A Three-Pronged Value Investing Strategy
TWST: Please start with a brief history and overview of Boyle Capital.
Mr. Boyle: I started Boyle Capital in 2004. We are 100% employee owned, and today we manage around $120 million. People who like to give investment advisers complicated names would call us "concentrated value investors." We essentially manage three different strategies. We have the equity strategy, which is our flagship strategy. The equity strategy generally consists of 10 to 15 companies, regardless of market capitalization. The second strategy is what we call the value strategy. The value strategy is going to be more diversified than the equity strategy and will typically consist of stocks, bonds and cash. Lastly is the dividend strategy, which consists of 10 to 20 high-quality companies with a focus on dividend payers.
TWST: Please tell us a bit more about your investment philosophy and approach to your equity strategy and portfolio.
Mr. Boyle: All of our strategies are heavily influenced by the teachings of Ben Graham. At the end of the day, we are trying to compound and grow the capital that has been entrusted to us without taking a lot of risks. When you look across our strategies we typically have three types of companies that we own. First is the high-quality company where we are buying them at a fair price. An example of a company like that today in our portfolio would be a company like Fairfax Financial (FFH.TO). Fairfax is the only company, by the way, that we have in all three of our strategies today. Next are what we believe are good businesses that can be purchased at great prices. An example in our portfolio today would be a company like Bank of America (BAC). Lastly, occasionally we will own what we call "probabilistic investments." These are situations where some kind of event, for example a legal outcome, is being mispriced by the market and we feel the probability strongly favors our viewpoint. An example in our portfolio today would be a company like MBIA (MBI).
TWST: Would you discuss each of those in a little more detail, starting with Fairfax Financial?
Mr. Boyle: As I mentioned earlier, Fairfax is the only company we own in all three strategies. I've often said that if I had to go away for 10 years and I couldn't know what was going on in the world or I couldn't follow the stock market, this would be one of the few companies I'd feel comfortable investing in. Why is that? It's run by a great owner-operator in Prem Watsa who has surrounded himself with outstanding people. The one thing that always sticks out to me when I attend their annual meeting is the culture. You can tell that the values of Fairfax are imbedded in everything they do. Very reminiscent to a Berkshire Hathaway in that regard. My clients and I sleep well at night with people like Prem Watsa working on our behalf.
Fairfax not only talks the talk, but they walk the walk as well. In fact, you would be hard pressed to find too many companies with a paper trail of success similar to Fairfax's. Since 1985 they have grown their book value per share at something like 25% annually. The stock price over the same time frame has returned in the low 20%-a-year range.
How have they done it? For starters, they are about as skilled investment managers as you will find. If you go back to 2005, prior to the financial crisis, Fairfax was worried about the one in 100-year flood. As a result, they took steps back in 2005 to try to protect themselves. They hedged their portfolios and bought credit default swaps on some of the largest financial institutions in the world. When things collapsed in 2007 and 2008, Fairfax made billions. If that weren't enough, they unhedged their portfolio in early 2009 and bought a number of the financials like Wells Fargo near their lows.
Today, the company trades right around $400 a share, which is roughly 1.1 times stated book value. While they won't be able to duplicate the record of 25% a year that they've done in the last 25 years, we think it can achieve its goal of 15% growth in book value. They have a lot of dry powder to take advantage of continued stress and are well positioned in emerging markets. For example, they own either outright or through minority interests, P&C businesses in China, India, Singapore, Brazil and Malaysia, to name a few. The growth won't happen in a straight line, as their results tend to be lumpy, but we believe the stock is a good long-term investment.
The other thing we like about Fairfax is that they are one of the few equity investments that we can find that is hedged against a drawn-out deflationary period. Everyone today is concerned about inflation. There are record levels of money printing around the globe, which has to lead to inflation. At least that's what the consensus is right now. Fairfax is just as concerned today about the opposite side of that coin. What happens if we have a scenario similar to what we went through in the U.S. in the 1930s, or what Japan is going through and has been going through for the past 20 years? You have this wave of Baby Boomers that will be retiring in the coming decade and their spending levels are likely to go down as they go through the life cycle. You also have a situation where a large percentage of the population today is maxed out in terms of their leverage, and we are just starting to see them deleverage. What Fairfax would tell you is that their study of history suggests that when these deleveraging periods occur they typically last a number of years. So they have gone out and tried to protect themselves in the event things are different this time. They have what's called a CPI-linked hedge that would protect them over the next decade in the event that there is deflation. If you take that along with the fact that their investment portfolio is nearly 100% hedged today, Fairfax is one of the few equity investments that becomes more valuable as things in the economy or market get worse.
TWST: And Bank of America, do you have as strong a conviction on that company?
Mr. Boyle: We do. We've been pounding the table for the last six months about the potential in bank stocks and in particular Bank of America. So far, everything that we see coming out from the banks, whether it's Bank of America or the competitors of Bank of America, suggests to us that banks are slowly but surely recovering from the financial crisis. For example, consider the implications of the stress test results that were released on March 13. The banks were subjected to some pretty severe conditions, and 15 of the 19 largest banks passed those, which should give investors comfort that the balance sheets of these banks have been repaired significantly. It is this balance sheet strength combined with the ongoing earnings power that gives us optimism. The current earnings power of banks like Bank of America is sufficient enough to deal with the remaining problems associated with mortgages and litigation. Once you get to the other side of it, we think you have a bank in Bank of America that has the potential to generate a couple of dollars a share in earnings, and that looks pretty darn attractive when you consider a share price of around $9. It won't happen overnight, obviously, and will require some patience and perseverance. Eventually though, we expect them to earn their way out of this mess; and when they do, the stock should be much higher.
TWST: And what about MBIA?
Mr. Boyle: MBIA is kind of a unique investment and certainly not for everyone. There are a lot of moving parts. However, after a few years of research it's one that we think is a great investment opportunity at today's prices. Again, MBIA is an example of a probabilistic investment for us, where we think the market is mispricing the likelihood of a positive outcome.
To understand MBIA you have to go back to the credit crisis. MBIA had insured mortgage-backed securities originated by the likes of Countrywide, which as you know was later acquired by Bank of America. MBIA was in a really difficult position as a result of the billions in losses tied to these securities. They brought back former CEO Jay Brown, who has a great paper trail of success, and the first thing he did was lay out a transformation plan for the company. A major part of that plan was to split the company into essentially two parts. You had one that contained the municipal financing part of the business. The other side contained structured finance, things like mortgage-backed securities, a lot of the things that the company probably wishes they hadn't been in.
That transformation was challenged by a number of banks, including Bank of America. The banks alleged that MBIA did not have sufficient liquidity to operate as a standalone entity on both sides. That transformation challenge still remains today. Of the initial 19 banks that were involved in the challenge, 16 have dropped their challenges. Of the three remaining, the biggest is Bank of America. As I mentioned, this is a complex situation. Along with the transformation challenge you also have the fact that MBIA is suing a number of the banks, including Bank of America, on something known as reps and warranties. MBIA is alleging that, as a result of the misrepresentations that were made with respect to the warranties in the mortgages, they would not have insured the mortgages in the first place and therefore, not have had to pay out the claims. So they are suing Bank of America to get back the losses that they have paid out. So you have these two ongoing legal issues that are hanging over the stock today.
Our thesis is that we ultimately expect Bank of America and MBIA to settle. If you look at recent legal settlements to the likes of Assured Guaranty, they support the monolines claims with respect to the reps and warranties issue. Furthermore, if you take a look at the reserves that the banks have been building, from virtually nothing in 2008 to, in the case of Bank of America, $16 billion-plus today, the banks are preparing for payouts and settlements. They know they are going to have to pay up. Once a settlement occurs, then there is no need for the transformation challenge, and we would expect that to be dropped. Once the transformation challenge is gone, MBIA can resume underwriting municipal offerings again, something it hasn't been able to do while this litigation is ongoing. Again, there are a lot of moving parts to this investment, and we encourage people to do their own homework, but we think the odds are high they are going to be successful. If they are not, we believe the run-off value is higher than the current share price. Time will tell if we are right.
TWST: All three of those examples are financials. Are there any other sectors that you're overweight today?
Mr. Boyle: There are essentially two sectors that we are overweight today. One is financials and the other is in natural gas. It seems inevitable to us that at some point natural gas is going to play a much bigger role in the energy picture, and with it off 85% from the 2008 highs we have to be close to the bottom. Obviously it is impossible to time the absolute bottom, but we think natural gas makes a lot of sense for those with a long-term time horizon. An example of a company we like today is Birchcliff Energy (BIR.TO).
Birchcliff is a Canadian natural gas company with significant resources in one of Alberta's most abundant gas fields. It is led by a management team that we believe to be best in class. Starting from scratch in 2004, they built a company that is expected to produce 28,000 barrels per day by the end of this year. It has tremendous growth potential given its land holdings. More importantly, it has kept costs low and managed to turn a profit in this environment, which hasn't been easy to be sure. In October of 2011 the company announced it would seek a sale after receiving unsolicited offers. A few weeks ago, the company announced the termination of the sales process after not receiving what it believed to be an acceptable offer. It noted in the press release that it had received two offers during the process, and both were higher than the price at the time of the offer. Based on the price range during the sales process it is safe to assume they had offers somewhere between $9 and $15 a share, versus the current price of less than $7.
We have felt all along that a sale of the company was the end goal, and we still feel that way. The major shareholder of the company is a gentleman named Seymour Schulich. He is about as smart as they come and has a great paper trail of success. He was Co-Founder of Franco-Nevada, which ultimately sold to Newmont Mining. In addition, he was an early investor in Canadian Oil Sands Trust. Schulich understands the energy space and has been pouring millions into this company. He controls over 35 million shares and has been a buyer at recent prices. Given the daily volume, it is nearly impossible for him to exit this position short of a sale or merger of the company. We expect the company to continue to grow production and profits and then, once natural gas prices rebound, we think they will seek another sale.
TWST: Are you underweight any particular sectors?
Mr. Boyle: We're underweight retail, for a lot of the reasons that I mentioned earlier. We're worried about consumer spending as we go forward. We expect an environment where consumer spending is going to be constrained for a number of years as a result of demographics and the deleveraging that is underway. We think the retail space is going to face some challenging headwinds, and many aren't priced for it.
TWST: You mentioned before, in the context of Fairfax Financial, the concerns of inflation versus deflation. What macro factors do you most worry about?
Mr. Boyle: We are not macro investors per se. We are what we call bottom-up investors. That is, our investment decisions are made one company at a time. However, when we make an investment, we try to go through the different possible scenarios. I mentioned earlier the fact that we worry about the potential of deflation. How do our companies do if we experience deflation for a prolonged period of time? We want to buy cheap enough that we can still make money if that is the case. On the flip side, we want to make sure we are prepared for an inflationary environment. So while we don't make investments based on our macro views, we try to make sure our thesis holds up under a number of different macro and micro scenarios.
TWST: How would you describe your overall outlook for the market for the rest of 2012?
Mr. Boyle: We really don't have a short-term view of the market. We do think the quality of our portfolio is as good as any we've had since we started. But I couldn't tell you if it will take five days or five years to realize that value.
TWST: Is there any particular advice you'd offer investors today?
Mr. Boyle: I think the biggest thing that investors need to focus on today is making sure they understand their situation and how they are invested as a result. What are their objectives? What is their time frame? What is their ability to withstand volatility? A lot of people have learned over the past decade that it doesn't make sense to risk that you need for that you don't. Volatility can be an investor's best friend or worst enemy, depending on their temperament. I saw a lot of people that got scared out of the markets in early 2009, only to miss out on the recovery. Investors need to get away from trying to time markets and focus instead on what it is their goals are and where they are in relation to them.
TWST: Thank you. (MN)
Brian Boyle, CFA
Founder, President & Chief Investment Officer
12257 University Ave.
Clive, IA 50325
(515) 255-8681 - FAX