A Fundamental, Bottom-up Large-cap Investing Strategy
TWST: Please start with a brief history and overview of the firm.
Mr. O'Connor: It's hard to be brief about Cooke & Bieler. We were founded 62 years ago in 1949 in Philadelphia as a manager of money for high net worth Philadelphia families. Skipping over most of the details, we've been using the same high-quality, low-risk, fundamentally based style over that time period. Today, we manage about $4.5 billion, mostly institutional money for pension funds, foundations and endowments. We still have a significant number of high net worth clients, and we subadvise mutual funds as well. Most of our assets under management are large cap, although we also manage midcap and small-cap portfolios.
TWST: How would you describe Cooke & Bieler's investment strategy?
Mr. O'Connor: We start with three observations about the world, three sort of core beliefs that guide us in our approach to investing. One is that fundamentals drive stock prices over time. It sounds obvious, but it's something that we think the world has largely lost track of as holding periods have gotten shorter and shorter. But your long-term returns in your stock investment are going to be largely a function of the returns that the business generates. That's one observation.
The other is that capital preservation is a key driver of returns, and some of that is just math. If you lose 25% of your money, you need to make 33% just to get back to where you started from. Also, while measures of risk have gotten more and more intricate and involved, sometimes investors can lose sight of the reality that their real risk is having as much money at the end of the period as they need. You are investing for a reason. So we keep that focus on not permanently losing our clients' money as the driver of our risk controls.
And our third observation is that you have to carefully structure and manage your organization, because the culture in which people operate in many ways defines the decisions they'll make. You can have smart people doing very accurate risk assessment, but with the wrong incentives they can make the wrong decisions. We're very focused on making sure our organization is set up to benefit clients. And at the core of that is our team structure. We don't have one portfolio manager, we have a team of seven analyst/portfolio managers, which we think gives us a competitive advantage. That's sort of where the philosophy starts, and that drives us to really be fundamental-based, value investors - good businesses with good balance sheets that we pay attractive prices for.
TWST: You mentioned capital preservation being the driver of risk control. What else does the firm do in terms of risk management?
Mr. O'Connor: We have a multilayered approach to risk management, again with that focus on preserving our clients' capital. It starts with us with individual stock selection, buying high-quality companies that we understand well and that have well-defined competitive advantages, and buying them with an appropriate margin of safety, meaning we don't overpay. One of the easiest ways to permanently lose money is just to pay too much for what might be a valuable asset but not as highly valued as you thought. So it starts there, and then we consider portfolio diversification, managing our macro exposures and embedded risk in the portfolio.
We are being careful to go beyond just sector weightings and sector limits, to look at the underlying economic logic. You could have found yourself in 2007 owning a boat manufacturer, a homebuilder, a bank and a title insurer, and thought they were all in different industries and hence that you were well diversified. But you would have found out that they are all very exposed to the same thing. So you have to watch that. Then we have a rigorous, continuous review process for every holding, so we are constantly updating our thinking to make sure that our original beliefs and expectations are being borne out by the reality.
TWST: We're going to talk specifically about the firm's Large Cap Value strategy, so please tell us a bit more about that in terms of goals and portfolio characteristics.
Mr. O'Connor: I'll start with the characteristics. It's a fairly concentrated portfolio, typically between 40 and 50 holdings. We do a lot of research on each individual company in the portfolio, and we want them to be a significant enough part of the portfolio that their performance matters. It is very fundamental and bottom-up driven, so sector weights will vary significantly from the indices. We're generally measured against the Russell 1000 Value Index, though we do have some clients who prefer to measure us against the S&P 500. In general, our goal is, over a full market cycle, to outperform those indices by 150 to 200 basis points, and to do so with less downside risk. One of the hallmarks of Cooke & Bieler's performance is that we tend to outperform strongly in down markets, again coming back to the focus on capital preservation.
TWST: You've mentioned some of these, but what are the criteria you really focus on doing a bottom-up stock selection process?
Mr. O'Connor: It starts for us just looking at the fundamental dynamics of the business the company is in, how capital intensive it is, what returns they historically earned, what returns they're likely to earn going forward. We like to get to know management. Ultimately, capital-allocation decisions and management's investment decisions will have a significant impact on the returns investors earn, so we want to have a high degree of confidence in management. And then we want to make sure that the businesses we own are conservatively financed. People learn this about every 10 years and then they go on to forget it, but you can have a really good long-term business, but it doesn't matter if you run out of money in the short term. You need a business to be able to finance itself. So our companies generally have much higher interest-coverage ratios and much less debt than is typical for companies in their industry or the broader market. So that's the way we approach it, and then maybe the easiest part is coming up with an estimate of intrinsic value, and then we try to buy them at a significant, usually 40%, discount to that estimate of intrinsic value.
TWST: How do you incorporate macro issues, trends and sector plays?
Mr. O'Connor: We are rigorously bottom-up, but we recognize that bottom-up investing has to go all the way to the top, and so we are aware of macro trends and what's going on. We do that in two ways. One is part of our risk control. We want to make sure that we understand what macro factors our companies are exposed to, and make sure that the portfolio overall doesn't have an outsized exposure to some macro factor that we don't understand or aren't comfortable with. For example, today it might be easy to find businesses in a number of sectors and industries which are cheap because they are in some way exposed to European default risk. We don't want to have a large portion of our portfolio exposed to that risk, which we don't think we have an ability to forecast. So we're constantly looking at the portfolio to make sure we are not getting an inadvertent macro bet embedded into the portfolio.
Then the other half of that is we try to be opportunistic about exploiting macro fears. We've seen these risk-on, risk-off trades. Sometimes you find great companies that maybe have some economic cyclicality, but investors are selling them in a flight to safety, and you can buy great companies at very attractive prices if you're willing to live with a little volatility. We can do that because we have a high degree of confidence that these are very good businesses that are going to compound value for shareholders over time, and they have the balance sheet strength to survive whatever economic volatility may be in store. So it's that combination of monitoring for risks and trying to react opportunistically when the rest of the world is being driven by these macro factors.
TWST: The markets certainly have been volatile. How has that affected Cooke & Bieler in general and your Large Cap Value strategy specifically?
Mr. O'Connor: The markets certainly have been volatile. It's probably given us an opportunity to find more new ideas and more opportunities that we would otherwise. The volatility seems disproportionate to actual events on the ground and, again, more driven by these macro feelings than rigorous analysis. When that's the case, it gives us a chance to react to business fundamentals and buy attractive franchises at good prices. I think it's made us busier than usual, because things move up and down, and stocks we thought we'd never like fall into our lap.
TWST: What are some of your top investment picks or investment ideas right now?
Mr. O'Connor: An example of what we were just talking about is State Street (STT). It's a big custody bank. Financials generally aren't a dominant part of our Large Cap Value portfolio, because money tends to be a very commodity business. You only care about the interest rate you're paying for a loan, you don't care who's giving you a loan. Similarly on the deposit side, people are very price sensitive. So it's a very commodity business. State Street, however, isn't a bank in the sense that they don't make much of their money from commercial or real estate loans. They're really a trust bank, making most of their money from their custody business. They make most of their money providing services - record keeping, custody services, security lending services - to mutual funds and other institutional investors. It's a great business model, not terrifically capital intensive. Demographic and market trends for the long term are in their favor, so it's a business that's likely to continue to grow for some time. There have been some concerns about pricing in some ancillary services, and to some extent they get caught up in concerns over financial regulation and capital requirements and just a general aversion to anything labeled a bank, so it's given us an opportunity to buy what we think is a great company at an extremely attractive valuation.
TWST: Would you share another?
Mr. O'Connor: Another one, again a sort of typical Cooke & Bieler theme, would be RockTenn (RKT), which is a maker of corrugated cardboard and other paper products, based just outside Atlanta, Ga. The paper industry is not a very exciting industry; however, people are always going to need cardboard boxes, so it's not going away anytime soon. It grows in line with GDP. It's an industry that historically had been subject to long periods of overcapacity and really mediocre returns, but it's largely consolidated in the last 10 or 15 years. Now the top four players control almost 80% of the market between them, resulting in more pricing discipline. And RockTenn was fortunate and skillful in that they entered the last downturn with a very clean balance sheet and made it through relatively unscathed. One of their larger competitors, Smurfit-Stone, was forced to declare bankruptcy. This was a case where you had what was a pretty good business in Smurfit-Stone, it just had a really bad balance sheet. They made some investments they needed to make right before the downturn, and unfortunately the capital cost of the investments forced them into bankruptcy. So coming out of the reorganization, RockTenn was able to acquire them. The old Smurfit-Stone shareholders paid for these investments, and the current RockTenn shareholders will get the benefits of these investments, so we're very happy with that. America has a cost advantage in corrugated cardboard because of our supply of softwood trees. That presents an embedded competitive advantage for RockTenn. We are very excited about the stock. We could easily see it generating $10 a share in free cash flow, for a stock that is trading under $60 today, and we started buying it more cheaply than that. Fair value is around $90, so we are very excited about RockTenn.
TWST: You talked about what goes into the stock selection process. Tell us about what leads to exiting a holding.
Mr. O'Connor: We always say that the things that lead you to exit a holding should be the inverse of the things that led you to buy it in the first place. So for us, we buy companies because we think they're good businesses and we think they're undervalued, simplistically stated. So we generally sell them because we think they're either no longer attractively valued on an absolute basis or relative to some other potential holding, or we lose confidence in the business. If we do our jobs right, the former, the valuation being realized, would be more common than the latter, where we're forced to change our assessment of the business.
TWST: Any recent examples?
Mr. O'Connor: As we talked about earlier, the volatility of the market has probably led us to transact more than we would normally; we tend to be a very long-term-oriented investor. But recently, we sold Chubb (CB). That was a stock that had done very well for us. Insurance tends to be a defensive financial. People began to think there was some evidence of a pricing turn, and so Chubb appreciated to the point where it wasn't ridiculously overvalued, but we felt it was probably fairly valued for what it was. And we had other potential portfolio additions, particularly in the financial sector, that were more attractive, so we sold Chubb to put the money into those.
V.F. Corp. (VFC) was another stock that had done very well for us over a number of years. They're a large apparel manufacturer; they make Wrangler jeans, along with North Face outerwear and Vans skateboard-inspired apparel. Very talented management team, great capital allocation and savvy acquisitions. Just recently they bought Timberland (TBL) boots, which is a business that had had some internal issues, but we think V.F. will be able to fix those and it will be another great bolt-on to what they call their outdoor coalition of brands. Unfortunately or fortunately, other investors recognized that, and the stock appreciated to a point where we thought it was fully valued, so we sold. There are examples of things that don't end this happily.
Recently we sold Avery Dennison (AVY), makers of pressure-sensitive labels that you see in office supply stores for mailing labels and things like that. That was a case where the office products business in particular for them was always very competitive, and they were harvesting the cash from that and moving into tags for retail distribution and some other higher-growth areas. And without a lot of explanation, they suddenly began to shift that strategy to commit more capital to the office products business, and not very successfully in our estimation, so that led us to exit that. Management wasn't doing the things we expected them to do and, maybe for competitive reasons that we hadn't been aware of, management's strategy, we felt, was going the wrong way, so we sold.
TWST: What's your general outlook for next year?
Mr. O'Connor: We always approach it from a fundamental basis, so we know there are a lot of worries, and it's hard to know what the Europeans are going to do and what the impact on our side of the Atlantic will be of whatever it is the Europeans do. But if you look at the businesses we own and the businesses we follow, they seem really well positioned. Everybody took a lot of costs out during the downturn. Profit margins have come back, remarkably strongly in the cases where revenue has. The financial companies we follow are all much better capitalized now than they were three or four years ago, so they are much better positioned to absorb any European shocks. So building from the ground up, we're cautiously optimistic about the economic environment in general and stocks in particular for 2012. Things aren't as screamingly cheap as they were in 2009, but we don't see things being overvalued. We think there is a lot of opportunity for patient and careful investors.
TWST: What advice would you offer investors?
Mr. O'Connor: To be patient and careful. We think it's always important to not overreact to headlines, and the market seems to have a hard time doing that - not overreacting. Warren Buffett's advice to try to be greedy when others are fearful, and fearful when others are greedy, has probably never been more applicable. For us, the easiest way to get yourself psychologically prepared to do that is to do a lot of research and make sure you understand clearly what's going on and what's going to drive the results of your investments. I guess that would be the sum of my advice: focus on the things you think you understand best, be patient and careful, because there will be a lot of opportunity if you can see these events as your friend.
TWST: Thank you. (MN)
Edward O'Connor, CFA
Partner & Analyst/Portfolio Manager
Cooke & Bieler
1700 Market St.
Philadelphia, PA 19103
(215) 567-1681 - FAX