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Focused on Value - Sprott U.S. Media (30/3/2017)

Focused on Value - Sprott U.S. Media (30/3/2017)
By Sprott U.S. Media 3 years ago 19102 Views

March 30, 2017

If millions of ounces of reserves exist, I don't care who you are, that's value

Albert: I’m pleased to be joined today by Whitney George. He is the portfolio manager of the Sprott Focus Trust and he joins me by phone from his office in Darien, Connecticut. Whitney, thanks for joining me on The Power & Market Report. How are you?

Whitney: I’m great. Thanks, Albert. I’m happy to be on the phone with you today.

Albert: I want to begin with the interview you did recently with Rick Rule here in California a few weeks back. A very interesting interview and anyone who didn’t get the original transcript from our e-letter is invited to write to me at editor@sprottmedia.com. It’s a 16-page transcript of the conversation you had with Rick Rule. And what I enjoyed the most is that you both share a value investing background. Rick, of course, has focused on natural resource investing for his entire career. You have focused more on the traditional value investing approach, yet you do find value in natural resource stocks. So I’ll just throw that out for you because Warren Buffett, he does not pursue these types of investments. And one of the questions Rick asked you was what’s going on here? Why the divergence in views? Can you talk a little bit about that to start?

Whitney: I think what Rick and I both share is a combination of a very long-term outlook towards investments and understand that everything has its cycles and they come and go and there’s a long history that you pick up with some experience of mean reversion that works out quite well. In the commodity space, it’s often said that the best cure for low prices is low prices and the best way to get rid of high prices is sustain high prices. So, that’s clearly true in the resource area but it’s true in a lot of things.

Rick and I are also somewhat contrarian. And I think I mentioned in the article my favorite Warren Buffett expression about becoming fearful when others are greedy when others are fearful and, again, that plays into the long-term. I find it very hard to predict what’s going to happen in the next few days, next few weeks or months. But I think it’s a lot easier to make intelligent judgments over what’s going to happen in the next 3 to 5 years, and I’m sure that Rick shares some of that with me.

Warren Buffett is fascinating. I’ve spent most of my career studying his annual letters and reading books about him. More often than not, you’re better off doing as he does not necessarily as he says. It’s probably not well-known or long forgotten that at one point in I think the late ‘90s—1996 maybe—Warren Buffett owned 130 million ounces of silver, which got my interest because I was wondering what’s up given what he’d said about resources, but it certainly piqued my interest again in the late ‘90s, early part of the century. So it’s not necessarily something he’ll never do. Clearly, he’s got a lot of people scratching their heads right now with his purchase of Apple and his ongoing purchase of IBM because he always said he didn’t understand technology stocks.

I think one of the important things about being a good investor is one has to be adaptive and I think one has to be prepared to try and understand what one can understand and have a very open field of vision in terms of what sort of things that you might try and learn about or might be interesting.

Albert: Whitney, there’s so much in what you just said. First off, I’ve heard it said by Rick Rule and others that the cure for high prices is high prices and vice versa. That also can be said for anything that’s produced by human beings in exchange by human beings, I would imagine. But the other thing is your comments on Warren Buffett about him really not being an outspoken advocate—actually the opposite, right? Being a critique of metals yet purchasing them. Sometimes when he does things that people don’t understand, the explanation is that there’s someone else within Berkshire who is making those purchases. Is that the case with silver? How much did you look into that?

Whitney: No. He was running the investment portfolio on his own in the late ‘90s and, again, I suspect that he owned a position in silver in the mid-single digits and when it rallied into the low double digits he probably sold call options against it and played that a number of times. Then, ultimately, when silver broke out from $12—I’m trying to remember when that was—early 2000s, the position magically just disappeared. And my hunch has always been that the options he had written against his position were exercised in the way it went. So it’s not something that that people have really studied. He does make an interesting point about gold being something that you find in the ground and then spend a lot of money digging out of the ground only to put it back into the ground, i.e., in vaults, as being sort of a silly exercise.

But, again, a lot of the junior resource stocks that I have looked at, some of which I owned, do just that—they find it and leave it in the ground and they let somebody else come along and gamble by digging it out. And so, I have those kinds of exploration companies, they’re identifying, finding the value which is, of course, what I’m always trying to do and so I can identify with that. If some millions of ounces of reserves exist, I don’t care who you are. That’s value creating.

Albert: It brings to mind an interesting image of Warren Buffett writing call options on precious metals while traveling in a private jet. I want to talk to you about something else, about his avoidance of technology and his investment in Apple and other companies. Could it be that these technologies are just mature enough that it’s a comfortable investment for him? After all, you can think of a railroad at one time was a technology investment. Now we consider it infrastructure. Is that sort of what’s going on now?

Whitney: I think so. Apple in particular one could argue is a consumer products company more than as a technology company. Now they do spend massive quantities on R&D to be at or near edge of technology to have desirable products. But I’m sure like me, he was attracted to the free cash flow generation that the business has inherently and also their capital allocation. Their stock is statistically relatively cheap and they’ve [been] using free cash flow and then some other balance sheet to buy shares back. At the same time, they’re returning some in dividends.

So, I think it probably checked a bunch of the boxes. It doesn’t matter if you can’t figure out whether iPhone 8 is going to be a hit or not. They are building a franchise or have built a franchise that is formidable and that shows up in the margins and the free cash flow that the business generates even after spending multiples on R&D of what their competitors would spend.

Albert: Whitney, some people are referring to Apple more like a luxury lifestyle brand now. Do you see that angle?

Whitney: Yes, I definitely see Apple as more of a consumer products company. They spend vastly more on R&D developing new innovative products that people like and will pay a premium for. But at this stage, it’s the ecosystem that they have built the way they control your life once you’re an Apple customer with your information in their cloud and photographs, music all of the applications. So, it’s more and more a service business, less and less dependent on hot new devices, although given the way they spend money on R&D, I’m sure they’ll have plenty of interesting things for us all to get excited about down the road.

Albert: Right. I’m going to leave technology for a second, maybe circle back at the end of the interview because I want to talk about some of your comments to Rick about your career. So, specifically, when you were working as a broker, one of your biggest clients was Chuck Royce and you talked about your experience following or in the 1987 crash. And this is one paragraph here where you’re talking about not being able to get anyone interested in buying stocks. You got Chuck Royce on the phone. He’s one of the only people that would talk to you and he asked you for 5 stocks. You give him your 5 best picks and he says, “OK, buy me 10,000 shares down every 1/8 until they stop.” This is—who does things like that? I guess we should just explain what that means, but—

Whitney: Sure.

Albert: You can’t run out of money and you have to be sure these stocks aren’t going to zero, isn’t that correct?

Whitney: Well, if they all go to zero what kind of career we’re going to have in the money management business anyway? So, I think Chuck, very experienced, recognized panic selling when he saw it. The 1987 crash was driven by a new innovation in portfolio insurance through futures on the S&P 500 and options on those as well that went awry. So, it’s not too different from some of the mini flash crashes that we’ve seen in the last 5 years or so. There’s always a possibility out there. Chuck had a good sense of what businesses were worth. He knew that I was buying or recommending companies that had very strong balance sheets. He might have had some knowledge about the companies I was recommending already without telling me. So, I’m not the only person that got that kind of order from Chuck Royce on that day or that week. He understood how dollar cost averaging works.

Back then, stocks traded in increments of an 1/8 to a point or 12.5 cents. That was kind of the bit spread for generally liquid securities. And so, today, an equivalent order would be down every 10 cents or down every nickel or whatever increment one wanted to start with. Clearly, he had a large appetite for larger than 10,000 shares. Nobody knew where it was going to end. But honestly by the time I got the orders in, we were pretty well through the crisis to begin with. So, at some point, all of this sort of exhausts itself and when the crisis ends stocks can go back up in the same kind of vacuum that they went down and that’s something he understood. So, he didn’t know where they would bottom, but he knew and believed that the cheaper he bought them, in the long run, the more attractive the purchase was going to be and so—and he orders that way.

Again, 10,000 shares for him at the time probably didn’t represent a very large percentage of the money he was running. It was more stylistic than it was a big order; in other words, he didn’t say “Buy me a million shares” or something. He just said, “Buy small increments and keep on buying them until they stop,” and sure enough, at the end of the day, his average price on all of his purchases was fairly nicely below the closing price on those stocks that day.

Albert: Right. So we have to put things in perspective, but still you have to think about how bad things were at the time. And so I want to ask you in your dealings as a stock broker, what percentage of investors, the professional investors, would you say have the courage to do something like that at a time like that?

Whitney: It’s a fairly, fairly small minority, you know. It’s not something you can necessarily be taught in school. It’s something I’ve described to people as only experience can help you obtain. In 1987, I thought the world was coming to an end. I was happy to get anybody on the phone and certainly happy to get an order, but the firm I had worked for went out of business two days later and had to sell their seat on New York Stock Exchange. That’s a point I left out in my interview with Rick. And so we had to find a new home. So, the financial impact of Chuck’s order really didn’t have much magnitude.

Certainly in the 1991 bear market life was a little bit easier for me having seen bear markets before. Each time you go through one, your conviction that there’s the other side, which is a recovery, becomes stronger and I think it’s just that experience alone just creates a muscle memory that allows you to maybe react to crisis situations with a slightly cooler head than you might the first time you see it.

Albert: You eventually ended up working with Chuck Royce and Rick asked you what differentiated you guys? You guys were obviously good at sales but it takes more than that to create the type of track record that you’ve had, the success you’ve had over that period, a long period. You said it was a portfolio manager-driven culture where the portfolio managers run the organization, so everything is done around accommodating them. I’ve worked in organizations like that too in my other career and this is something I’ve always wondered about. Sales obviously is a skill and a talent of its own, but then the company has specific talents. So it’s talent versus sales. Which is more important? Which do you want the culture to reflect? And in your case, you seemed to think that it was the talent—the portfolio talent. Can you talk about that a little bit?

Whitney: Well, I mean I think it’s—you know, what do you put first, the marketing of a product or the creation of a product? And it gets to who’s running the show. So, when I say that we had a portfolio manager-centric culture, what I meant is we created products that we thought were great products, that we invested first and foremost our own money in, similar to the way Sprott is run these days. And then if it worked out, the clients would find us. That’s opposed to other asset management organizations who are run by marketing executives and their job is to go figure out what will sell. So, you start with the client. What does the client want? In the last few years, it’s been yield. So, go start some REIT funds and utility funds because that’s what the client wants to buy.

So at the end of the day, it’s the client who’s leading the investment process at the start as opposed to the investment professional. So very often, products that we would start took 3 or 4 or maybe 5 years before anybody discovered them. But once they discovered them, we had many happy shareholders who stayed for many, many years as opposed to chasing the next marketing concept.

Albert: It seems like the latter, chasing marketing concepts or the whims of the investor may produce very good short-term, immediate results, but then would leave you exposed to the crash when the trend necessarily reverses course. Do you agree?

Whitney: I agree. I mean money chases performance. And it’s a lot easier to sell somebody a product and make a commission if everybody knows at the cocktail party that that’s something cool that you want to own. That very often is precisely the moment where a risk manager, somebody who cares about preserving capital when things are tough and making it when the opportunities are there might want to retreat. Now, that’s not a very popular marketing decision because the people who make money selling things for their living want to sell as much as they possibly can. But again, that’s chasing performance and if you chase performance from one cycle to the next, you’re going to come in closer to the top than the bottom and leave closer to the bottom than the top. You’ll repeat and ultimately end up with a very mediocre experience.

Albert: Elsewhere in the interview, you talked about micro- versus mega-cap investing and you make a good point here that micro-cap investments take time to research as well. So if you’re going to put in the time to do the research, you might as well research opportunities where you can put money to work and that’s I guess Whitney George speaking as a money manager. What if you were an individual investor and that wasn’t a problem? Would you put your time instead into the micro-cap stocks?

Whitney: Yes. I mean that’s—for me, it’s the inefficient frontier and I guess what I meant to say is for most, not including us when I was at Royce, why not spend the same amount of time on a big company where it’s easier to go and buy and sell large amounts and put the money to work as opposed to having to be very patient, often spending years to accumulate a position that would—you know, make a significant impact on the portfolio. But there’s a payoff for doing that work. I think that’s true for individual investors as much as it is for larger investors. Obviously, it’s very hard to run—you know, to buy micro-cap stocks which we used to define as 300 million or less, maybe 500 million now if you’re running billions and billions of dollars. You know, it will take you forever to come and go out of that situation if you didn’t trade that much. And even if you end up a 10% of the company, it’s not going to be a big position in your portfolio.

So size is an impediment too for people to get into micro-cap stocks, but it’s a vast, vast universe, thousands and thousands of names, always with something going on. Lots of inefficiencies exist because they’re not well-covered. Just as it’s difficult for a portfolio manager to use them, it’s even harder for the sell side research brokerage firms to make any commissions marketing them and so they get overlooked. When things get overlooked there’s often an opportunity to find something that’s mispriced.

So, I’ve used micro-cap stocks in my portfolio. Sometimes you come to a point where you can get a mega-cap company like an Apple at the same valuation, absolute valuation, as a micro-cap. Then it makes a little bit more sense to go to the big one because it’s likely to appreciate faster than waiting for the micro-cap stock to one day get acquired by other company.

Albert: Rick Rule makes a similar point with regard to natural resource companies. It’s similar but not the same. He says, “You know what, small mines and small companies involve risk just like big ones, but small mines will never become large mines even when successful.” So for that reason, he likes to pursue bigger opportunities within this smaller space, so kind of an interesting parallel. There’s one question I wanted to ask you while that interview was going on. You mentioned companies that you like, companies that you don’t like, and I’m wondering if Amazon.com would ever become a company that you like because it is growing. You said, the ideal company is something that is totally reinvesting its earnings Amazon is profitable, reinvesting, and also growing. And in some ways, Amazon fits the bill. I’m wondering if Amazon is anywhere close to becoming the type of company that you would be interested in.

Whitney: Nowhere close, because they’re basically investing in businesses that are very, very low return businesses with the intent to one day dominate those businesses and then produce reasonable returns on that capital, but it’s unclear and every time you turn around, there’s another initiative. They have some very good high margin wonderful businesses that if they decided to be in the service business in the cloud business, for example, or in providing merchants with this marketplace. Those are wonderful businesses. You know, getting into groceries and competing with UPS and FedEx for shipping I don’t think is a particularly good business.

So, it’s a mix and someday it will shake out, someday investors will want a return on their capital and lose a little bit of faith in Amazon’s ability to just do whatever they want and have it work out great, and in that moment, you’ll have to see what they end up with. Which businesses will they keep and which businesses will they decide aren’t fruitful and divest or write off. And all of these companies have their moments. You know, Apple was a high-flier forever. I started buying the stock the day after Steve Jobs died because obviously people thought it was over.

So all of these growth stocks have a way—they’re cyclical too. I think—again, as Rick had mentioned, I think one of the things that could happen is if interest rates really actually go up and there is a discounting mechanism now put on these companies in terms of what is their cost of capital versus zero and what is the return they’re getting on that capital, you might see a lot of today’s high-fliers have a reasonably meaningful correction. Some will make it. Some won’t. I’m sure Amazon will make it because there are a lot of great businesses buried in there, but not at these valuations.

Albert: Whitney, I know you’re not a fan of banking stocks and that strikes me as one area where the companies are not making their cost of capital uniformly. Can you point to any other sectors where if interest rates were to rise to where I guess pundits and the Fed have their 3-year projection that would not be making their cost of capital and would be victims like you’ve highlighted?

Whitney: Well, there are lots of businesses that historically haven’t been great businesses. Utilities would be a whole segment. You know, they obviously move up and down with interest rates, but the underlying businesses of utilities over time have not been particularly profitable and they have a high requirement to pay their shareholders large dividends. REITs is another interest-sensitive area where you can find properties that aren’t REITs at 10% cap rates but once they become a REIT, they trade off without yield and in most cases become, in my mind, fairly valued and then subject to the whims of the interest rate environment.

Banks are just hard because they use a lot of financial leverage and they don’t have much operating leverage–even less post-crisis with the regulatory environment we’ve been in. They’ve essentially been regulated into Utilities. And one of the problems with Utilities of any sort is that there is always an agency out there protecting the consumers from shareholders should they get too greedy, and I just do not want to have that partner.

Albert: Let me flip this question around. Which industries do you feel have a good degree of interest rate insensitivity, meaning robustness in an environment of rising interest rates?

Whitney: Well, again, asset managers have been the financial stocks that I have always favored because, again, they don’t require an enormous amount of leverage. In fact, they don’t really need much capital at all. You just need to retain your people and your talent. But you got all the operating leverage to improving markets and one would think that if your principal business was money market funds, a rising interest rate environment would be very helpful so that you could start to charge fees again because it’s very hard when interest rates are zero to charge somebody a fee for the money market fund. That is one example.

And again, it depends on why rates are rising. Certainly if rates are rising because the economy is getting healthier and we’re getting back to normal, industrial companies are going to do well. Materials companies are going to do well and have been. Technologies continue to do well. I mean it depends on why rates are rising. If rates are rising because nobody wants to buy U.S. debt anymore, then we’ve got a different problem out there and stocks aren’t going to be a haven from anything.

Albert: I want to talk to you briefly about this article in Bloomberg today, “Private equity wins even when it loses, thanks to debt market.” This combines our discussion with easy debt markets, with the way you look at companies and that is as businesses not just as stocks. Your thoughts just on the—I guess on private equity in general because these firms, they’re criticized endlessly for this, for basically milking the companies for their own benefit and then leaving the companies in a scrap heap. It seems like lately it’s been getting worse. Is that true?

Whitney: Well, I think the tailwind of 30 years of interest rates declining has certainly been helpful to a leveraged buy-out model. I mean if you can refinance continuously, no different than people taking cash out of their homes before the financial crisis, you can live pretty high on the hog and you can—if you’re making your clients what appears to be a lot of money, you can charge a lot of fees.

Private equity competes directly with small- and micro-cap stock investing. It’s the same pool of money in terms of institutions that is allocated to those sectors. The advantage of private equity is there’s no mark-to-market on the portfolio every day. So if you’re a pension, you don’t have to sit there and see your results daily in the newspaper like you would with the mutual fund. So people sort of take some comfort in that and think that it is different than the stock market. Well, it’s different than the stock market in that there’s no mark-to-market every day but it’s no different in that when liquidity dries up, it’s going to become a very, very difficult business.

And again, a lot of the companies they invest in get recycled. They get fees for doing all sorts of things, you know. Occasionally, it is very helpful. Sometimes—you know, and I know this as a value investor, a company gets themselves into a situation where it’s going to take 3 to 5 years to get it fixed and maybe it is better for them to be doing it in privacy of private equity and then return to the market when they’ve got their problem solved which would be a very happy exit for the private equity firm that sponsored that.

So there is a role for them to play, but like everything else, it tends to get overdone and again when a lot of money chases any kind of concept the returns diminish, the practices become a little bit more difficult. And again leverage is something that cuts both ways and we’ve had a tailwind for the years of leverage for a very, very long time excepting maybe the financial crisis.

Albert: It is one thing to, for instance, take a company private to make the necessary changes and then sell that company later either I guess in the public market or by some other arrangement. But what do you think about basically using the debt market to fund dividend payouts and then later watching the company struggle long after the private equity firm has reaped the benefits of it? And I’m thinking about Mervyn’s in particular, which is one company that was highlighted in the article.

Whitney: Well there are 2 things. There’s retailing and then there’s—you know, there are private equity deals that don’t work out because they got too aggressive about refinancing and pulling cash out. Private equity managers are trying to generate a demonstrable return to their investors and, lacking the ability to sell a company, recapitalizing it and pulling cash out is one way to generate a return. Now if that ends up being overly aggressive and results in bankruptcy that’s—you know, that should be expected.

Retailing is particularly interesting because in some difficult examples, the companies don’t really give you a true picture of their liabilities because they don’t have to put their leases on the balance sheet. They’re in the foot notes, but if they own the stores, they’d have to finance them and it would be on the balance sheet. But by controlling stores through long-term leases, they basically have assets that they’re just paying a small interest rate or rent on that allows their returns to look a lot better. But when things go wrong, those leases suddenly become obligations because if you have to close stores, you have to settle up with your landlords and so their balance sheets end up looking a lot worse than anybody thought if they were just looking at the annual report or public documents.

Albert: Can you talk about then the related practice of taking a retailer such as Sears or Mervyn’s and splitting out the real estate holdings into a separate firm?

Whitney: Well, that’s a clever way to get some of the assets, in the case where they actually own properties or they have very attractive leases that they could easily get out of profitably. That’s just stripping out value. I started shorting Sears in 2007 and if it weren’t for such a massive short position and short squeeze and everything else, I’d still be there. But they’re doing a masterful job of gutting that company. At the end, shareholders certainly will end up with nothing and a lot of the bondholders will end up with nothing. And the clever financiers will end up controlling valuable real estate which somebody else can come along and do something else with. So that’s been a slow death march now for at least a decade.

And the problem compounds. If the turnaround takes too long for a private equity and they’re stripping money out as opposed to reinvesting, the problem compounds. The stores get run down. Nobody wants to go there anymore. You can only do that for so long before it becomes evident and the spiral starts to accelerate.

Albert: Talking about these retailers like Sears brings to mind J.C. Penney as well as the fact that is kind of fashionable now to rip on Bill Ackman. Were you ever a believer in the J.C. Penney turnaround story?

Whitney: No. But J.C. Penney was too big for me to look at. I had plenty of turnaround stories in retail Claire’s stores once upon a time, Dressbarn which is now Ascena. I still own The Buckle, The Brass Buckle which is primarily a denim, blue jeans, and tops store chain around the country. I don’t dislike retail. I just think you have to be very careful with the accounting. I think our economy right now is not in a favorable position. Consumers are still quite strapped and so results have been difficult. I think the online sales are growing. I don’t think that’s really the death knell of traditional retailing and people still need to try things on.

But it can be difficult and turnarounds can be difficult and particularly if someone is not prepared to be patient and take the right steps remerchandise maybe, maybe change some leadership, do some business things as opposed to stripping out assets.

Albert: Do you think—and this is obviously a massive speculation, but just the big department store model now is facing headwinds from online retailing and whatnot that are just going to be in the long run too difficult to overcome? So, for Macy’s, Sears, J.C. Penney, and all of those stores?

Whitney: Yeah, there are some good retailers that have done the combination correctly. You know, people don’t believe it but there’s still a huge catalogue business out there and online has really cannibalized the catalogue business more than it has the in-store business. At the end of the day, if somebody is online, they have to have a delivery system for you to get the merchandise and so setting up warehouses all over the country is one way to do it but using your stores more proactively as distribution centers for online sales and bringing people into the stores can work very nicely. I think there’s a—you know, I never say never. I think there’s a good combination out there of doing two or all three of those kinds of merchandising under one roof.

Albert: Whitney, we’ve got to go now but I want to thank you for joining me and I want to remind you people watching this video, you really want to check out this interview between Rick Rule and Whitney George. If you didn’t receive it by email, you can request it specifically by emailing editor@sprottmedia.com. I’ll make sure you get a copy of that.

Whitney George, thank you very much for joining me. It’s always a pleasure to speak with you and I look forward to doing this on a regular basis.

Whitney: Please. I would enjoy nothing more. Thank you, Albert.

Sprott's Thoughts

Sprott Global Resource Investments Ltd. is a wholly-owned subsidiary of Sprott Inc., a public natural resources investment management firm listed on the Toronto Stock Exchange (Symbol SII). Sprott Money is pleased to bring selected writings from the financial experts at Sprott Global to our readers from their newsletter, Sprott's Thoughts.

The author is not affiliated with, endorsed or sponsored by Sprott Money Ltd. The views and opinions expressed in this material are those of the author or guest speaker, are subject to change and may not necessarily reflect the opinions of Sprott Money Ltd. Sprott Money does not guarantee the accuracy, completeness, timeliness and reliability of the information or any results from its use.

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