Ken Burgess is a CFA and Managing Partner at Systematic Financial Management. He serves as lead portfolio manager for their Small Cap Value Free Cash Flow and SMID Cap Value Free Cash Flow portfolios.
Systematic Financial Management has over $9 Billion in Assets Under Management.
Burgess has a great eye for finding undervalued stocks using his value investing strategy. Late last year he did an interview with Value Investor Insight where he discussed his process in finding undervalued investments.
Following is an excerpt from the Burgess interview with Value Investor Insight:
It’s rare to speak with a value manager these days who doesn’t lead with his or her focus on high-quality companies. You’re no exception. What does high quality mean to you?
Ken Burgess: The free-cash-flow strategy we started over twenty years ago was and is predicated on the belief that we can access the higher investment returns generally associated with small-to-medium sized companies without sacrificing portfolio quality. So yes, we’re a high-quality manager, which isn’t in and of itself that unique. What I think is somewhat unique is how we define quality.
It’s not about consistent sales growth, or high returns on equity, or high operating margins, or many of the other metrics people typically cite. When we talk about a high-quality company, all we’re looking for is superior financial strength. It’s more akin to the credit analysis the ratings agencies do. They look at the cash flows of the business over time, their volatility and their sustainability.
They compare those cash flows with the company’s overall debt burden from interest and principal repayment. Companies generating lots of cash, with minimal debt and exceptionally strong debt-coverage ratios, get strong credit ratings. Those are the same companies that interest us. Our focus is on operating cash flow less capital spending – what the company could readily distribute in the form of a dividend.
While consistency is a factor, that’s not to say we wouldn’t invest in a company with negative free cash flow due to a rough patch or the need to make big investments. We’d want to understand the cyclical or other impacts on cash flow and reflect that in a more normalized view over a cycle. In terms of debt coverage, we won’t invest in a company unless it can retire all of its total outstanding debt with free cash flow within ten years.
To put some perspective on that, roughly 20% of the companies in the Russell 2000 Index today have negative debt-coverage ratios, meaning they have outstanding debt and are burning cash. The average number of years needed to cover all debt for Russell 2000 companies is just under 22.
In our small-cap portfolio as of September 30th the comparable number was 5.5. While we like to believe we hit our share of home runs, the strategy is more about not striking out.
Systematic Financial [VII, October 31, 2007] puts a lot of emphasis on screening to generate ideas. How does that generally work with your strategy?
KB: Our quantitative analysts every Monday morning prepare what we call a research focus list, consisting of roughly 200 small-cap and 100 mid-cap companies that trade at low multiples to free cash flow, have limited debt, and have strong debt-coverage ratios. We look at longerterm historical data for cash flows and capital spending rather than just the latest 12 months, to help us correct for recent and temporary aberrations.
If you screen without doing that you’re more likely to miss potentially interesting ideas. I would point out that while the focus list is extremely valuable for idea generation, we’re not a slave to it. Screens capture what the company has done in the past and where it is right now. That can point you in the right direction, but there has to be an investible thesis about where the company is going and how value will be realized in the future.
Take a company like Ennis [EBF], which primarily makes business forms. We’ve owned it in the past and it’s well run, throws off considerable cash, has a great balance sheet, pays a good dividend and trades at a low multiple of normalized free cash flow. That said, given the secular challenges to its business, it’s hard for me to see what’s going to make the stock go up over the next five years. It’s regularly on our list, but it’s not one we’re compelled at the moment to dig into.
What other types of situations have you found that can make high-quality companies cheap?
KB: Rather than the growth stock becoming a value stock, we also find stocks trading at what we consider attractive prices because they’re generally underfollowed and their growth prospects are underappreciated.
A good example in our portfolio today would be Universal Display Corp. [OLED], which sells organic-light emitting-diode technologies that are used in a variety of applications – including smartphone screens, flat-panel TVs and solid-state lighting products – and can offer advantages over other technologies in terms of brightness, power efficiency, weight, display life and all-in manufacturing costs.
Sometimes as a technology is gaining traction and becoming commercially viable, the market gives companies too much benefit of the doubt and overappreciates their potential. In Universal Display’s case, while it’s becoming more recognized, the market in our estimation has taken more of a wait-and-see approach.
But with a strong patent portfolio, multi-year license and supply agreements with companies like LG and Samsung, a ramping overall market for its technologies – and, by the way, $8 per share of net cash on the balance sheet – we still believe free cash flow growth in coming years will support a materially higher stock price. [Note: OLED shares trade today at just under $53, within 6% of their 52-week high.]
Describe generally how you approach valuation.
KB: We analyze businesses to arrive at future expected cash flows and then use a discounted-cash-flow model to estimate what something is worth. Built into that is a required total rate of return of at least 15%. In other words, we arrive at a share price we could pay and still earn 15% per year. We want to pay less than that, but will not pay more.
We take very much to heart Ben Graham’s notion of margin of safety and use what we believe are demonstrably conservative assumptions. If you can do that and still conclude a business is undervalued, that’s built-in margin of safety. Most people think about that in terms of downside, but it can build in upside as well. What if things actually happen to go right for the company?
Given the margin of safety you aspire to at the individual-stock level, why hold 125 positions to further mitigate risk?
KB: We’re careful with position sizes when investing a relatively significant amount of money in smaller-cap stocks that aren’t always the easiest to trade. We want to take advantage of the higher volatility in smaller-cap names – adding to long-term positions when they become depressed and lightening up on those positions when they get ahead of themselves – and it’s harder to do that well when you’re trading around large stakes.
Our maximum position size is 5%, but our biggest names tend to be 2% to 2.5%. By holding the number of names we do and taking into account our sector and industry weights relative to the benchmark, we’re striving to be more consistently good than intermittently great. The very concentrated portfolio can be dramatically off-mark at times, which isn’t to say that makes it wrong, it’s just not the type of risk we choose to take.
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