I'm in the only business in which no one wants to purchase something when it is 25% lower in price!
This past week, a client asked the good question of why we would purchase a company such as Mattel which has declined in value and sell or trim our positions in companies which have risen in price - particularly when the company doesn't pay a dividend which is generally at the core of our philosophy and critical to our client's future retirement success. Because this question goes to the core of our investment process, I thought I would share my answer with our friends, clients and investors. My reply email is enclosed as follows:
Dear <John>, It's a very good question and one asked not only by our clients, but also by advisors to whom we sell and my own analysts and financial advisors since we all tend to focus on the worst performing stocks in the short term. Of note, I'm wired a bit differently (ask my wife) and actually prefer for stocks to go down in value so I can purchase more shares at cheaper values. Though I get paid less when the market declines since our fees are based upon portfolio value, our clients income doesn't change as long as the dividend remains stable and/or continues to grow. I often quip that I'm in the only business that when an asset is selling for 25% less, nobody wants it!
This of course leads to your important question as to why we would own a company which doesn't pay a dividend. Though the end doesn't justify the means (and I am unable to promise continued performance), the big picture is that our process has led to our Morningstar 4-star rating (both overall and 10-year) for our Disciplined Alpha Dividend strategy (the U.S. stocks you and I hold in our portfolio). This strategy is again outperforming this year earning just under 2% returns year-to-date while the Russell 1000 Value index (the type of stocks we purchase) is slightly negative through March 15th.
As you correctly note, we generally don't invest in companies which don't pay a dividend as I like to "get paid to wait" while we patiently own companies for the long term. We always invest in companies which I'm comfortable owning for a very long period of time and which I would like to own the business - thinking not as if we simply own shares of a stock, but as business owners. As such, I believe the toys business though distressed, is not dead as my six year old continues to play with her dolls (including Barbie and American Girl from Mattel) with her friends in addition to electronic games on her IPad.
I also very much appreciate the dividend component of our strategy which obviously dominates our process. As such, there are just a few companies which we own which have cut or eliminated their dividend as I have to believe them to be compelling opportunities in which to forego the income. Though so many of these distressed companies have worked out for us (recently like DineEquity), they are also more volatile and can certainly be cheap because they are simply crappy companies in a dying industry wherein I should simply cut my losses. It is this question which keeps me up at night.
Specifically, our process entails purchasing companies which generally have three characteristics (see slide 20 of attached presentation):
1). Value: selling for a reasonable or distressed valuation below what I believe to be its intrinsic value (see slides 18-19);
2). Dividends: provides growing and generally above average dividends (see slides 12 - 17);
3). Global Macro: has potential for earnings and revenue growth both domestically and often abroad. In addition to the micro, this characteristic also includes a macro framework in which we may find value in certain geographic areas of growth or a sector/industry which we believe to be undervalued (see slides 8 - 11)
Within that value framework, we also purchase companies which fall into three categories (see slide 21):
1). Classic Value: These are companies which usually sell for lower valuations and contain higher dividends. i.e. financials, health care, energy, etc. This section generally makes up the largest amount of our portfolio unless we are in a recession;
2). Persistent Earners: Companies which are selling below their historical valuations and are reasonably priced. This section is generally the second largest in our portfolio as we are usually unable/unwilling to purchase richly valued companies unless the entire market has sold off driving valuations down for everyone. Currently, Pepsi is an example of a company we own whereas Boeing would be one in the category which we don't. Though growth managers may continue to drive Boeing higher paying a rich valuation of 20 times forward earnings with an average dividend of just 2%, the downside risks for such companies is large as exhibited from Boeing's recent 8% decline in the past two weeks.
3). Distressed/Contrarian: These are companies which everyone hates, and continue to sell, exacerbating price declines. i.e. Mattel, Pitney Bowes or Teva. Due to the volatility in this category, this is almost always the smallest portion of our portfolio and contains very few names. This category can lead to companies which have tremendous gains when the consensus is wrong on them (such as past holdings Caterpillar, Dow Chemical, Darden Restaurants, Western Union or recently DineEquity), but also may include companies which truly are going out of business. Though Warren Buffett is now too large to invest in such companies, he used to do so often and called them "cigar butts". They are companies which have been thrown out, but still have a few puffs of smoke in them. The stub may be ugly and soggy; however, it is still producing some smoke (revenue) and may have value left. Though buying companies under their book value as his professor and mentor Benjamin Graham encouraged is effectively impossible in decades post the Great Depression, the theory on purchasing such "tossed away" companies remains the same.
There is of course no mathematical formula for which one can produce an algorithm with the above metrics to spit out companies in which to invest. Thus, there is more art than science employed when purchasing any company in which I decide to invest understanding that I could screen out every available company if I wanted it to fit perfectly into our investment process. The process merely acts as a framework for which to make decisions thereby leading us to purchase companies such as Mattel which sometimes don't pay dividends. If it makes sense to me that the management has cut or eliminated the dividend for a good reason, and I believe that the company's prospects are sound for a turnaround over the long term (5-10 years), then I will invest in the company.
You'll notice from the attached chart, that we have owned Mattel a very long time dating back to December of 2007. During this period of time, we have outperformed and underperformed numerous times - with recent performance over the past couple of years obviously underperforming. From the second chart, you'll also notice that there is a tremendous amount of short interest (~ 22% currently) working against the company. You'll recognize that as the stock price has declined, there is an almost perfect correlation of short interest moving higher. Thus, if/when consensus moves against short sellers and some good news materializes (it usually doesn't take much), short sellers are forced to cover their positions thereby driving the price higher. In today's investment environment, there is a proliferation of long/short strategies which pushes managers into growth/momentum stock positions (i.e. long Hasbro) while selling short those companies which are declining in price (i.e. Mattel). This is truly herd thinking and the type I avoid as it can lead to catastrophic losses as I've seen numerous times during my 21 year career. I've actually dedicated a good amount of my upcoming book on both this phenomenon (momentum vs. value investing) and the explosion of alternative investment strategies which I believe to be the latest fad. These alternative strategies coupled with leverage and the algorithmic trading which is so frequent are leading to the extreme volatility we see from time to time.
Regarding your question on equal weighting: Long before the term was hijacked into a marketing ploy by financial companies, we have employed a "smart beta" approach, or more simply, an equal weighting of our positions wherein we purchase more shares of companies which have sold off (i.e. from 0.8% to 1% adding shares of Mattel) and selling shares which have appreciated in value (i.e. from 1.4% to 1% selling shares of Apple, JP Morgan or Intel). This strategy ensures one position doesn't dominate your portfolio over another. Though counter intuitive, trimming and/or selling the out-performers and buying underperformers is exactly the action that value investors do. This action is also critical from a risk management function in my opinion.
From a philosophical standpoint, why would one want to pay more rather than less for an asset? Doing so would be akin to regularly swapping homes in an expensive neighborhood simply paying more each time for your neighbors' houses. Our approach would be to sell your well appreciated home in your expensive neighborhood and move to a neighborhood which provides the same shelter and comforts (hopefully in an up and coming neighborhood) and at best purchasing a multi-family home to live on one side while having the other half of the home provide rental income (dividends) for which you to live while the homes fluctuate in value. The deepest distressed/value investing is going into dilapidated/burned out neighborhoods believing a revitalization will occur as a city's population pushes further out into the suburbs. This is obviously riskier - while also entailing more patience and time - which is why I don't invest as often in such companies as Mattel, Pitney Bowes or Teva.
I know this has been an exhaustive summary so please don't hesitate to call us should you have more questions. I believe the question is an excellent one and gives me a chance to answer something I was going to put in my book (and likely an upcoming blog) since it is so often on many client's and investor's minds since it is counter-intuitive.
Click to download our Mattel Chart, our Mattel Short Interest Chart or our Unconstrained Fixed Income Presentation to Learn More!
