Grey Owl Capital Management - "Good Things Happen to Cheap Stocks"

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by, Grey Owl Capital Management (Guest Contributor)

October 31, 2011

“Ben, the two of us need look no more
We both found what we were looking for
With a friend to call my own
I'll never be alone”

-          Michael Jackson, Ben

“Good things happen to cheap stocks.”

-          Steven Romick, manager of the FPA Crescent Fund

While we outperformed the market by almost 300bps in the third quarter, September was a far more brutal month than we would have expected given the concentration of high quality businesses that make up the bulk of our portfolio and the large cash position we have held.

Correlation and volatility remain extraordinarily high.  Cryptic statements from Ben Bernanke (and the even more obtuse European leadership consortium) carry far more weight than underlying company fundamentals in today’s “risk on, risk off” trading environment.

When the noise becomes loudest, we find it most useful to get back to basics.  We’ll spend a portion of this effort discussing the current market environment, but the bulk is dedicated to a fundamental discussion of our four largest equity positions which make up approximately 23% of our equity separate accounts.  But first, our typical performance table as of September 30, 2011.

Bizzaro World

It seems like we’ve been transplanted to the fictional planet in the DC Comics universe where everything is inverted.  How else do you explain the behavior of assets subsequent to Standard and Poor’s downgrading US Treasury debt on August 5^th?  Here is a comparison of select asset class returns from that date through the end of the quarter:

Despite the headline downgrade of US debt, in a fear-driven market, investors are conditioned to seek safety in what has been, since World War II, the world’s reserve currency.  It will likely take years for this muscle memory to atrophy.  With the US debt ceiling drama giving way to sovereign financial concerns in Europe, the fear gauge was high.

The uncertainty was equally manifest in equity markets.  The S&P 500 traded half a dozen eight percent swings in just August and September.  Real issues of slow economic growth, expensive markets, and unserviceable debt caused investors to sell.  Then “our friend Ben” (or his European counterparts) responded with a “twist” or “QE” or the concept of a “stability” package and traders were off to the races:  RISK ON!  (As if money printing could create wealth.)

The correlation data further demonstrates that macro events, not business fundamentals drive day-to-day price movements in today’s markets.  Eighty percent of stocks have traded in directional sync for the last two months.

Unfortunately, until such time as global, developed world debt levels become sustainable and constant fiscal and monetary tinkering abates, we expect volatility and correlation to remain high.  We don’t pretend to have an edge in anticipating these actions.  Where we do have an edge is in our ability to make “time arbitrage” investments.  Companies that trade at low valuations and that can consistently grow intrinsic value provide very strong returns over multi-year periods.  This is the core of our portfolio and where we turn next.

Review of Four Largest Positions:  23% of Portfolio Assets

We run a concentrated portfolio.  As of September 30, 2011, our top four positions made up almost 23% of total assets.  Typically, our top positions are “core holdings” that we would expect to own for many years.  While it would sure make life easier if the market values of our securities positions increased at a steady rate, that will never be reality.  Security returns will be lumpy, even in high-quality businesses.  Thus, we tend to spend more time worrying about the underlying business dynamics than day-to-day, week-to-week, or quarter-to-quarter investment returns.  For each of our top four holdings, the underlying business dynamics remain quite strong and improving while the stock prices remain cheap.

Microsoft
Position size on 9/30:  7.3%

We have discussed Microsoft at length, most recently in a blog post and prior to that in our third quarter 2010 letter.  While the market price for Microsoft stock has barely budged in the last year, its business fundamentals have greatly improved.  Annual earnings per share (EPS) are up 19% year over year, shares outstanding have shrunk, and the dividend was increased 25%.  The company continues to make gains.  We own Microsoft at a current P/E excluding net cash of 7 and a dividend yield of 3%.  This price projects a massive deterioration in Microsoft’s business going forward.  Based on all the available evidence, nothing is further from the case.  Good things happen to cheap stocks.

Berkshire Hathaway
Position size on 9/30: 5.7%

Over the past three years, Berkshire Hathaway has been able to compound per share book value at an average rate of 9.4% per year.  This includes the bottom of the recent recession and related stock market selloff.  (Berkshire’s very large equity portfolio is a significant percentage of book value and is marked to market.)  In addition, free cash flow from Berkshire’s operating businesses has grown out of the recessionary trough at an extraordinary rate.  We expect Berkshire should be able to grow book at a low double-digit rate for several years.  Given this, we think the stock should trade at between 1.5 and 1.75x book.   Today it trades at 1.15x book.  Good things happen to cheap stocks.

Lexmark
Position size on 9/30: 5.3%

We discussed our Lexmark investment thesis at length in our last quarterly letter.  Lexmark is transitioning out of its consumer printing business to focus exclusively on business printing.  We want to see their “core” business printing segment grow as a percentage of revenue quarter by quarter and year over year.  This is happening.  We also want to see the operating margin continue to expand, as this higher margin business becomes a greater percentage of revenue.  This too is happening.  Thus, while Lexmark’s revenue growth is anemic, its EPS growth is quite reasonable.  Once the consumer business is fully exited, modest top line growth should resume.  Frankly, trading at 4.61x EPS (excluding net cash) Lexmark is priced like a wasting asset:  a royalty trust with a six year life and a flat payout structure would provide an 8% annualized return if you paid 4.6x its payout.  Given a reasonable expectation of mid-single digit earnings growth, a high return business like Lexmark should trade at a mid-teens multiple.  Good things happen to cheap stocks.

Markel
Position size on 9/30: 4.9%

Over the past three years, Markel has been able to grow book value per share at an average rate of 12.26%.  This includes the recession and market trough and like Berkshire, equity securities make up a meaningful portion of Markel’s book value.  Markel is far smaller than Berkshire.  Whereas Berkshire has in many ways become a broad industrial company, Markel is still almost purely an insurance operation and has thus suffered more directly in the current soft insurance market.  We expect Markel will be able to grow its book value in the low double digits for many years and could experience significant book value growth when insurance markets harden.  Therefore, we think the stock should trade between 1.6 and 1.9x book.  Today, Markel trades, like Berkshire, at just 1.15x book.  Good things happen to cheap stocks.

Conclusion

Buckle your seat belts.  We fully expect markets to remain manic and co-dependent.  The market can’t live without its friend Ben, so a few weeks of weak data and no intervention and we’ll have a selloff.  Likewise, as soon as rumors of the next hundred billion dollar intervention surface, traders won’t be able to buy equities quickly enough.  The situation in Europe is a mirror image.  Thankfully, in a world of 20,000+ individual securities there are always pockets of opportunity.  We must be prepared for our individual ideas to trade with the market for periods of time, but over the long-haul “good things happen to cheap stocks.”  When possible and prudent, we will use manic periods to lighten our exposure and depressed periods to add to our best ideas.  In addition, we are working hard to mute volatility if we can do so without sacrificing long-term results.

As always, if you have any thoughts regarding the above ideas or your specific portfolio that you would like to discuss, please feel free to call us at 1-888-GREY-OWL.

Sincerely,

Grey Owl Capital Management

Grey Owl Capital Management

Grey Owl Capital Management, LLC

This newsletter contains general information that is not suitable for everyone.  The information contained herein should not be construed as personalized investment advice.  Past performance is no guarantee of future results.  There is no guarantee that the views and opinions expressed in this newsletter will come to pass.  Investing in the stock market involves the potential for gains and the risk of losses and may not be suitable for all investors.  Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security.  Any information prepared by any unaffiliated third party, whether linked to this newsletter or incorporated herein, is included for informational purposes only, and no representation is made as to the accuracy, timeliness, suitability, completeness, or relevance of that information.

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The performance information presented above is reflective of one account invested in our model and is not representative of all clients. While clients were invested in the same securities, this chart does not reflect a composite return. The returns presented are net of all adviser fees and include the reinvestment of dividends and income. Clients may also incur other transactions costs such as brokerage commissions, custodial costs, and other expenses. The net compounded impact of the deduction of such fees over time will be affected by the amount of the fees, the time period, and the investment performance. Grey Owl Capital Management registered as an investment adviser in May 2009. The performance results shown prior to May 2009 represents performance results of the account as managed by current Grey Owl investment adviser representatives during their employment with a prior firm. The data shown represents past performance and is no guarantee of future results. No current or prospective client should assume that future performance results will be profitable or equal the performance presented herein. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable.