(Ep.119) The Acquirers Podcast: Bernard Horn – Global Master: International And Global Deep Value Investing

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In this episode of The Acquirers Podcast, Tobias chats with Bernard Horn, founder and principal at Polaris Capital Management. During the interview Bernard provided some great insights into:

  • When Value Investing Was Like Shooting Fish In A Barrel
  • Building A Low-Correlation Global Portfolio
  • Knowing When To Sell Made Easy
  • Value Investing Comeback
  • Moore’s Law & Inflation
  • How To Filter 40,000 Global Companies To Find The Best Investments
  • Value Investing Globally Before The Internet
  • Building Global Portfolios In An Interconnected World
  • Global Accounting Standards Are Not All The Same
  • When Low-Correlation Global Assets Yielded 14% Dividend Yield

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Full Transcript

Tobias: Hi, I’m Tobias Carlisle. This is The Acquirers Podcast. My special guest today is Bernard Horn. He’s the founder and principal at Polaris Capital Management. He’s giving us a masterclass on Global Value Investing, coming up right after this.

I love that little tidbit in one of the notes that you started out hand-entering the data into your Apple II computer.

Bernard: Yeah. This goes back to 1980. I started my first company in 1980, In fact, we’re just interviewing a young new graduate with a computer science degree. We asked us how– Is technology an important part of our firm as well? It started out that way, and I was explaining that my first Apple II computer which had 64 kilobytes of memory and a cassette tape recorder. You had to load the operating system from a cassette tape. You put it in the recorder, you had an AV jack that went into the computer from the cassette. You had to time the play button on the recorder, so you hit the play button, and the return button on the computer, and it read out the operating system into the computer. That’s how you booted the computer up. Then, you’re up and running for [laughs] as long as the computer would stay there, but [crosstalk] Apple.

Tobias: It’s funny. I had a Commodore 64, and it was the same [crosstalk] had the tape.

Bernard: Oh, yeah. Right.

Tobias: You had the crazy little– that I could remember by. I had it by memory at that time. It completely lost in– and it had this crazy little command string you had to type in.

Bernard: Right. Yeah. To get it to go. [laughs] [crosstalk]

Tobias: You started a precursor to Polaris in 1980, same strategy, same focus?

Value Investing Globally Before The Internet

Bernard: Yeah, basically, exactly the same strategy just many evolutions ago. But basically, the same fundamental value, underpinning your cash flow, underpinning the concept of value. Back then, there were a dozen countries in the world you could invest in, and I had to learn that all from the ground up, and it was not just the investment side of it, but the operational side was not trivial back then, because– [crosstalk]

Tobias: Yeah, I can’t imagine. Was that unusual to be invested globally in 1980?

Bernard: It was very unusual. It was unamerican in the minds of some people. The Dow Jones 30 was what everybody focused on if you can imagine a world like that. The S&P 500 was just being used as an investment concept. Dean LeBaron had set up a Batterymarch Financial Management with Evan Schulman, who was the Fortran programmer, who did a lot of the trading systems and the data systems, but they were very avant-garde in the business back then, because they suggest that people actually might invest in the market portfolio, which was the S&P 500.

That was a shock to everybody in the business. It was very disruptive, as we think about the word today. But I interviewed him before I started up my company. At the time, when I was studying finance theory at MIT at the Sloan School, there was a lot of literature suggesting that if you invest it outside your home country, you got a tremendous amount of risk reduction, because the correlations– especially back then, the global economy was the global economy, but it really wasn’t so integrated.

When Low-Correlation Global Assets Yielded 14% Dividend Yield

Consequently, you could find companies that were in their own world, selling electricity into the Spanish market that had nothing to do with the rest of the world, only the industrial production in Spain. So, there were great low-correlation assets that you could buy all around the world, and Spanish utilities in 1982-1983 gave you a 14% dividend yield, and a whole lot of upside and not so much downside, because the economy ultimately was growing. My idea of at least the academic literature at the time suggest that the market portfolio wasn’t the Dow Jones 30. It could be the S&P 500, but I thought it was way broader than that. I just felt if you’re really going to– The market portfolio should be the global equity universe, and that’s basically what I started out doing in the early 80s.

Buying at the time low PE stocks, although– I knew because I was a coop student at the Gillette company for over a five-year period. One stint I did was at the financial reporting department, which was responsible for assembling the financial statements for all of Gillette’s vast global subsidiaries and consolidating all those financials up into a consolidated financial statement. I knew from looking at the subsidiary in Belgium, and Germany, and Mexico, that the accounting standards back then were drastically different from one country to another. When we were trying to convert the subsidiary financial statements from all these other countries into the parent company financial statements, I knew pretty quickly that the world was very different once you step outside your home country, and I knew too that there were many strange accounting concepts, for lack of a better word.

The CFO at the time at Gillette was Tom Skelly, a wonderful, wonderful man and an extraordinarily knowledgeable person. Even though, he was CFO of this big global company, he would always wonder– His German CFO at the Braun company, which sold shavers, and a bunch of other things, he was always surprised that the earnings of that subsidiary were rock solid and steady. He knew it was impossible for that to happen. He would always be amused that he could never seem to find wherever the reserves were that that German CFO had squirreled away, so that he could pull them out whenever they had a down quarter, and everything kind of was smoothed out. I knew to be skeptical [laughs] of financial statements in the mid-70s. I knew that the cash flow– The cash flow statement was more difficult for everybody to manipulate than it is today, here we are, 40 something years later. So, I always felt cash flow, A, was from an accounting point of view, more of a pure statement of what a company’s really earning.

Quite frankly from my perspective, no investment is worth anything, except for the cash flow that it generates for the holders of that security or that company, or whatever it might be. I learned very early on that cash flow was the primary metric of value and we’ve been doing that ever since. Yeah, going back to the 80s, the basic tenets of what we do the value concepts that we use today were very much born on that. The whole DNA of what we do today was born out of this academic research that said you can get better low correlations, you mix them together, you drop your volatility, you don’t really sacrifice much in return, because equities are pretty much going around in the same return around the world.

When Value Investing Was Like Shooting Fish In A Barrel

Back then, it was like shooting fish in a barrel. You could go around the world finding companies that nobody even heard of before. Obviously, they were heard of by the locals. But the mispricing of assets from country to country was stark, and very, very fun and make decent amount of money. But there were risks like everything. There’s not all upside. There’s a lot of downside. In a fairly short period of time, I lived through more crises in international markets, because I was just in them. Hong Kong had a minor real estate crash. It killed the market for a while. I was talking about the Spanish utilities. There was a reason that they were yielding 13%, 14% was because there was a minor economic crisis there. No matter where you were you, the frequency that you would experience crises was much greater. So, I felt I had a much quicker baptism by fire if you will, and got used to navigating this volatility and understanding how you might mix it together to create better portfolios.

Tobias: When I look at the long history of equity pricing, early 80s must have been, that was a very cheap period in the States, perhaps a very cheap period globally. What was it from your perspective?

Bernard: There were clearly some undervaluations, primarily born out of the 70s. Because the 70s was really the first time in at least US stock market history, where you had stagflation, tremendous inflation, the most important aspect of that is that it was unexpected inflation. Consequently, lots of things had to adjust that had never adjusted before, because you had the 60s, which was the golden era of US equities. The 50s was kind of a growth period when everybody came back from the war, had lots of babies, economy was growing like gangbusters that fed into the 60s.

So, the 70s was this massive shock to the system where you had– Cheap oil was going to be there forever, and all of a sudden, people were lined up at gas stations. You had tremendous inflation, stagnated the economy, and bond investments that had been– I had widows come into my office in the early 80s whose husbands had bought them bonds in the 60s for their retirement. A 4%, 5% bond, you can imagine what the duration risk on that longer term bond was, when the coupon was at 4%, or 5%, or 6% in the 60s. Then the 70s hit, and T bill yields went to double digit.

The long-term bond yields went up and the value of these– Poor widows, bond portfolios dropped in half. It was 1% or 2% change a 30 year gives you a real nice downdraft in your portfolio. I was trying to do financial planning for people to get money under management, and they’d come in with these portfolios that had been devastated by the 70s. There was tremendous value in that context. The problem was that for a lot of people, the opportunity was the result of their portfolios getting pretty beat up.

Quite frankly, the memory of that inflation, and I think this is what people don’t really appreciate about unexpected inflation, and to some degree that memory exists today in the minds of many investors. But the actual double-digit inflation in the 70s only lasted a year or two. But the interest yields were way higher than inflation and persisted for years after that and as a result, kept valuations low. To come back to your question, the memory of that decade of the 70s, when equity prices flatlined for a decade in the US, which had never happened before, that created this real angst about, should I invest– I don’t want to invest in bonds. Equities had been decimated. There’s no real money going into it. A very different world than you have today when every week is another trillion-dollar stimulus, free money being showered on people and like this tremendous money is pouring into all these various assets.

It was a very great, it was a very interesting time in the investment business, and there were tremendous values, but at the same time, you had to believe that it was going to someday turn around which starting 1982, which was fortuitous for me, because I started my first business in 1980. It really started to turn around. Volcker’s high interest rates to tame inflation worked. The only thing that persisted was these things called COLA, C-O-L-A, Cost Of Living Adjustment clauses, that were basically In almost all contracts back then, including labor contracts. Wages, prices, input costs to companies, all got indexed into the pricing, and it created this feed into inflation that persisted for a long time. It wasn’t until, we had a recession that quiet that down and then people had to go out and get jobs and so forth. It was a very different time.

Moore’s Law & Inflation

Tobias: When you look at the investment landscape now, some would say that the COVID shutdown has created some unexpected inflation. There’s an argument that it’s transitory. How do you think about that, and put it into your investment process if you would?

Bernard: Yeah, I’ve been saying for years– I’ll come back to this when it comes to our investment process, but for years, we’ve been analyzing a great deal of deflation in the prices of the goods and services that the companies that we can invest in. They’ve had a very difficult time pricing higher than inflation. When I worked at Gillette, the product managers in the 70s because of all that inflation, their instruction from the C-suite was to be sure that your products were priced ahead of inflation. Pre-COVID, that was not so easy, and many companies have had a very difficult time doing so.

But I think going into COVID, we were in a period of deflation. Coming out of it, we had this biggest working capital cycle in the history of business. You shut down the whole global economy. You don’t have any sales coming in, so, you collect all your receivables as quickly as you can. Pay your payables off if you can, work your inventory down, and don’t order anything, because you don’t know looking into the abyss, when the economy is going to restart. It’ll be a few weeks, it’ll be six weeks, then turned out to be a quarter, and it was two or three quarters.

But then, when everybody restarted that global economy, the working capital cycle has restarted. It’s the first time that the global economy has restarted all at the same time. Yes, there are shortages. I think you throw in the stimulus, shutting down schools, so parents can’t go to work, daycare is not there, people being paid unemployment insurance as a safety net, but that’s sticking too long probably from where it is. So, this restart of the working capital cycle clearly is putting upward pressure on companies, and they’re able to actually raise prices, which is for the last 10 to 15 years and longer for many companies, a real newfound thing.

Some managers have never been able to raise prices. Now is the first time they’re actually out there raising prices. They’re feeling pretty good about it, and the one thing as far as a transitory question you’re asked, the one thing that I see, that reminds me a lot about what I just spoke on in the 70s is that companies are telling us– We asked them, “Gee, you’re getting all these price increases. You’re can’t ship stuff. How are you dealing with those costs?” The normal answer pre-COVID was, “Well, we’re getting hit by higher energy costs, but we’re able to save money over here, because we can’t pass it on in pricing. Therefore, we’re having to really keep our operation running more and more efficiently all the time,” and that’s a continuous improvement process. Today, you ask the same question, and they’re saying, “Well, we’ve negotiated with our customers that we can pass along the price increase.” That’s happening more and more. It almost reminds me of that period in the 70s.

As far as is inflation going to be transitory, I would have said pre-COVID, not at all. Its Moore’s law will come back with a vengeance, and it will drive prices down, and if that doesn’t do it, low-cost countries where people are willing to work 50 weeks a year, seven days a week with two weeks off, that deflationary pressure on labor is going to persist. Look, I think it’s probably going to be– I think that those powerful forces of the deflation forces are probably going to come back, but in certain sectors, we’re definitely seeing pricing power that we haven’t seen in 15 plus years. I think it will be a little bit longer than transitory, but of course, the definition of transitory in the minds of central bankers these days– Central bankers have been trying to create inflation for over a decade. If that’s their definition of transitory, I don’t know what it really means for us in terms of inflation pressures, but yeah, I think that that’s the– Yeah.

Building Global Portfolios In An Interconnected World

Tobias: When you launched in the 80s, you were talking about, you go to an individual country, and you’d find that it was uncorrelated to the rest of the world, and it seems that we live in a much more interconnected world now, and probably COVID is a pretty good demonstration of how interconnected we actually are. How does that change the way that you invest? Do you agree with that characterization that we’re becoming increasingly interconnected?

Bernard: I don’t think there’s any doubt we’re more interconnected. I think the answer to that is absolutely yes. As far as building portfolios in an interconnected world, how can we do that and still somehow achieve these correlations? I think that one has to be a lot more careful in the construction to achieve that these days. Especially, when it seems like every day you come in, you look at the screen, and somebody pushed the button that says, today’s a value day, and then the next day, they press the button, and it’s a growth day, and it seems like where’s all the low correlation?

I have to say that there are still clear examples though, where a company is invested or does business in a particular geographic area or a niche in some industry somewhere in the world, no matter what happens on Wall Street or Washington, their business is going to keep chugging along, and it’s not going to be particularly correlated that well with the overall market. We can see that in our screens. We still have a surprising number of companies more than half that come through with low betas, and we do a ton of work on looking at what’s beta. What’s good beta? What’s bad beta? I can’t tell you how many hours we’ve invested in that very subject. But it’s a very interesting problem, because the world is definitely interconnected. You have to really be careful in your stock selection.

At the end of the day, what we look at, as I said earlier, is we just really focus on cash flows. We try to identify what’s the ultimate source of that company’s cash flow? Is it correlated with a whole bunch of other things in our portfolio?

We can find a lot of companies where the units that they sell, the prices that they sell at are not necessarily correlated with what else is going on. We try to find as many of those as possible. Of course, the bigger the companies you invest in, the more globally diversified they are. the more interconnected they are. I think we’ve always been of the view that we’re completely agnostic as to the countries we invest in, the industries we invest in, or the size companies. A good part of our portfolio tends to be not large cap.

Not mega cap, I would say. We just try to do the best we can, we try to understand every company’s cash flow, the source of that cash flow, and be sure that we don’t have a huge bet on some factors, all of which contribute to the cash flows on a big part of our portfolio. But you can clearly find a bunch of companies that are not connected. But the stock prices, like they say, in a crisis, the only thing that goes up are correlations.

Tobias: [laughs]

Bernard: The fundamentals of the business could be perfectly uncorrelated, but the stock price will go down at the same time. That’s what you have to live through as a value investor, as any kind of investor these days, I think.

Global Accounting Standards Are Not All The Same

Tobias: There’s been an effort I think globally to make sure that accounting from country to country is reasonably standard, so that if there is implementation which is distinct from that practiced in the US, but there’s still reasonably comparable. Do you find that the accounting is more tractable now than it was when you started out? Does that process still have some ways to go?

Bernard: It’s definitely more integrated among the accounting regulatory bodies. They do try to make it a little bit better. But there are still some pretty big differences. I would say overall, the accounting bodies try to be consistent, but there are still some pretty big differences among countries. The bigger differences though are within sectors. For instance, a steel company’s income statement, balance sheet, cash flow statement is going to look very different than a software company. That’s really where we see these accounting differences. They will likely persist because the industries and the businesses themselves are so very different. I think that’s where we tend to spend a lot of our time just trying to decipher what those differences are, adjust for them, and try to automate as much as possible those adjustments.

How To Filter 40,000 Global Companies To Find The Best Investments

Tobias: Given that you’ve got a global portfolio, and you’re tracking a very large number of companies, how do you then whittle down from the very large screen to what ends up in the portfolio?

Bernard: Well, we start with a massive amount of data. We have a database, which most people can get at them these days. But there are about 40 plus thousand publicly traded companies in the world and that’s our universe. Now, if you look at that universe, a large part of it are tiny companies that are virtually– most of which– a lot of them are un-investable. $25 million market cap stocks, these are small operations you can’t buy a lot, but they do populate the database, and they are available especially for some of our small cap funds. We have two small cap funds.

So, those are available, but we take this universe and really what we’re doing is trying to find– The very question is which companies are priced to give us a return that’s going to allow us to beat the benchmark. We have a corporate manager would have a weighted average cost of capital, a discount rate, or hurdle rate. We have what we call a Polaris Capital global cost of equity. It starts at 7% real after inflation, and that’s what index funds over many decades have returned to equity investors.

Our clients can take their money, put it in an index fund, and as long as the 7% that’s occurred for the last 75 plus years, is the same returning again in the future, then 7% is the number that we have to beat. If we give people back a 7% after inflation return, what do they need us for? They can go get that in an index fund. The only way that we should invest in anything is if we can beat that return. We say, at least start with 200 basis points. We say, our hurdle rate is the benchmark return of 7% plus another 2%, and then because we’re investing around the world, we do something that’s rather elegant but relatively simple.

We also try to adjust for the exchange rate risk that is inherent whenever you step outside your home country. To solve for that problem, we look to the efficiency of fixed income markets, and we believe they’re extraordinarily efficient. The interest rate arbitrage is quite strong in fixed income markets. We look at the real bond rates from one country to the other, and we add that real bond rate to our 9%. You have 7% plus 2%, plus the real bond rate.

The idea is that if we take our client money and go outside their home country, wherever that client might be, and let’s suppose that Brazil has a 3% real yield on their 10 year, that’s the fixed income markets telling us that, if you put all your money in Brazilian reals, you think you’re getting another 3% over your US dollar rate. But probably the real is going to depreciate against the dollar by 3% a year, and you’re going to be back into dollars at about the same price. We want to make sure that, if we do go invest in an equity outside, and we do suffer a 3% exchange rate loss that when we’re back into the client’s home country, we still got that 7% plus the 2%, and we’ve justified our existence. That’s the way we think about.

We take this universe, find companies that are priced to give us that hurdle rate, and that gives us our working list. From there we go on to dig deep into the financial statements of the company and try to find which of those companies are fairly priced. Now, they look optically very cheap, but maybe they’re cheap for a good reason, because whatever. It’s not well managed, it’s in a declining industry, and so on and so forth. Our job is to find out which of those companies are mispriced such that we can make that excess return going forward over time. That’s what we do on a day-to-day basis.

Tobias: You include in that some company visits, how often are you visiting the companies in the portfolio?

Bernard: Pretty much all the time. We typically spend about 25% of our time on the road. We haven’t obviously done that last year, but we look forward to doing that again. We see a lot of companies coming through Boston. It’s one of the centers for financial investment management in the country. So, pretty much most companies that want to talk to investors work their way through Boston at one point. We have a chance to see them here. Now, whether that’ll happen post-COVID is an interesting question. I think the burden will be on us more to go out and see people as opposed to waiting for them to come see us going forward.

But clearly, understanding the database is important. Understanding the financial statements is really important. Reading the financial annual report from the back cover to the front, going through all the notes of the financial statements, it’s there where you find a lot of reasons why the stock is undervalued, because there’ll be a huge pension liability. Maybe the leverage, maybe the terms of the debt are such that the capital structure will impair the ability of shareholders to get money out of the company in terms of cash flow.

Then, you have to decide what companies are well managed. If the management team, quite frankly, is taking that cash flow that looks like they’re generating, but they’re wasting it and destroying shareholder value, well, that’s probably one reason why the stock might be inexpensive. Trying to find the companies where the management teams really get it, where they have good strong leadership, where they’ve really know why they take $1 and turn it into $2, and have some left over for shareholders. That’s the hard part, because markets are extraordinarily efficient and trying to find those companies that are mispriced that are also going to deliver strong sustainable cash flow to the shareholders. That’s the thing where we have to spend all of our time. That’s how we add value.

Building A Low-Correlation Global Portfolio

Tobias: Once you’ve found these ideas and validated them, add it to the portfolio, how do you think about sizing in the portfolio individual names, industries, countries. How does that work?

Bernard: Yeah, that’s a little bit of the art, and there’s a little bit of science to it, but there’s a lot of art as well. We try to make sure that we can– At the very top view, we try to find– Think about constructing a portfolio, where we have minimum variance in the cash flows of the companies, we’ve invested in. Let’s suppose we have a 75-stock global portfolio.

With 75 companies, let’s suppose we merge them all together. Each one of those companies has a stream of cash flow going forward. Now, if they were all in one industry, the cash flows will go down at the same time, they come back at the same time. Obviously, that’s the classic case of diversification. We want to have some cash flows in that industry, and some in another, and some in another, and geographically will also affect that. So, we try to construct a portfolio so that the cash flows in the companies are somewhat low correlated with one another. We do that as much as possible.

Of course, at the same time, the market’s only giving us valuations in certain sectors or countries, which represent good value for one reason or another. That is going to be a big departure from the typical benchmark. From the get-go, we’re going to be away from the benchmark. Now, we just have to make sure that as we are away– so those are by definition of big bets, and so we want to make sure that we’re not outsmarting those big bets by trying to overweight or underweight certain things, because we’re already over and underweight by looking at our screens. What we wind up doing is we equally weight the portfolios in terms of sizing. A lot of the inefficiencies in today’s markets are not in the $100 billion, a trillion-dollar market cap stocks. Maybe those trillion-dollar market cap stocks are really overvalued, but they only go up anyway.

Tobias: [chuckles]

Bernard: It’s hard. [laughs] We’ve all been there on the– Anyway, we equally wait them if there’s some small cap, medium cap stocks, and we can’t put a full position in then we would make it a half position, a quarter position, whatever makes sense for us. So, our 75-stock full positions might drift up to 80-85 companies, because we’ve mixed in some small and mid-cap stocks in there that we can’t put a full position on. That’s what we feel. We know sitting here today that there’s a mistake in some company in our portfolio, we just don’t know where it is, we figure it’s randomly distributed.

A mistake to us is anything that doesn’t perform better than the benchmark. Theoretically, if we were brilliant, and we knew all our mistakes were, we wouldn’t make the mistakes, maybe we wouldn’t be human or would be superhuman, or something like that. But there are some things that are just unpredictable. If an earthquake creates a tsunami, it washes out a nuclear plant in North Tokyo, and they shut down that nuclear plant, and now the cash flows from that company dry up, and oh, by the way, that population gets extremely nervous about nuclear.

So, they shut down all the other nuclear plants in the country, and even if you’re invested in something else, that cash flow changes. That forecast that we had, the future forecasts of the cash flows on some company could be completely unpredictable from anything that we could fathom. I think that that’s something that– We know we’re going to have mistakes, so we try to diversify as much as possible, and we try not to outsmart the randomness of markets too much.

Knowing When To Sell Made Easy

Tobias: How do you think about adding, and trimming, and rebalancing, is that something that you do?

Bernard: Yeah, we do that. The bulk of our portfolio changes come from normal portfolio turnover. We screen, we find companies, we do the due diligence, they come up to be a great buy idea. Now, we have to put it in, the only way we allow that to happen is if we kick something out of the portfolio. So, there’s this natural evolution of the portfolio, and usually, what happens is that, when we go to buy something, we take something out. Then, we in the process of doing that, we have to reconfigure the portfolios a little bit. There will be times when we buy something, it’s equally weighted, we hit it. Company takes off, it’s overweight in the portfolio, or the opposite happens. Like many value investors, you buy something, you think you got it timed, but then something happens and it goes down, and now it’s underweight in the portfolio.

Well, those underweight will tend to keep in the portfolio for a little while. We’ll understand what it was that made that stock stumble. We can monitor that, and when that uncertainty or risk is resolved, we try to get that right, and then bring it back up to full weight. We’re pretty good at that. We’re actually very good at that. The selling is not so hard, because we tend to have such pedestrian forecasts of company’s cash flows. We know what the historic minimum and maximum margins, growth rates, pricing, volume, and so forth is in a company. We’re always undercutting that in our future forecasts.

Therefore, we have a buy and a sell price. Now, when the company stock price goes up, and all of a sudden, we look at that stock price and say, what assumptions do we have to make in terms of sales, margins, and so forth, to justify the current stock price? When all of a sudden, we have to assume peak margins. We have to assume growth rates on a 5- or 10-year basis that they’ve never been able to achieve before. It’s pretty obvious that the stocks valuation is stretched, and those are easy sell decisions, and then we recycle that money into new ideas as well. We try to let our winners run, we try to time our losers back in at the right time, and that’s the way we manage the portfolio.

Value Investing Comeback

Tobias: Given that it’s been a tougher decade for value and the US markets have been very, very strong, international equities have suffered as by comparison. How do you feel about the coming decade for value and for international portfolios?

Bernard: Yeah, I think usually anything that underperforms for so long, at some point, it’s going to revert back to the mean. I feel that there’s a certain amount of comfort in that basic mathematical approach to investing. However, I will say that I think this separates us in some ways from other value investors. One of the things that I said earlier, and we don’t really talk about this, because it’s a bit of the secret sauce that we do, but when we look at companies, we only buy companies that give us a return that’s better than the expected return on the benchmark, as I said earlier. When I said that, I refer to real returns after inflation returns.

We’re looking at companies that have to beat a certain real return. When we do that, we need to forecast future cash flows in real terms, which not many people do. When you do that, you have to look back in the past and say, has this company been able to raise prices? Has the price per ton of paper been growing faster than inflation, or has it been growing in real terms, or negative in real terms?

I have to tell you that industry to industry to industry, we have found that because Moore’s law has permeated the global economy so much that what you see in computer chip prices, where every year they go down in nominal terms, and they go down massively in real terms, that same pricing pressure happens in the paper industry, it happens in mining, it happens in services, it happens in investment management companies, [chuckles] because people use computers to price up portfolios and manage them, and that drives prices down, investment thesis down.

So, I don’t think people truly appreciate the impact that this is having on future cash flows in real terms. I think what a large part of the value underperformance has been for the last 10 or 15 years is this Moore’s law playing out in the global economy as it’s getting more and more diffused. I think that what looks optically very cheap, isn’t always sustainable future growth in real cash flows.

I’ll say that much in saying that I do think that value can come back. I know there’s this idea that it can revert to the mean, but I think what we do differently than what I think other people is that we focus extremely hard on the ability of companies to price their goods and services higher than inflation going forward. That comes from innovation, that comes from pricing power of one sort or another. I think in the last 9 out of the last 11 years on our international equity mandates, we outperformed the benchmark, when value had no business outperforming the benchmark. And same on global, I think we’ve been underweight the US economy, the US market, which if you did that the last 10 years, you’re toast to begin with, but notwithstanding that, we still I think outperformed in 6 out of the last 11 years. The benchmark not just a value benchmark.

I think a lot of it has to do with this idea of looking at company’s ability to grow cash flows in real terms. Because look, the only reason you invest in equities is not because you like to see your portfolio go up and down by 22% standard deviations a year, around 6% or 7% mean. The only reason you want to take that risk is because you believe that company will grow their cash flows in real terms, because if their costs go up, they can do something to either control those cost increases by gaining on efficiency and productivity, or raise prices or do a whole bunch of other things, innovate.

It’s that behavior in the private sector that allows cash flows to grow in real terms, which ultimately grow stock prices in real terms. But I think it’s become a lot more difficult over the last 10 or 15 years, and it’s probably going to get more difficult. We have to find companies that are going to be able to defeat this kind of deflationary pressures of technology and the whole global competition. People working in Cambodia, and Vietnam, and China, and wherever, who are willing to do things that in developed world countries that people get paid too much to do.

Central bank policy has a really hard time changing Moore’s law. It has no effect. For central bankers to think that, by increasing the money supply or by quantitative easing, they’re going to change Moore’s law? Good luck. They can’t wave a wand that magically equalizes wage rates and productivity rates across countries, so you’re always going to have these deflationary forces. I think the question is, are the developed world countries and companies able to overcome those deflationary forces?

I think that that’s really what’s key to determining whether value is going to outperform growth. Growth as being, people pay premium for growth, because cash flows are growing in real terms, and that’s what it’s about. So, it’s not what value investing was when I came into the business in the early 80s, when you just bought low PE stock I mean. I did my thesis on Fischer Black, and he had a page in the value line investment survey, which was their advertisement, and their justification for value investing is buy low PE stocks, and it work back then.

Tobias: [chuckles]

Bernard: But it’s a little more complicated these days with technology, and Moore’s law, and all these other things.

Tobias: Look, I think that’s a perfect note to leave it on. Bernie, if folks want to follow along with what you’re doing at Polaris, how do they go about doing that or get in contact with Polaris?

Bernard: I suppose like everybody, we have a website. It’s a polariscapital.com, and just get us there, and we’ve got a relatively small firm. We’re a boutique, we don’t try to be everything for everybody. We have a very small number of clients, about 45 clients or so. The secret, I think, is to try to keep the portfolio team focused on research and investing in getting good returns. We don’t do a lot of outreach on marketing, but we do have a lot of funds. So, we try to focus people on investing in our funds, and keeps us efficient, and we know the returns are better in funds anyway.

Tobias: Bernard Horn, Polaris Capital Management. Thank you very much.

Bernard: Toby, wonderful to speak with you. It’s a great honor, and thanks for having me.

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