One of my favorite value investors is Paul Sonkin.
Sonkin is a portfolio manager at GAMCO Investors/Gabelli Funds. He’s co-Portfolio Manager of the TETON Westwood Mighty Mites Fund, a value fund which primarily invests in micro-cap equity securities and he has over 20 years of experience researching small, micro and nanocap companies.
Sonkin was also the portfolio manager of The Hummingbird Value Fund and the Tarsier Nanocap Value Fund and an analyst and portfolio manager at Royce & Associates, Inc. He’s been an adjunct professor at Columbia University Graduate School of Business where he’s taught courses on security analysis and value investing and he was a member of the Executive Advisory Board of The Heilbrunn Center for Graham & Dodd Investing at Columbia Business School.
As if that wasn’t enough, he co-authored the book, Value Investing: From Graham to Buffett and Beyond, with Bruce Greenwald.
One of my favorite Sonkin interviews was one he did with The Manual of Ideas in 2009. It’s a must read for all value investors.
Here’s an excerpt from Sonkin’s interview with The Manual of Ideas:
MOI: What was the genesis of your firm, and how would you describe your investment approach?
Paul Sonkin: I started in December of 1999, so we’re coming up on ten years. I had worked at Royce and then I had worked at First Manhattan. First Manhattan did large cap value, and I really wanted to get back to what I had done at Royce—which was micro cap value—because that’s what I really love. I met with Mario Gabelli and said I wanted to manage his micro cap fund. He had this guy who worked for him who had started a partnership, and he said, Why don’t you start a hedge fund and I’ll give you some money and own a piece of your management company? So that was how I really got the start at Hummingbird. It’s just old-school, Graham-and-Dodd-type value investing.
We’ve pushed the envelope a little bit—Bruce Greenwald talks about doing an asset value based on replacement cost, and then an earnings power value and an earnings power value with growth. The asset value is really Graham’s “net nets.” The earnings power value would be the low P/E. The earnings power value with growth is where you may be paying a full price for the current earnings power but you are getting all the growth for free. We tend to stay in the first two categories, although we have gotten into situations where we are paying for earnings that we firmly believe will materialize, but they haven’t materialized yet—and then we’re getting a lot of growth on top of that for free.
That’s evident in a lot of the positions we have.
MOI: It sounds like a quandary you have as a value manager who wants to look out for your investors. You want them to be in with more capital at a time like this, and yet most people act in an opposite way.
Sonkin: There was an academic study done on Fidelity Magellan. The return of Magellan was, let’s say, 15% over a 15-year period. But if you looked at the actual money flows in and out, the average holder of Magellan only made 4% because they bought and sold at the exact wrong times.
The interesting thing is that while our performance in Q3 wasn’t that great, people penalize us for that. You would think that when the rest of the market has moved, you don’t want to give money to people who have done well; you want to give money to people whose stocks haven’t moved yet. It’s a real quandary, and it takes a sophisticated investor to recognize that we have a strategy that over the long term outperforms.
There are times when value investing doesn’t work. We saw in 2008 one of those times, where you had extreme dislocations in markets. You had people just puking out positions with a total disregard to price. Now what we’re seeing is that people are coming back into the market, but they want to be in the more liquid names. It’s a rubber band that stretches and stretches and stretches, and eventually it’ll snap—and we’re waiting for that snap.
MOI: It seems that with those kinds of companies, a lot of them may not be very sophisticated and there might be a lot of low-hanging fruit that an active shareholder could have management pick off and create value. How would you describe the rewards to activism?
Sonkin: We don’t really consider ourselves to be activist. What we’ll try to do is that if a company is making a decision, we’ll offer some suggestions. Should they buy back stock? Should they pay a dividend? We’ll opine a lot on capital allocation. Managements know their companies and their businesses, and they usually know how to run their businesses, but they’re less sophisticated in terms of capital allocation. We’ll try and guide them to make capital allocation decisions that we feel are shareholder-friendly. Usually, management owns a lot of stock, so if you suggest things that are shareholder-friendly, nine times out of ten, management is going to take your suggestion because it’s also in their best interest.
MOI: Do you need to weight the quality of management more heavily in your decision process when dealing with micro caps than larger companies?
Sonkin: Of course. When you’re dealing with a larger-cap company, they have more of a bench to draw from. But one person in a large organization can still have a meaningful impact—look at the decisions George Bush made. He was running the largest organization in the world, and one man was able to have a big impact.
It’s true that [with small companies] you have less delineation in the job functions. We went to meet with a company yesterday, and we met with the chairman, the CEO and the head of operations. The head of operations was operating as a COO. The CEO plays a big role in the sales functions and the operations and the finance side. With smaller companies, you have managers wear a lot of different hats.
MOI: Do you look at their compensation very closely?
Sonkin: Of course. One of the documents we spend a lot of time on is the proxy statement. It discusses the compensation, the board, and has the certain transactions section, which is where you find the insider skullduggery that’s going on. With a lot of these companies, you’ll find that the CEO owns the building and leases it back to the company; or what expenses are being paid for by the company. Usually, you’re trying to separate the wheat from the chaff with these small companies. If you have an owner-operator, it’s usually preferential to an operator. But we’ve seen different cases—we’ve seen cases where management owns a lot of sock and they still take big salaries and they treat the company like their own piggybank.
What we see with a lot of our companies is that management has significant shareholdings, and they take a rather modest salary because they realize that $100,000 to them is $100,000 in their pocket. $100,000 to the bottom line, if it increases earnings by $0.01 per share, and you put a 10x multiple on it, and they own x number of shares… But it takes a rather sophisticated manager to do all that mental math.
MOI: Your portfolio is fairly diversified…
Sonkin: It’s fairly diversified, though we’ve become more concentrated over time. From this current debacle, there are so many cheap companies. We have tended to buy more stock in companies that we knew very well. We’ve tried to find companies that can execute well against a tepid macroeconomic backdrop. We think we have good companies.
MOI: In terms of broader investment perspective, what would you say are some of the mistakes that keep investors from reaching their goals in the stock market?
Sonkin: You have to find a style of investing that works. You have to find a style of investing that fits with your personality. I’m cheap and paranoid, so value investing works very well for me. And then what you have to do is that once you’ve decided to pick a strategy, you’ve got to stick to it. That’s really where the discipline comes in. Where a lot of people get into trouble is when they’re not disciplined and they deviate into different areas—that’s when you get market cap creep and style drift, which we’ve never had. We’ve made mistakes, and I guess my goal is not to avoid making the same mistake twice, but not to make the exact same mistake the tenth time in a row. It can be very challenging, but that’s what I strive for.
MOI: Seth Klarman put it well when he said that he invests from the bottom up but he worries from the top down…
Sonkin: Exactly. What Seth Klarman does is that he is always looking to overlay insurance on the portfolio and is always looking for cheap insurance. He happened to be in a lot of credit default swaps because they were really cheap. It was great disaster insurance. Inflation protection now is—or was—really cheap, so you’re able to put that on. So what he is doing is overlaying on his portfolio disaster insurance. He is worrying from the top down, and that’s he was able to have such a good year last year.
To read the full Sonkin interview with The Manual of Ideas, you can find it here.
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