In this bull market, value investing may appear to be a strategy that's guaranteed to underperform the market. Yet, some hedge funds are prospering now with a value portfolio.
When growth or momentum investors declare that the days of value investing are over, Zeke Ashton, founder of Centaur Capital Partners, a Dallas-based hedge fund, replies that "value investing is never dead."
Market observers often forget that some of the earliest hedge fund managers -- Warren Buffett is the iconic example -- were value investors. The Centaur Value Fund, co-managed by Ashton and his partner Matthew Richey, produced net returns annualizing well over 20% since its inception in August 2002.
Since the Centaur Value Fund was created, shorts have always been part of the strategy. However, the portfolio has always been net long, and the shorts are used on a case-by-case basis for stocks believed to be excessively valued.
In an interview with
, Ashton explains what it means to run a value shop with some short exposure in the portfolio.
TheStreet.com: Describe your investment and screening process.
: Basically, we are trying to find investment ideas that can produce 15% to 20% average annual returns over time with acceptable risk. So, we are ideally looking for healthy, growing businesses with good management at cheap prices. We have developed a number of screens that help us identify those stocks that show statistical indicators of combining the two basic ingredients we look for: high-quality businesses selling at cheap prices. We then select the most compelling ideas for further research. We use our shorts when we see evidence that the stock is too rich and that the market will revalue it in a reasonable time frame. We don't feel the need to short for hedging purposes. Because our value-based stock selection gives us, on the long side, a margin of safety against significant loss, we don't need as much short exposure as many other funds.
You only use stop losses on the short side, not on the long side. Why?
Mathematically, there is a limit to the damage one bad long idea can do to your portfolio. On the short side, losses can be many times the original position size, and as a manager, one has to respect that. So, we draw the line at how much pain we are willing to take on the short side. On the long side, we can afford to be stubborn as long as we believe the value is there.
Why the use of shorts in what is essentially a long-only portfolio?
We continue to be long-biased because the economics on the short side are nowhere near that of the long side, but we have found that shorting has enhanced our performance, adding on average anywhere from 2% to 4% a year to our returns. Shorting also provides some float that we can re-invest on the long side until we need that capital to cover the short position. Finally, shorting tends to make our returns more consistent from year to year, and though we don't use it for that reason, it's a beneficial side effect. Our value-based approach is helpful in identifying good short opportunities that are slightly less risky than the event-driven shorts that can often get very crowded. We typically have between six to eight short ideas in the portfolio, and our short exposure ranges from 10% to 25% on average.
What makes a good short?
There are a number of different ways that we can classify good short ideas, but essentially, we are looking for a photo negative of what we look for on the long side. In other words, we are looking for some combination of a low-quality business at an excessive price. It helps if there are a number of other risk factors we can identify, and we prefer it when we can identify a catalyst that we believe will make the risks obvious to other investors. Short ideas come to us from a lot of sources. We have developed screens to help identify stocks that appear overvalued statistically. Sometimes we find a great short candidate when we are in the process of comparative analysis on stocks we own or are considering purchasing on the long side. We look at the pricing of the whole industry and see one that is just way higher than everything else and for no reason that we can justify.
Sure. Texas Roadhouse isn't a horrible business -- we'd call it an average business. But the stock is priced as if Texas Roadhouse is a great business. We don't think that Texas Roadhouse is that much different or better than any number of steak restaurants --
Lone Star Steakhouse
are two comparables that come to mind. At year-end, Texas Roadhouse had 221 locations, of which, 127 were owned and 94 were franchised. The market values the company at $1.1 billion, or about $8.6 million per owned restaurant. Lone Star Steakhouse, for comparison, owns 290 restaurants, plus there are 18 franchised restaurants. The market values Lone Star at $550 million, or $1.9 million per owned restaurant, not counting Lone Star's $60 million in cash. Lone Star also owns many of its locations, while Texas Roadhouse leases everything. Outback Steakhouse has 984 owned restaurants and is valued at about $3.2 billion -- about $3.25 million per store. We simply don't believe that Texas Roadhouse is that much more valuable per unit than its publicly-traded competitors, and we think a lot of growth is already priced in to its stock.
What are the risk factors you seek to eliminate and, why limit your portfolio to only 20 to 25 positions?
We find the 20-stock model provides a nice combination of concentration and diversification. If we are right on an idea, it will contribute meaningfully to our returns. If we are wrong, we usually won't suffer a large percentage loss, particularly if each idea has some element to it that provides a margin of safety against significant capital loss. We can't eliminate all risk, but we seek to eliminate some risks that are obvious, such as companies with bad balance sheets, and some that aren't as obvious, such as companies with underfunded pensions or extreme customer concentration. Essentially, we look at the weight of the evidence, and if there are too many red flags, we usually take a pass.
Let's talk about one of your long picks: Fidelity National Title (FNT) .
Fidelity National Title is the number one title insurer in the U.S. The company was recently spun off from Fidelity National Financial, and quite simply, the title-insurance business is a very profitable business, but the profits are highly variable from year to year. We believe that the stock is cheap. It trades at a single-digit multiple to average-cycle earnings, which we believe is quite compelling in this market environment. The low price is caused by worries that a housing slowdown will hurt earnings, and of course, earnings are likely to be lower in a slower real estate environment. We simply believe that such a scenario is already priced in and that Fidelity National Title will be profitable enough to produce excellent returns on our investment from here. Because the stock pays a nice 5% dividend, we are willing to be patient if it takes awhile for the market to come around. We also like the fact that management has indicated that it will prioritize returning cash to shareholders, which is the right way to run the business.
We believe Intuit has two dominant franchise businesses, TurboTax and QuickBooks, both of which produce very high returns on capital and outstanding cash flow. In addition, Intuit's management is now focused on growing the core businesses and has recently indicated that it will be using its capital to buy back stock rather than pursue acquisitions outside its core franchises, which it had done with mixed results for several years. Basically, we believe that Intuit is a high-quality company with decent growth prospects at a very reasonable price relative to the free cash flow it can produce.