(Image Credit, youtube.com)
Another value investor that I like to watch closely is Charles de Vaulx.
De Vaulx joined International Value Advisers, LLC (IVA) in May 2008 as a partner and portfolio manager, and serves as chief investment officer and portfolio manager.
Until March 2007, de Vaulx was portfolio manager of the First Eagle Global, Overseas, U.S. Value, Gold and Variable Funds, together with a number of separately managed institutional accounts.
In addition to sharing Morningstar’s “International Stock Manager of the Year” Award in 2001 with his co-manager, de Vaulx was runner-up for the same award in 2006.
From 2000 to 2004, de Vaulx was co-portfolio manager of the First Eagle Funds. He was named associate portfolio manager in August 1996. In 1987, he joined the SoGen Funds, the predecessor to the First Eagle Funds, working under legendary investor Jean-Marie Eveillard as a securities analyst.
One of my favorite de Vaulx interviews is one he did with Forbes in 2013 called, Charles de Vaulx On Stocks: Buying The Best House In A Bad Neighborhood. It provides some great insights into his investing strategy.
Pay particular attention to his thoughts on finding quality businesses and praying they are cheap, how to invest in overseas markets and, how to maximize your performance when the market is volatile.
Lets take a look…
This is a excerpt from the 2013 interview that de Vaulx did with Forbes called, Charles de Vaulx On Stocks: Buying The Best House In A Bad Neighborhood.
Steve Forbes: Charles, good to have you with us. You’ve had a long and distinguished career, and I want to begin by asking you to define “value investing.” It’s a term everyone uses, but people have various definitions of it. So, what is your definition of “value investing”?
de Vaulx: The basic definition is the belief that there are at times discrepancies between the intrinsic value of a company and the price at which that stock trades. So sometimes we try to identify companies, when there’s a large gap between the price of the stock and what we think the real value of the company is. Having said that, we have always had a bias towards better businesses; in other words, those that are able to compound their value over time.
Forbes: Are those harder to find than the trash companies?
de Vaulx: Those are much harder to find, obviously than the net-nets, the cigar butts Ben Graham (PH) talked about. But if you can find those, the beauty is that time becomes your friend. If you buy into an average of mediocre business, you need that gap between the price and value to be closed as quickly as possible. You need, the old man to die. You need a new management to come in and restructure.
Forbes: A catalyst?
de Vaulx: You need a catalyst. Conversely, if you own a compounder, then time becomes your friend. And we also have a clear bias, Steve, towards companies with significant insider ownership. We believe that eating your own cooking is a very powerful thing whether it’s us as money managers, or…
Forbes: Talk for one second about what you do about eating your own cooking?
de Vaulx: Well, I eat quite a lot of it. I think collectively the 42 people that work in our firm have north of $100 million of our own money in the funds we manage, which for us is a significant amount.
Forbes: And those are two funds?
de Vaulx: Those are two funds, one which is Global, the whole-world one, which is international only.
Forbes: International being non-US?
de Vaulx: Being non-US, right. So we do believe, and it’s been proven historically, that companies, when insiders own a lot of the shares, tend to do a much better job. They care more. They have a longer-term vision.
So if you want to invest in companies with significant insider ownership, these companies tend to be smaller. What gives the float, what trades in the market, what’s not held by the family, may be smaller, so you can’t get in and out of these positions easily. So in principle, you have to be willing to hold onto these shares for many years. So you need to believe that the intrinsic value of those companies can grow to some extent over time.
Forbes: Now how do you do your screening, so to speak? Especially since you do the whole world?
de Vaulx: Well, most value investors do their screening by focusing first and foremost on the price. They try statistically to identify cheap-looking stocks, stocks that trade at a low PE ratio. Stocks that offer a high-dividend yield. Stocks that seem to tread at a low price-to-book basis.
Once they’ve identified all those cheap-looking stocks, they do their homework, one stock at a time. Try to identify among those cheap-looking stocks which ones have somewhat decent businesses, because the problem with these lists of cheap-looking stocks is typically those stocks will fall into two categories: either the worst companies in any business or the most mismanaged companies.
Now conversely, our starting process is different. We start with the quality. We want to investigate companies where we believe the business is a good one. So, I’ll give you an example. Many years ago, I stumbled upon Thomas Nelson. Did not know anything about it, but I figured, “Gee, it’s a book publisher, a Bible book publisher.” And I figured, “Gee, that has to be a good business. Not much in the way of author rights.”
Then I hoped and I prayed that for a reason or another, the stock would be cheap. And optically, the stock did not look cheap. The price-to-earnings was quite high, but I noticed that there was a weird accounting quirk, whereby there was a huge amortization of goodwill which in fact was a non-cash charge, and one which one could adjust the earnings-per-share for that. If you looked at cash, the cash EPS as opposed to report at earnings-per-share, the stock looked much cheaper.
So again, whenever we read about a business that seems unique or uniquely good in its field, we investigate and hope that the stock is cheap. Now maybe it’s a company with three divisions. Maybe two divisions do well, one does poorly. And yet most investors may look at the company in aggregate and may unduly punish the company.
A good recent example may be Sealed Air (NYSE: SEE), a company that makes bubble wrap, and they have other divisions. One of the three divisions has not been doing as well as the others, and I think that’s why the stock went down recently to $14, $15, and it has been able to bounce back since.
Forbes: You once said, “Dismiss metrics like EBITDA.” You focus just on what you call “free cash flow”?
de Vaulx: Well, yes. I mean, EBITDA is earnings before depreciation. Now most businesses need maintenance CAPEX to stay in business. So we focus a lot on free cash flow. And today, for instance, if you look at the companies in the oil and gas industry or gold-mining, the sad reality is that the production costs have gone up a lot, including CAPEX.
To replace an ounce of gold in the ground, or to replace a barrel of oil of production, you need capital spending that’s two, three, four times what the company is depreciating, which means that the real earnings, the free cash flow, is a lot less than the reported earnings. So, looking at free cash flow is a good starting point.
Forbes: You also do something that seems to contradict value investing, and that is you exploit volatility? When you think of value investing, you think of holding a stock forever, but you go in and out.
de Vaulx: Yes, Steve. You know, you’re right. A lot of people associate value investing with buy-and-hold. But I think it’s strong, yes as a value investor, you have to be willing to hold onto a stock for three, four, five, six, seven years. So, you need a mental outlook where you’re willing to sit on it for a long time.
It may take a while for the price to meet that intrinsic value. And hopefully that value will have grown over time. But at the same time, if markets are volatile and if the price of that individual security meets its intrinsic value right away, you should get out of it. I do cringe when I hear about no buy-and-hold investing. And in fact, in the low-return world, which I believe is the world we live in now, I think a volatility should be exploited.
Forbes: Or go through what you did with Japan recently?
de Vaulx: Right, exactly. So, Japan has witnessed this huge rally that started mid-November, when the new Prime Mister, Mr. Abe, came onboard. I think the market rose 55%, until May 21st. Then the market proceeded. So, as the market went up, some of the names we own started to reach our intrinsic value estimates, so we trimmed them. But then as the market corrected 22% after May, we started buying back mostly the same names we had been selling. And in one instance, we started buying into a new name.
Then more recently, until a week or two ago, you know, the Japanese market had bounced back. And after that, we had become net sellers again. So I think volatility, you’re right, is like a razor. You can put it to good use. You know, you can use it to make yourself look good, or you can in other words, you can use it to buy low and sell high, or you can put it to bad use. You know, you can cut yourself with it, i.e. buy high/sell low.
Forbes: Did you come up with your own formulas to determine intrinsic value?
de Vaulx: No. I mean, I think to go back to the Ben Graham definition of intrinsic value: it’s what a rational buyer would pay in cash to buy an entire business. So, we rely mostly on M&A multiples, private market transactions. So when a company such as Heinz, the food company, gets acquired, we monitor at what kind of multiple of revenues, of earnings, free cash flow the takeover takes place.
Having said this, we are aware that there are times when money is loose, when credit is abundant. There are times when a corporate acquirers themselves over pay, and we try to be mindful of those times. When we think that happens, we will use multiples that are less than actually M&A multiples.
In the case of the Heinz deal, Mr. Buffett himself recently, at the shareholders’ meeting in Omaha, acknowledged that it was easier for him and his Brazilian partner to pay 15 times [IBIT], because part of the deal was financed issuing bonds, high-yield bonds, yielding only four and a quarter percent. If they had had to issue bonds at 8%, they would have had to pay a much lower multiple.
Forbes: You seem to have a lot of issues? Some value investors focus on a few. You have over 100 in each of the funds?
de Vaulx: Yes. There are two reasons for that. One is that we have a strange investment philosophy, where we believe that the best way to compound wealth is by avoiding the losers and minimizing losses. So one tool to control risk is to have more names than if we were concentrated.
Now having more names does not mean that we don’t know our companies.
In fact, quite a few of our companies have been taken over, over the years, and the takeover price has been very close to our estimate of what the value of the company was. But the second reason, Steve, is that we are global investors. And even those we invested in outside the US, and even though corporate governance has improved overseas over the past 30 years, even though disclosure by companies has improved a lot overseas, the sad reality is that it’s still very far from perfect.
So as a minority shareholder, which the funds are, to protect oneself we need to have more names than we would in the US. I’m not sure I would sleep well at night if I had 8% of my fund in one Japanese name or one Korean or one Indian name.
Forbes: Everyone preaches discipline in investing, but you are practicing it in sometimes a very painful way. You talk about equities as the best house in a bad neighborhood, but that doesn’t mean you’re going to go in all equities. You have a very high position in cash?
de Vaulx: Yes. To argue that equities are the best house in a bad neighborhood was a way for us to say that, you know, cash has little appeal because after inflation the return is negative. Same thing with high-quality bonds. So it stands to reason that when cash and high-quality bonds yield so little, it becomes very tempting to be fully invested in stocks. But that would remain a relative argument.
For a value investor today to claim that this time is different, because interest rates are so low, and therefore because this time is different, there’s no need to insist on a margin of safety on a discount between the price and the intrinsic value, would be tragic.
If you go back a few years, in ’05, ’06, I was amazed by the number of companies, including financial institutions, that had become more and more levered, financially, because the extremes with Fannie Mae and Freddie Mac that were levered 100-to-one. But even GE and many other companies had become more and more levered financially.
Yet there’s a cardinal rule of investing, which states that it’s not enough for a stock to be cheap. For it to be bought, it has to be safe. Safe and cheap, to use the words coined by Marty Whitman from Third Avenue. And yet, the universe of stocks that were safe kept shrinking, and after a while value investors said, “You know, it’s not fair. Let’s forget about that rule. Let’s own those stocks.”
Then the ’08 financial crisis came and it hurt. And again, I don’t want to be remembered as the guy who decided that one of the central rules of value investing, which is that there’s a need for a discount, I don’t want to be remembered as someone who has decided to ignore that rule on the basis that interest rates are very low.
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