Warren Buffett, Graham and Dodd and Now, Sound Shore Management: Classic Value Investors are Happy Investors

September 5, 2022
John P. DeGulis is the President and Portfolio Manager at Sound Shore Management, a Warren Buffett, Graham and Dodd classic value investing style money management firm

John P. DeGulis, President and Portfolio Manager, Sound Shore Management

Peter B. Evans is a Partner at Sound Shore Management and is a Warren Buffett, Graham and Dodd classic value style portfolio manager

Peter B. Evans, Partner, Sound Shore Management

David B. Bilik is a Partner at Sound Shore Management and is a Warren Buffett, Graham and Dodd, classic value style portfolio manager

David B. Bilik, Partner, Sound Shore Management

Warren Buffett, Graham and Dodd, Classic Value Investing is key to navigating a rising interest rate, rising inflation cycle in the global economy.  These three portfolio managers turn this into specific classic value stock picks.

John DeGulis is the President and Portfolio Manager at Sound Shore Management, Inc. Mr. DeGulis joined the firm in 1996. Earlier, he worked at Morgan Stanley & Co. Mr. DeGulis holds an MBA from Columbia Business School and also graduated from Northwestern University.

Peter B. Evans is a Partner at Sound Shore Management, Inc. Mr. Evans joined the firm in 2005. Earlier, he worked at American Express. He is a graduate of Dartmouth College and Columbia Business School.

David B. Bilik is a Partner at Sound Shore Management, Inc. Mr. Bilik joined the firm in 2003. Earlier, he worked at Morgan Stanley. He graduated from Williams College and Columbia Business School.

John DeGulis puts the Sound Shore Fund investment philosophy into simple Warren Buffett type terminology.

“We manage the Sound Shore Fund the same way we do our institutional separate accounts. It’s a large-cap value strategy that is run in the same manner as we have since the firm’s inception in 1978. We screen for what’s cheap out there. Then we do our own fundamental research to come up with a reasonably concentrated portfolio of 35 to 40 stocks. It’s a very straightforward and disciplined process that we apply across all of our accounts, including the Sound Shore Fund…

It’s a value investing style. We are contrarians by nature. We’re looking for stocks that are cheap, but not just statistically cheap on a sort of static ratio basis, if you will, a low p/e — it’s certainly one way to screen and we do that to create our opportunity set. But then we very quickly take that opportunity set and do our own fundamental research to discern which stocks we think are going to be the best risk/reward ratios. So it’s a classic value investment style.”

John DeGulis gives an example:

“I’ll start with Vistra (VST). It is a diversified electricity supplier.

They have both generation as well as a retail business that does transmission and distribution.

It’s an interesting company that came together through a series of acquisitions over the years, but now is one of the largest providers of electricity in the United States.

They have exposure to many markets.

Their biggest market is Texas.

But they also have exposure in the mid-Atlantic, they have some exposure in Illinois and business in California. So it’s diversified geographically within the United States, but still entirely a U.S. business.

And it trades for very, very cheap multiples on both earnings and cash flow today and prospective cash flow and earnings as you look out.

So in today’s marketplace, given everything that’s happened in the electricity markets, their earnings power has increased since we bought it.

And it now trades for a p/e that is, we think, under 10 times what the earnings power is of the business.

And also very importantly, free cash flow, which is critical in a capital-intensive business such as electricity generation, is similarly at very low multiples of earnings.

So when you look out to 2023, and 2024, earnings estimates for Vistra (VST), they’re north of $2.60 a share; the stock is trading at $23.70 today.

We actually think those earnings numbers are a bit low when we look out at the various scenario analysis of what they might earn in 2023, and 2024, given how electricity prices have increased over the last 12 to 24 months.

So we’re looking at a company that’s trading for less than 10 times earnings, less than 10 times free cash flow, that we think is an increasingly important part of the energy infrastructure in the United States.

The other important part about Vistra (VST) is they’re diversified by their fuel source.

So about a third of their businesses encompass retail and electricity transmission and distribution.

Meanwhile, the electricity generating business, which is about 70% of the company, is diversified by fuel source.

They’ve got nuclear, they’ve got coal, they’ve got natural gas, and now they also have wind, solar and some batteries as well.

And so they are increasingly investing in renewables.

You’re going to see that mix shift, continue to accelerate towards renewables and away from carbon over the next 10 to 20 years.

And they have targets set out for both 2030 and 2050 as they execute their transition.

They’ve already closed about half of their coal plants.

They’ll continue to close their coal plants over the next five to seven years — that’s already planned.

They’re putting incremental growth capital principally into solar and battery technology and they’ve already built up a wind business as well.

So you have this transition, much like you’re going to see in many parts of the United States, but also globally as we move away from carbon as our electricity generation continues to transition into more renewables.

But there has to be a pace to it. Obviously, we’ve seen with storms and weather and geopolitical events, there’s a balance to all this.

It’s important to maintain stable electricity in all environments.

And so the trick is that we need to transition to renewable low-carbon or no-carbon sources at the same time, providing good stable electricity as we transition.

It’s a big part of the story.

There is a transition to renewables.

And in the meantime, they are continuing to grow their cash and their free cash flow and they’re generating a tremendous amount of free cash flow that’s going to be returned to shareholders.

In fact, we think they’re going to be buying in upwards of 50% of the stock over a four-year period.

They are about a year and a half into that.

So you’re getting a very significant share shrinkage and return of capital to shareholders in the meantime.

If it trades at what we think is a very fair and reasonable 10 times free cash flow per share, which next year could be north of $3.50, you get a stock into the mid-$30s as a target.”

Peter Evans also has a favorite current example for his Warren Buffett, Graham and Dodd classic value stock.

“We also own a company called Flex (NASDAQ:FLEX), which manufactures a wide variety of products on behalf of companies like J&J (NYSE:JNJ)Ford (NYSE:F) and Cisco (NASDAQ:CSCO), all over the world.

Their products range from data center routers to glucose monitors to EV charging stations.

In addition to very efficient manufacturing, Flex helps its customers navigate supply chain challenges that we’ve seen of late by nearshoring and then using its scale to source components when there are shortages.

Flex also has a subsidiary called Nextracker, which sells tracking systems for solar panels to increase their efficiency.

Earlier this year, the private equity firm TPG invested a valuation equivalent of over $6 a share.

Their CEO, Revathi Advaithi, who we know from her time at Eaton, refocused the company on less cyclical end markets, like health care and cloud data centers.

And despite having a majority of its earnings in these attractive end markets, core Flex is trading at less than five times earnings.

So just using a modest 10 multiple on this core business, there’s more than 65% upside to our price target. The company is operating very, very efficiently under new leadership…

A slowdown is likely at this point. But if we dig down to a stock-specific level — if I go back to Flex, their free cash flow generation is actually counter cyclical. When there is a slowdown, they wind up selling down their inventory. And they’ve been very good at buying back shares.

Flex has shrunk its share count by about 15% over the last five years.

They have the ability to actually take advantage of a slowdown and a commensurate reduction in their share price to maintain earnings, and then increase that earnings power over time.

We try to find companies that we think can control their own destiny as they go through slow times, as well.”

The portfolio managers agree that now is the best time for Warren Buffett, Graham and Dodd classic value investing style:

“The setup for us, the opportunity set, is a good one for a value style, such as Sound Shore.

And the reasons include that coming into the COVID pandemic, there was a boom in the growth stocks and long-duration assets because of perennially low interest rates.

That era may be ending.

We’re going to move back to, in all likelihood, a marketplace more defined by earnings and earnings growth, which is where we spend most of our time.”

This new market environment favors the Warren Buffett, Graham and Dodd, Classic Value Investing style of Sound Shore Management.

“All the uncertainty that you are now seeing in the market, both economically and politically, gives a lot of volatility and change in market prices that are often more significant than really the value of the businesses.

And that’s what our job is: to find those opportunities.

And so, we’ve been doing this for a very long time, very targeted in the stocks that we own.

But given the amount of disruption that you’ve seen over the last 10 years leading into COVID, and now, today’s marketplace as the Federal Reserve is raising rates, has actually given us an opportunity set that is quite fertile.

As we look forward, we certainly don’t make predictions as to where the equity markets are going to go.

But we do feel like our strategy has every opportunity to do well.

the firm is 100% employee owned. Our retirement money is in the Sound Shore Fund.

So we’re very much aligned.

We have one strategy.

We’re very much focused on making sure that we’re getting the returns for our investors. So that’s another important point to underline in terms of what differentiates Sound Shore.”

Get the complete list of their top picks from these Warren Buffett, Graham and Dodd classic value investors by reading the entire 3,316 word interview, exclusively in the Wall Street Transcript.

John P. DeGulis, President & Portfolio Manager

Peter B. Evans, Partner

David B. Bilik, Partner

Sound Shore Management 

Warren Buffett, Graham and Dodd, Classic Value Investing