How to Find Great Investments, and Why You Should Ignore DCFs – David Winters

Johnny HopkinsDavid Winters, Research, ResourcesLeave a Comment

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David Winters is an awesome value investor and Founder and Chief Investment Officer of The Wintergreen Fund.

Prior to founding Wintergreen Advisors in 2005, Winters was Chief Investment Officer of Franklin Mutual Advisors and Portfolio manager of the Franklin Mutual Discovery Fund. Winters joined Mutual Series in 1987, one year before the death of legendary investor Max Heine. He spent the next decade working side-by-side with another investing legend Michael Price.

This is what Morningstar had to say about the Wintergreen Fund, “Thanks in large part to Winters’ Malaysian and other Asian picks, this fund has returned 18.7% and outpaced more than 85% of its world-stock rivals for the year to date through Dec. 9. This is anything but a fluke.”

“Winters’ security selection was generally quite good as global markets were all over the map during his first four years at the helm, so this fund has handily out-gained its typical peer and suffered rather moderate volatility since opening in late 2005. And he had lots of success with the same deep-value discipline at a prior firm before founding Wintergreen.”

So Winters is a value investor that makes a lot of sense.

Recently I was going though some old interviews with David Winters and found this awesome piece from the Graham and Doddsville 2007, Summer Issue.

Here is an excerpt:

Q: You’ve described yourself as being on a global treasure hunt. What’s the checklist of characteristics that a situation has to have before you invest?

DW: I don’t know if there’s an exact checklist. There’s no magic formula because every situation is a little different. But if you’re talking about what my ideal investment is, first of all I want a good underlying business. A business that is, hopefully, getting better over time, so time is your friend.

Then I really need to have management who are committed to doing the right thing, who I sometimes describe as being in the boat pulling the oars in the same direction as the rest of the shareholders. I think you want to have both those factors plus an undervalued security price. When you have those 3 things, then you have a trifecta. And you want a trifecta.

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Q: You’ve talked about constructing a portfolio of pearls, where the barnacles on the shells hide the underlying beauty underneath. Where does the search start for you?

DW: The new 52 week low list is a great place to look. And sometimes it isn’t just individual names, but a sector may be out of favor. Other times it’s complexity that really distorts something that’s wonderful, because most people don’t like complexity. This business is about people basically being spoon-fed, and if you have a conglomerate that requires a lot of work and more than one sector, that really turns people off.

We’ve found over the years that in the best investment situations, the more you dig at them the more good stuff you find. And in the bad investments, the more you dig the more you find additional skeletons in the closet (e.g., toxic liabilities that aren’t on the balance sheet). Often you can figure out pretty quickly if an investment is one where the assets are understated, or is it one where the liabilities are understated. You want lots of assets for free, or the potential for free.

Q: How do you evaluate downside risk in a security?

DW: The ultimate downside risk in a security is permanent loss of your capital. In almost any business other than an asset play, risk and reward are evaluated on the basis of how much cash you can generate over time.

You must be aware of Ben Graham’s margin of safety and look at what the company is really worth. What is the relationship between the company’s worth and its current market price? Does the company have the ability to raise prices?

There are many businesses that are so brutally competitive that they don’t have any ability to raise their prices. Then you have to look at what their competitive position is in the world. Do they have an edge? And are they making a product that can be easily duplicated somewhere else, in a fairly undifferentiated manner, at a much lower price.

If you’re in a business like that, you’ve got a problem. The other thing to consider is whether there has been a fundamental change in the underlying economics. For example, for many years the newspaper business was a virtual license to print money.

If you owned the newspaper you were one of the richest people in town. Now that is no longer the case because you’ve got classified and display advertising going to the internet. Newspapers have lost pricing power and they’re losing revenue. So I think you really have to pay attention to whether there is a game change, and that’s not always apparent in the valuation or in the annual report.

Q: Michael Price visited our class, and he did not have very good things to say about utilizing DCFs. Do you employ them at all?

DW: I probably inherited Michael’s skepticism for DCF. I think of DCF as garbage-in, garbage-out. Conceptually it’s right, but the ability of anybody to make accurate estimates is low. During the many years I worked for him, one of the lessons I learned from Michael was not to be so dependent on earnings. Wall Street is so obsessed with, “Did they beat by a penny? Did they miss by a penny?” If you’re investing in securities that are so contingent on that, the possibility increases that you’re going to get beat.

Our approach is to try to buy today at a discount and get tomorrow for free. Somebody showed me a DCF model last week and I looked at it and I was pretty skeptical. They had a terminal growth rate of 2%, and I asked, “What happens if it becomes 5%?” The value went up by 100%.

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So I share Michael’s skepticism about DCF. I think it’s an over-rated tool. Think about the bubble years, when people were extrapolating things far into the future that ended up being preposterous, while at the same time you could buy real companies like Brown-Forman, that distills Jack Daniels.

At the height of the bubble Brown-Forman dropped to a valuation that was probably half of what an arm’s-length transaction would take place at. People were buying DCFs because they wanted get-rich quick schemes. Brown-Forman had no debt, net cash on the balance sheet and a LIFO reserve. And getting back to Jack Daniels…it holds a place of honor in my heart near the American flag.

Q: How do you recognize, and avoid, value traps?

DW: I’ve been involved in some value traps over the years, and I’ve learned a lot about their characteristics. There was one that we owned years and years ago where the stock price never went up, and eventually got taken out.

You have to try to figure out if the business is any good, and whether the people are any good, but you know if you find something that’s a value trap, time is your enemy. You really want time to be your friend.

You want to go to sleep at night knowing that you’re incrementally getting a little wealthier, even if the stock price or the bond price does not reflect it. You have to recognize the impact of time on your investment.

Take HSBC. Though we don’t own it anymore, we loved the idea that somewhere around the world, somebody was going to an ATM, borrowing money, or making an investment. It’s kind of a neat thing to own a piece of a business where 24 hours a day they’re working hard for you. We love those situations.

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