International Fund Sub-Advisor Mark Little (Lazard) Looks for the "Best Combination of Profitability and Valuations"
May 2015 Interview
Mark Little is a managing director, portfolio manager, and analyst at Lazard Asset Management. He has run a sleeve of Litman Gregory Masters International Fund since January 15, 2012. Through the years we have followed Little, we have found him to be a thoughtful, disciplined investor with strong analytical capabilities that allow him to cull the best ideas from Lazard’s large research platform.
We often hear questions from investors, wondering how international managers can stay abreast of so many differing economies, not to mention a vast opportunity set of companies. Can you talk about your global analytical resources at Lazard and how you utilize them?
Lazard is a global firm, and as you know, lots of firms will talk about global analysts. The key, we think, is how we’re organized and how we actually work with the people that are on the ground.
Really, [we have] two types of resources.
First would be specialist sector analysts who are based mostly in London and New York, [e.g., analysts] just focused on banks or the energy industry. One of the things to note about those people, they have a range of experience, from junior to hugely experienced people with 20 to 30 years in the industry and very senior in the firm.
They’re not employed to publish research or to provide wish lists. The way that they’re compensated and judged is on the basis of the stocks that we actually own in our clients’ portfolios. If they’ve got a great idea, unless we’re actually putting our clients’ money to work, then it doesn’t really matter. Similarly, if it’s something that we own that they don’t like, they come to see us to tell us the valuation’s too high, the market’s got it wrong, you’ve got to come out.
It really means that the relationship we have as portfolio managers with those sector specialists is incredibly tight. We’re constantly working to the same aim of driving stocks in and out of the portfolios. It’s a fantastic resource for us to have, and a key part of how we generate the ideas.
We’re also able to access the regional and specialties of the firm, whether it’s European managers or [the] emerging-markets franchise. Lazard has a very strong capability, with 30-plus people just looking at emerging-markets stocks. Since they’re based in New York but generally on a plane, we have great world-class places in cities like Sydney or Tokyo, where again we can use that local expertise.
But I think in terms of how we actually work with that, there are really two ways. The parts that come through from the analysts in the form of companies that we’re looking at, but also, as a team, we’re very proactive in working with those analysts. So we’re bugging them with valuation screens or things that are changing. Or companies that have come to them in London or New York. We get on a plane. Often we do that with an analyst.
I’ve just been to Dublin earlier this week. I went to Paris a week ago. Then I’m going to some of the countries that look really interesting in markets right now—Turkey, Russia, Thailand, Indonesia, Macau, Hong Kong—all of which are areas that have seen significant weakness and opportunity. We can’t understand what’s happening in these places from behind a desk in Mayfair or Manhattan. You’ve got to get on a plane and go see what’s happening in Manila or in Istanbul or wherever it is.
You've described your investment approach as looking for the best combination of profitability and valuations—irrespective of market capitalizations. You then divide your investment opportunity set into three categories or types of companies. For the benefit of our readers, could you describe these categories?
Absolutely. As you say, it's that tradeoff between returns and valuation that we're looking for. But what we tend to find is that every stock we own is going to fall into one of three categories.
We will own the classic compounding stocks, where they're generating high returns, high cash flows, and also most importantly have the ability to reinvest those cash flows at high returns. You get a compounding effect on valuation over time that the market tends to underestimate.
That doesn't sound necessarily controversial, but part of what we do is to find stocks that are off the beaten track. So in our International Fund portfolio, for example, we own a stock called Don Quijote. Despite its name, it's actually a Japanese discount retailer.
It's a great business. It's got the cheapest prices. It sources very well. It has a culture and a cost structure that's very different from most Japanese companies and retailers.
The reason it's a compounder is because it's reinvesting that money into rolling out a chain of MEGA Don Quijotes right across Japan at really attractive returns.
It also caters very well to an emerging Chinese tourism demand in Japan. It's just become much easier for Chinese tourists to go to Japan. Don Quijote actually is a store that they can go to buy luxury items.
So it’s a great off-the-beaten-track business that we've seen compound away for many years.
We also own stocks that we call “mispriced,” where valuation is a starting point. Here, the cash flows—the potential profits of the business—are undervalued, often for some sort of short-term reason or cyclical reason. There has to be a reason why the market is going to change that sort of view.
The example here we have in the portfolio would be Antena 3 [Atresmedia Corporación de Medios de Comunicación]. This is the no. 2 television station in Spain. TV stations are fantastic businesses. They have effective capital investment, and they generate huge amounts of cash.
You sometimes get the opportunity to buy these assets about every 10 years when cyclically they're at a low point and you buy them at a trough multiple—a trough sale. They're not generally making much money. But you buy them on a sales multiple, and then as things start to pick up, these businesses make 30% to 40% flat margins that are not at all captured in people’s analysis.
The final example would be restructuring companies. Here, we're buying a turnaround. So we're not buying profits today. We're buying profits in two or three years’ time.
We're watching every quarter for that improvement in margins. That improvement in cash flow. That disposal of underperforming divisions.
A good example here actually would be something like Valeo, which fits actually in all three categories.
When we first bought Valeo in our world of funds, this was just after the 2009 financial crisis. It was priced to make zero or 2% margins forever. You had a new management with a very clear plan to improve the profitability of the business, taking costs out, starting to stand up to its customers, and pricing their products, which are fantastic, much more commercially. So you saw an improvement in the margins in the restructuring.
As that process neared conclusion, the margins went from 2% to 6%. The stock was incredibly cheap for the returns and the cash flow the business was now producing. It was on about 7x earnings, and we felt it was a completely mispriced asset.
Today, actually, that valuation has changed. It's roughly doubled in value. It now needs to justify its place as a compounding business.
It's a high returning business. It's sort of 20% or 30% return on equity. It is now a business that's growing much faster organically than global [car parts] because it makes so many of the new things that are going into today's and tomorrow's cars.
So it's giving high returns with organic growth and unusually very high visibility over several years. That means that the valuation today actually still looks very interesting for a compounding business.
Those are the types of ideas that we find in our portfolio.
Valeo is a great example. I think we have talked before about how the Street is probably still underestimating the shift in the auto parts industry, where the source of returns has shifted from manufacturers to suppliers like Valeo.
Absolutely. I think the industry's changed really materially. Car suppliers have had a terrible history or reputation that's been fully deserved. They tended to be a local supplier with one huge customer. When that huge customer said, jump, or cut your price, they had no choice but to do so. What's happened is, the supplier industry has consolidated to a much smaller number of players. At the same time, the business has gone global.
So [for] a lot of the key components going into cars now, there might only be two or three or maybe four global players who can supply that product or have the technology to provide that product. A lot of the technology and research and development has gone to the suppliers, as well. Suddenly, they're supplying eight to 10 to 15 car manufacturers.
So that balance has really shifted. There are very few people that can provide their technology on a global basis. And individual customers are now much less important for the likes of Valeo.
So you've really seen that shift. You've seen returns and margins materially improve among the supplier base, while there's still quite a lot of pressure on especially the mass-market part of the auto industry.
Speaking to these three categories, are there different risk factors you take on in each? And if so, in what way does that impact your research focus as you're evaluating these companies?
Yes, absolutely. On the compounding side, the key criteria really is to understand whether those high returns are sustainable and [whether] they can keep reinvesting. The questions are: Is your competitive advantage still there? Is the competition coming in and is something changing in the industry? Can you still reinvest? Are the opportunities still there at attractive returns?
Obviously we're watching the valuations to make sure it makes sense, but we're focused on that compounding [effect] over time.
On the mispriced side, we may think something is cheap, but the question is, why is that going to change? What is it that's going to happen that's going to make people realize that this asset is cheap and for the market to revalue the business?
If it's a cyclical business or something that's gone wrong, actually is this is a one-off? Is it a downturn that lasts for a shorter period of time? Or is something starting to structurally change that means now actually we're wrong and it is cheap for a good reason and returns are starting to fall.
However low the headline valuation might be, if returns are going down, it's incredibly hard to make money from that situation. Because you just never know when that's going to turn. Until it does, the market will not give a high valuation.
From the restructuring side, the risk is very clear. These are situations where initial profits and cash flows might be poor. The risk is in the execution. The market tends to be very skeptical about restructurings, and rightly so because they're difficult and a lot of them don't work.
It really is every quarter seeing, is it happening? Are things changing? Are things turning around? Are the metrics on track or are they beginning to slip?
So quite different considerations for the three different types.
How do you apply your approach to the Litman Gregory Masters International Fund portfolio? In what way have you found it to be different from the more diversified portfolios you run?
Essentially, it's exactly the same approach. We're looking for exactly the same things.
In this portfolio, we can put in effectively the highest-conviction names amongst what we're seeing.
For conviction, we're always looking for a couple of things. The obvious one is, we want a lot of upside in our stocks. We want the downside protected in some way by the valuation, by the quality of the business, and by the cash flows.
Then the third part of it that's as much art as science is that something that says, this is exciting because we really believe we understand or know something about this business that the market is not getting. It's that difference between our understanding of the situation and the way a business can be valued, and the market's understanding. It's how that gap closes that's how you really, really drive returns.
It's those three things that we're always looking for in this portfolio. We're putting in those highest-conviction names.
I think the real difference is that we don't need to worry unnecessarily about diversification. So we can just put the 10 [or so] names that we like the most without having to think, what unintended consequences might we have in this portfolio? Because that's all being done by Litman Gregory above us, with the diversification of managers.
That's the real beauty and freedom of what we’re able to do with this very concentrated sleeve of the portfolio.
What interested you in running a portfolio for Litman Gregory Masters Funds?
I think it was a couple of things. Firstly, it was just that freedom to say, here are the eight to 15 or 10 just great, great stock ideas. Those with clearly huge potentials. I need to put money behind the best ideas and to drive potentially exceptional performance.
You have to be very different from the market to be able to perform very differently. And this gives the pure expression of being able to do that. It's a competitive industry. When you find something great, you want to be able to put lots of money behind it and here you can.
The other thing clearly was what we've seen of Litman Gregory over many years. I know I have said this before, but the due diligence process that Litman has is just unrivaled just in terms of its length and intensity and quality of the questioning and the thoroughness of the questioning.
It's clear that the firm takes an incredibly long time to really understand what we do and how we do it. So that's hugely interesting and speaks to the quality of the fund that's created from that. Because we know that same process has been applied to all the other managers that are being invited into that process.
I think it's those two things together. The chance to do that, when we felt we'd been incredibly well checked out, and to run a portfolio like this—it was obviously hugely attractive.
Switching gears a bit. With zero to negative government bond yields outside the United States, some sell-side analysts are justifying 45x or more multiples on some stocks. However, you’ve mentioned good value has been hard to come by. So the question is, what's wrong with that relative thinking in your view? Given that many argue interest rates could remain low for a very, very long time.
I think it's just extremely dangerous. The problem is that people are using very low interest rates in other asset classes to say, we've now got an extremely low hurdle. We apply that to equities and you get a very big valuation number. So the argument is, if Swiss bond yields are zero, then Nestlé should have a 2% dividend yield on 50x earnings.
I think the problem with that is if you seriously believe interest rates are going to be around zero for a very extended period of time, then the implication is that we're going to have very low or negative levels of growth. That's the reason that rates are at that extreme kind of level.
If you model an equity asset with a combination of the discount rate and growth rate, well, the discount rate has definitely come down a lot but so has the growth rate. And I think that part is sort of missed.
We have seen this before [in Japan]. Essentially, for 20 years, people argued that Japan should trade at much, much higher multiples because it had this low cost of capital. For years, we had almost no money in Japan because our clients' cost of capital hadn't suddenly gotten lower, and Japan was in deflation with no growth. In fact, it was going the other way.
The other problem with markets is that if all these stocks are priced at these kinds of levels, assuming zero interest rates, and a lot of the more cyclical areas of the market are optimistic that there'll be a decent recovery and activity in Europe and in other places. What makes us nervous about these groups of stocks is you can’t really have both. If interest rates are zero and there's no growth, then there's a problem with many of the cyclical sort of parts of the market. If we are actually going to get economic activity rebounding, then interest rates aren't going to stay at zero for very long. And then valuations of some very stable stocks as well as markets generally could come under real pressure.
Those are the challenges at the moment from the zero interest rate sort of environment and what it's doing to valuations.
Could you talk about recent portfolio addition Carlsberg Group? Given many of these consumer staple stocks have been driven up in terms of valuation multiples, why was Carlsberg attractive?
Carlsberg is really interesting for two reasons.
Firstly, this is one area of the market where there has been some opportunity—emerging-markets exposure. In this case, Carlsberg has exposure to Russia, which obviously was hit very hard by the collapse in the oil price and the collapse in the ruble.
The first thing that attracted our attention to the stock more recently was that it lagged very materially the very expensive [consumer staple] names. The Russian part of the business was the No. 1 beer company in Russia. It had gone from about 40% profit to well under 20% simply because of that collapse in currency—for what on a local basis is a pretty stable business.
So mainly, that was an interesting entry point [for us] for this kind of asset.
The other part, Carlsberg has very good assets. It has very strong positions in western Europe and other parts of eastern Europe. In Asia, it has a very nicely profitable business in China that's growing nicely.
The assets are very good. However, the way those assets have been managed has not been as good as it could have been.
Management has always been a difficulty for the valuation and the performance of Carlsberg. Again, we got interested in it, and the board has decided to replace the CEO. That got announced essentially just before we bought the stock.
At the same time, they brought in a process of zero-based budgeting. This is where you start your budget for next year not on the basis of last year, but next year at zero. So that's to justify every item in the budget. A pretty painful process, but potentially hugely successful.
Carlsberg's margins for the group are about 14%. We've got them going up to sort of 16% or 17%. If you really applied [aggressive zero-based budgeting assumptions] to Carlsberg, we think they could probably get into the 20s. So there's a huge opportunity to improve margins and returns at this business. And we've finally got a board and a company that's starting to do something about it.
So you had a combination of depressed by the emerging-market oil/Russia opportunity and the real change within the company.
We were buying the shares on about 14x next year's earnings. While not ridiculously cheap, it's much cheaper than [the overall sector]. On top of that, those numbers could be materially too low if they really start to get going on margin improvement. So we could be buying it much cheaper than those kinds of multiples. That's what really made it stand out as an opportunity.
What can hurt you with this stock? The Russian part of the business is not an insignificant part of the business. What other risk factors can hurt you?
Clearly, Russia is still a substantial part of profits. The Russian business has been under pressure even before the oil price collapsed. Alcohol consumption is very high. So the government has been pushing against some of these areas.
It's been a series of regulatory measures, plus a very substantial increase in prices that's putting pressure on the volumes.
I think we could spend much longer than we have today discussing the longer-term structure issues that Russia faces. So there are risks and there is still risk around that profit stream.
[Carlsberg] operates in competitive markets. A lot of those western European markets, yes they have strong positions, but historically, there have been too many players. It's been hard to take price. So that can be a barrier.
In China, they're one of the few companies that make decent money in the beer industry. They’re in western China where there's less competition. In a lot of places there's too much capacity. Pricing's been incredibly tough. Margins are low. So if that competition really spreads to western China, where they are, that could be an issue.
But the biggest risk to our thesis probably would be if what we see as a real change is just not as real as it seems—if it turns out it's minor and marginal and not the kind of sea change that we think is now occurring. So whether it's the new CEO or the commitment of the company to change, that would be the disappointment.
How are you dealing with the strong dollar given the foreign investments in your portfolio?
That's a good question. We don't hedge currency in this portfolio. So we do take currency risk in all the stocks that we own now. [In] a lot of cases, they are global companies. So you've sort of got a natural hedge to some extent.
Valeo, for example, is diversified to the global auto industry. Although it's quoted in euros, and clearly has some of its sales in Europe, it'd be no different to other global auto suppliers.
We don't claim to be experts at forecasting currencies. Again, we're not hedging and we're not trying to predict those precisely.
What we clearly will look at is a transactional problem. We did own Swatch, for example, in the portfolio. And we actually sold it, partly because of the move in the Swiss franc. Now there are other issues around luxury demand and what's happening in China, but essentially, Swatch has a Swiss franc cost base, and it sells its products in euros and other currencies.
When the Swiss National Bank moved to a very big revaluation in the Swiss franc that was a material transactional problem for Swatch that couldn't be hedged or arbitraged away. That was actually one of the reasons that we sold the shares.
So that's sort of the approach we take. It's part of our bottom-up process. We don't think we're going to have a great edge in predicting [currencies].
I think more generally, it's interesting. When we came into 2015, if you read any of the big strategy pieces that came out, essentially the view was very much, well, the dollar has to go up, and the stocks in the United States are going up. The whole rest of the world is going to do poorly.
It was a very, very one-way view.
So, we saw the weakness in the euro and other currencies. But at some point, these things will self-correct—to some extent. When you get those falls in exchange rates, it drives economic activity because you suddenly have an advantage to your exporting, which starts to turn things around.
And we've seen the weakness in the United States driven by the strong dollar among exporters and S&P companies. So generally when everyone is positioned one way, there is a self-correcting mechanism that starts to kick in.