Q:  What are the core beliefs behind your way of money management?

A: Our philosophy is that the companies that generate high returns on shareholders equity tend to have strong positions within their industries. They usually operate either in oligopolies, or in industries that aren’t very competitive. So the companies we invest in should rank high in their industry after analyzing the competition, the barriers to entry, the supplier and buyer bargaining power.

We believe that we can achieve superior returns by identifying high-quality growth companies for which the market has extrapolated a near-term issue, like an earnings slowdown, as a long term change in the company’s growth outlook.

Once we find a group of companies that meets those criteria, we look for the ones that trade cheaply relative both to our estimate of their worth and to their historic levels. Generally, we buy stocks when their price-to-earnings ratio is one or two standard deviations below the average. With that approach we aim to participate both in the growth of the company and in the reversion to or above the mean of the P/E multiple.

Q:  What’s your definition of a quality growth company?

A: We look for growth, but not for cyclical growth. We target companies that grow and provide high returns on equity regardless of the economic conditions. Examples of such companies include Johnson and Johnson, Coca-Cola, and Proctor and Gamble. The growth rate is less important to us because we understand that the multiple is a function of the growth rate. We simply pay a lower multiple for slower growth and a higher multiple for faster growth.

But the most important part is having realistic assumptions about the growth and its rate. We spend a lot of time analyzing the fundamental prospects of individual companies and whether their markets are big enough to facilitate further growth.

Q:  How do you translate this philosophy into an investment strategy and process?

A: The strategy uses a “reversion to the mean” approach, which is based on the idea that if a company is trading at one standard deviation below its historic average, everything else equal, there is an 84% probability of multiple expansion. If you can buy that company at two standard deviations below the mean, the probability for expansion increases to 98%.

For example, if we consider a large-cap company with a long track record of P/E multiples, we’ll go back 20 years to find its average multiple, the high, the low, and the standard deviation. We look at periods of higher interest rates, inflation, recessions and strong economic times to adjust our expectations for the environment we foresee. It is the combination of reversion to the mean and the growth of the company that drives our performance over the long term.

In our valuation screen we use different metrics for the different industries. These metrics may be price-to-sales, price-to-book, or price-to-earnings, depending on what’s more appropriate for the specific industry.

Q:  What has been your strategy in the past five or six years, when high-quality names, such as Coca-Cola, Microsoft, or Cisco have been growing, but their stock failed to provide any substantial return?

A: You are right, those stocks have not done well in the past five or six years; in many cases, they have had negative total returns since 2000. I believe that one of the reasons is that the hangover from the late 1990s continues. In other words, individual and professional investors still remember the losses in large-cap growth stocks and are very cautious about stepping back into that portion of the market. Clearly, these stocks were trading at inflated multiples but investors seem to have eliminated them from consideration despite the attractive valuations and earnings growth that we are witnessing today.

These stocks are at their cheapest levels in twenty years relative to themselves, the market, interest rates, and expected growth. The fundamentals of these companies are also strong - Microsoft and Coca-Cola recently both reported quarterly revenue growth of 17%. The earnings of these companies are growing rapidly but the market is undervaluing them because of the perception of more exciting opportunities in China’s demand for steel, copper, machinery, etc, which are areas with superior recent returns. Ironically, China will become a net exporter, or competitor, to many of these cyclical companies which will likely drive profit margins, and stock prices, much lower in the future.

Many of the biggest companies are trading at multiples that are far below their long term averages. For example, General Electric trades at 16 times forward earnings, Microsoft trades at 18 times, and Coca-Cola at 18 times compared to twenty year average multiples of 20, 37 and 30, respectively.

Investors appear to be confusing the compression of the multiples with the quality and growth of the companies. If the stocks aren’t moving, they want to reallocate elsewhere and have been in droves. Because of the money flow that causes multiple compression, it has been difficult to make money in these stocks. Interestingly, money flow is a contra-indicator of future performance. For example, huge sums were invested into large-cap growth and out of small and mid cap stocks in the late 1990’s, with disastrous results. We expect this historical pattern to repeat once again.

Q:  What are your expectations for those companies, even though they are trading at a discount? How long can you wait for the multiple expansion?

A: Our investment horizon is quite long. For example, we have owned Microsoft for six or seven years. The stock has delivered a return of 40% or 50%, including the special dividend, but it clearly hasn’t performed as well as the overall market.

However, selling because of underperformance of large caps would mean allowing the stock prices to change our strategy. The stocks that are performing well lately violate many of our fundamental and valuation criteria: many are cyclical, have low barriers to entry, inconsistent returns on equity and often experience major earnings declines. Again, the fundamentals of Microsoft’s are excellent and there is a good chance that Microsoft drastically outperforms the currently better performing stock that we replaced it with.

Overall, we believe that as long as the fundamentals of that company meet our criteria, the market will eventually realize it. Giving up too early is devastating for long-term performance. In the late 1990s, we were in a similar position as we sold many of our technology stocks at incredibly high valuations, and bought old economy stocks such as financials, midcaps, and retailers. Sticking to our knitting in that period was quite painful but the market eventually caught up and the strategy worked extremely well in the next five years.