How to find undervalued businesses, and why you should ignore management – Robert Bruce

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One of the best value investor’s on the planet is Robert Bruce.

Bruce graduated from Columbia Business School in 1970 and went to work on Wall Street as a securities analyst. Then he read about Walter Schloss in Forbes Magazine and it changed his life.

He now runs a successful fund with his son Jeffrey called, The Bruce Fund. The Bruce Fund has approximately $560 million in assets under management. According to this 2011 article by Forbes, Shut Up and Invest, the father and son don’t care much for Wall St or the media:

[Robert an Jeffrey] rarely speak to the press, refuse to be photographed and limit shareholder communication to the bare minimum.

By the numbers, however, the Bruce Fund (BRUFX) may very well be the best-performing diversified no-load mutual fund in the business today. Morningstar ranks it first in performance for 1-, 3-, 10- and 15-year periods among funds in its category. Last year the fund had a total return of 24% versus 15% for the S&P 500. Over the last decade it has had an astounding 18% average annual return. That’s better than the performances of Ken Heebner’s CGM Focus Fund and Bruce Berkowitz’s Fairholme Fund–by a wide margin.

So, he’s definitely worth listening to!

The problem is, because he rarely does interviews its hard to find anything about his investing strategy.

After searching on the internet I found an article on Robert Bruce in which he spoke to a class of EMBA students at Columbia University in 2008. As a result we get to read a lot of insightful questions and answers on this awesome value investor.

Let’s take a look…

I found this article on the website one of the best value investing bloggers, csinvesting is authored by John Chew who writes a bunch of great articles on all things investing education. If you get some time, check out his blog, its an awesome resource.

The following excerpt comes from the full article, which I found here, Robert Bruce speaks before the EMBA students at Columbia Business School.

I particularly focused on questions on finding undervalued businesses and his thoughts on listening to management.

Check it out…

Q: When you separate the companies from the Value Line, many are trading at a premium so what type of situations or news you are looking for to make a buy?

RB: Here is the analogy I like to use. We value investors like to buy our shoes on sale. This one I like and if it ever goes on sale, I will buy it. If it is in my size, I will buy the shoes. But the underlying thought, you may not get the shoes; it may never gone on sale. PATIENCE.

I identify a subset of 50 to 75 companies or 100 companies at the most that meets the financial characteristics that I want, and I wait for them to go on sale. Sometimes they never do. A company called McCormick (MRC) that I would use as an example that makes the spices and it has a wonderful long term record, but it never, ever gets cheap. If you ever wanted to buy McCormick, you could never buy it with a margin of safety—at least by my reckoning.

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The idea is to identify your candidates—these are the better companies—I would be happy to buy any of them if they got to my valuation level. You never know which company that will be. In the kind of market that we are now in, I am finding companies I never thought I would own. I bought a company recently called Paychex (PAYX). They are a small ADP; they are a wonderful company. It is run by Tom Galisono. The stock is at 20 times earnings but it has wonderful, sensational cash generating features. A price it has never really been before.

Q: At the same time in that world which is well publicized and well covered, you are able to find undervalued companies?

RB: I am using behavioral finance to discover what is discounted in the price. For example, I bought recently Black and Decker.

Now everyone knows about the housing slump and slowdown in homebuilding, but BDK has already fallen about 40% already so I would submit that the obvious news has been significantly discounted—entirely discounted? I do not know. What I have done with these behavioral models is to say it appears to me by my criteria that Black & Decker (BDK) is cheap as it has ever been. Does that mean it can’t get cheaper? Absolutely not.

One thing to remember is that when the last big Bull market occurred in the 1960’s there was a best seller called the Money Game written by George Goodman, ala Adam Smith. He was a brilliant man and a witty writer and I commend it to your attention for a light, fun read. The stock does not know you own it. People expect that when they buy a stock, it will stop going down and then go right up. You don’t ever find a bottom unless you are lucky.

When you are investing, you are making a positive expected bet over a reasonable time horizon. Ben Graham never used the term, Mean Reversion, but a lot of what we are talking about here is reversion to the mean. That is the fallacy, the big flaw of Wall Street research—investment analysts are very predisposed to trend extrapolation. They don’t think in terms of mean reversion. I am going to say that if Black and Decker is going to sell off from the high $90s to the $60s then a lot has been discounted already.

So I make some attempt even though the business has not turned south yet, the likelihood of that occurring is already reflected in the stock price. The kind of market we are in right now is a wonderful hunting ground for value investors. Volatility is where opportunities come from. I heard a statistic a few weeks ago so it must be more true now that 50% of the S&P is trading 50% below its 52 week high. That kind of reassessment of company prospects is going on. If you turn on CNBC today, you see everyone chewing their fingernails. What write-off is coming today? Who will miss earnings?

You are not in the game of predicting what the bank will do or what the write-off is going to be or what the bank is going to do. You are trying to find a stock with a margin of safety. The stock market will bottom out long before the economy bottoms out. I have been through many recessions in my career and throughout all of them the stock market did not go to zero. At some level they stop falling and it is always before the worst of the news is out.

Q: You look for seasoned companies of 10 years of more with superior characteristics. What happens next in terms of your strategic analysis? Life cycle?

RB: I don’t spend a lot of time on that in depth analysis because I compensate for that by the sizing of the bet. This is a portfolio management decision which is different subject from what we are talking about tonight.

The idea of money management and sizing of the bet should have some relationship to your confidence or your knowledge. Another change that I have made is that I now manage portfolios that are much more diversified than they used to be. Many relatively small bets, each with a positively expected value. I like to say independent bets, but due to the market there is a correlation. There is a market influence except for Gold stocks let’s say. When the market goes down 300 points like it did today, everything goes down. There is no independent bet.

In my youth I used to travel across the country and talk to managements and get to know them. It was a good thing to do then, but since with Reg. D there isn’t anything managements can tell you that you would really want to know.

Also with the Internet, there is the tremendous availability of the SEC filings of the press releases and company presentations. I am way in favor of Reg. D. It was called for and needed—a good idea; there is an abundance of information.

I am more interested in the bet sizing and the diversification because you don’t bring any edge to the party by talking to management. Managements are human. They are not geniuses. I am against all the lionization of CEOs like Chuck Prince, Sandy Weil. They are here today and gone tomorrow. The business is what is important. It is not the people. I don’t focus so much on the details of the business. I believe that the numbers speak.

There a lot of companies that are praised but when you look at the numbers you say, “What is so special? What is going on here?” There is nothing to get excited here. It is the differentiation between sizzle and steak. You get a loquasous charming manager who spins a good story.

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One suggestion if you are interested in a company and you want to be amused and informed, get a stack of annual reports, the last 3 or 5 or 8 years of annual reports on that particular company and read the message to shareholders and compare them and see if there is a continuity of purpose—one refers to another. Look for managements that degrade themselves. See if management is consistent and honest. “Last year we met two of our goals but fell short of….because many are not honest. Many managements are inconsistent or they change their focus from year to year.

They will say revenues went up this year, but there is not there, there. They are living day to day and these are, by the margin, not good businesses.

Q: Companies pass through inflation. How do you find a balance between the two, good
businesses and commodity-like businesses?

RB: Well, commodity businesses have their own cycles. There are cycles of investment. The general reason we are having such a boom in Copper, Steel and Aluminum is because there were decades of under-investment. And so we are in a situation where prices rise until new investment is stimulated.

In the example of a Wheat farmer, if the price rises, you can plant more and sell more after the next harvest. In the case of copper, you have to find the ore and spend a lot of money to develop so the investment cycle takes a long time.

But my message to you would be—I think that there are smarter and better ways to invest than in deep cyclical commodity companies. The ideas is to invest when the market price is below the cost of production.

Now you look and all the commodity prices are far, far above the cost of production which will stimulate new supply in just about everything and these are self-correcting cycles. The doomsday scenario never happens.

Q: Do you use multiple models of valuation to get some range of value?

RB: I am looking for companies….that if you look at Coke, it is remarkably consistent business, and you can see how much cash is generated and how much cash is needed in the business. Then what is done with the cash—what is paid out in dividends or buy backs and how much is reinvested in the business.

There is a fair amount of bottlers bought in the past few years if you look in the footnotes. Coke is a fairly simple business to model. Start with the idea of how fast does revenue grow? Obviously with these big companies, they are linked to GDP growth and the areas in which they operate. So if this is a mature company can it grow just as fast as GDP? Is it growing faster than GDP? Then you do the discounting of that.

We value investors want to get the future cheap, preferably free. Ben Graham believed in that. He didn’t want to buy growth stocks. He wanted the here and the now and he wanted it at a discount. When I first came to Wall Street, there was a firm called Tweedy Browne, they made a living as recently as 1970 where they were buying stocks at 70% of net/net working capital stocks and then sold them when the stocks went to 100% of net/net working capital. Of course, net/net working capital stocks disappeared in the late 1970s. But that is how cheap stocks used to get.

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