portfolio, the number of names has gone down to the lower end of our range – we typically hold 50 to 80 names – we are now in the low 50s. We are concentrating our positions.
Value has underperformed the market this year, and we still outperformed both of them. If you look at our attribution in stock selection, there is no question about it – this has really been a stock picker’s market. The fundamental underlying valuation of these stocks matters, and it didn’t back in 1998 and 1999. That has turned around, and this is the type of market that we do best in.
Q: What is the sell signal, then?
Once we come up with that normal earnings number, we end up valuing out each of our stocks using the dividend discount model framework. So, we end up with a fair value based up on our models. Once you have the fair value, you can compare it to the actual market price and end up with a price-to-value measure. If something reaches about 70% of fair value, it gets a bigger position in our portfolio than something with 80% of fair value, all things being equal.
Now, once a stock approaches fair value, we would be selling, but you always have to look at what other opportunities are there in the marketplace. Theoretically, we could sell something that is 90% of fair value if we see opportunities coming in that are 70% of fair value. We do have an absolute sell criterion, though. If a stock hits fair value, meaning 1.0 price-to-value measure, it must be sold. But stocks are normally sold long before that. We trim as the price goes closer to fair value.
Q: Since you use the dividend discount model, do you buy only dividend bearing stocks?
One of the screening criteria that were enhanced during the late 1990s was the dividend yield criterion. We still have a preference for dividend yield, but we also recognize that the stock buyback activity is very beneficial for shareholders. Particularly back in the 1990s, for tax reasons, there were times when companies were buying back stock in lieu of increasing the dividend. So, we changed that yield requirement to what we call a payout yield, which is dividends plus stock buyback. And this needs to be higher than the market. Generally, the portfolio has always had a dividend yield much greater than that of the S&P 500.
Our preference for dividends makes a lot of sense and recently you have seen a lot more articles that agree with us now. It lowers the risk profile of the portfolio, and a lot of our clients look for that reduced volatility. Dividend yield also tends to be a good flag for possible undervaluation. We do screen on higher dividend yield in stocks and we do take some of those through that process.
Furthermore, in the large cap arena, we are dealing with mature companies that do not have the same level of reinvestment opportunity that you might find in the small-cap and mid-cap companies. Large cap companies tend to be mature and within their market cycle. You don’t want them to give their management an incentive to reinvest their free cash flow, because they tend to squander it away. We’d rather get it back through dividends and reinvest it for our clients into other businesses.
Q: Your research process seems to be pretty complex. What research resources do you have at your disposal?
We have an investment staff of 15 portfolio managers and analysts. Everyone, including the portfolio managers, has analytical responsibilities and we break up responsibilities by industry. We have a very elaborate process, we are building our own models, we don’t use sell-side models. We start from ground up and really gain an understanding of these companies, where we are pulling together cash flow statements, balance sheets, income statements, projected out for five years.
Q: What would you tell a prospective investor, who considers buying your fund? What can they expect and what they should not expect?
If history is any indication, they can expect that in markets, that in our view are acting rationally, we are going to do quite well. In 1998-99 we had a very difficult time, but I think it was a distorted marketplace in terms of pricing. We didn’t do well at all, but we stuck to our conviction. The other thing I guarantee you is that we will be solely focused on the value end of the market. In 1998 and 1999 it was a big test, but we stuck to our convictions and did not change our investment style in any way.
We believe that the research effort here, which is very intense, will pay off in the long term and that is the differentiating factor – it will pay off in terms of outperformance.
What they should not expect? Well, we had such a strong performance over the past three years, but it was a unique opportunity, an anomaly in the market, where value stocks were on a relative basis undervalued and we took advantage of that. We still find opportunities, but not to the same extent. So, our expectations would be for outperformance, but not as extreme as what we have seen, which has been very extreme.
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