bigger than average balance sheet on thelong side – closer to 160% long – becausewe’re finding all these big companies wewant to have 5% positions in. To supportthat, we’re now around 90% short,which is requiring us to use more indicesthan usual. The M&A environmentmakes us hesitant to significantly increasethe number of company-specific shortswe have. We were short Albertson’s. Wewere short Sports Authority. These arestructurally bad businesses that some-body came along and bought. We have tobe aware of that and not add too muchrisk to the portfolio by adding a lot of new individual short positions.
Back to the long side, what situations tendto result in your finding quality value?RS:
One is the good company in anindustry that’s out-of-favor, for whateverreason. Another is the good company thattrips – the disappointment that hasn’timpaired the long-term value of the busi-ness, but the market overreacts in pricingit down. The third would be the goodbusiness that isn’t necessarily in plainsight – it’s obscured, say, by other busi-ness lines or special situations. JoelGreenblatt talking in your last issue [
, July 28, 2006] about American Express isa good example.I’m probably more willing to pay upfor quality than other value investorsmight be. Some of my investor friendsoften tell me my ideas are “too high-qual-ity” for them. I would distinguish some-what here from paying up for growth –I’ll pay more for a high-quality, slow-growing business. I look for companiesthat will grow value, not necessarily rev-enue, at above-average rates.The higher the quality of the business,the lower discount to our estimated valuewe need. We’re happy to buy a greatbusiness at 75 cents on the dollar.Something would need to be at 50-60cents on the dollar for us to buy amediocre business. On average, I’d sayour typical investment is 30-35% cheap-er than we think it ought to be and wethink it’s increasing value at 15-20% peryear on top of that.
Describe how you come up with ideas?RS:
Our best ideas tend to come fromwhat I call “old research, new events”.That’s typically the good company you’vestudied carefully and would love to ownat the right price, that gets marked downafter it trips or its industry goes out of favor. A great example was Yum Brands acouple years ago. Comp sales at one of their restaurant chains, KFC, were wayoff one quarter and the stock crashed35%. It instantly became an idea – I knewit was a good business and now it was onsale at a 35% discount.We also learn a lot from otherinvestors. I go to idea dinners and regu-larly talk to a lot of people in the busi-ness. I’m not afraid of ideas owned byother people, but you obviously need todo your own work and make sure they fitwhat you do.Many of our other ideas just comefrom having our eyes wide open. Youread publications like yours. You talk tocontacts you’ve developed in variousindustries. It’s often just about payingattention to what’s going on in the world.
On the short side, what attracts yourattention?RS:
We primarily look for material dis-connects between our view of economicearnings and the earnings that are report-ed and people are using to value thestock. It could be accounting related, sowe pay careful attention to things like ris-ing accounts receivable relative to totalsales, cash from operations that is notkeeping pace with net income anddecreasing returns on capital.We also look for long-term structuraldeclines – kind of the opposite of what welook for on the long side. Wall Streettends not to fundamentally mark stocksdown until bad news actually shows up inthe numbers. We’ll ignore the supposedvalue today and focus on whether wethink the “E” in a P/E is going to be mate-rially less in three to five years.
Once you’ve identified a potential idea,what do you do next?RS:
We’ll put an analyst on it, who’salways paired on the idea with me or oneof the two other principals in the firm.We’re leveraging the senior person’s time,but also want more than one pair of eyeslooking at things.We’ll prepare a basic two-page write-up after ripping through the 10-Qs, 10-Ksand proxy filings and listening to confer-ence calls. We want to get our armsaround the business both quantitativelyand qualitatively, so we summarize thingslike the company’s businesses, the com-petitive environment, recent financials,earnings quality, management, outstand-ing litigation and valuation.
What jumps off the page for you?RS:
I focus on return on capital and wantto see EBIT compared to invested capitalin the high-teens or better. We’ll look at itwith and without goodwill, to try to sep-arate out the impact of capital-allocationdecisions versus operating decisions.We favor companies with some formof amortization, where we think cashflow is higher than reported earnings andthat may be one reason why the stock isundervalued. We want to understandhow net income plus depreciation andamortization is converted to cash flowfrom operations. Is anything getting lostin working capital or coming from othergains? We also focus on the relationshipbetween capital expenditures and depre-ciation, to better understand how capitalintensive the business is.If we still think the idea is interesting,we’ll set up calls with the company to bet-ter understand how they operate andthink about things like capital allocation.
Value Investor Insight
ON SHORT OPPORTUNITIES:
We’ll ignore the supposed valuetoday and focus on whether the“E” in a P/E is going to be mate-rially less in three to five years.