Click on the company name to jump to Bath's comments on the stock.
Black & Decker
SunGard Data Systems
It might seem unusual to devote this week's
to a mutual fund that has a mere $3 million in assets under management. However, it's also unusual to find a $3 million fund managed by a skipper whose previous fund turned in a 20-year streak of successive positive years.
The fund is
Diamond Hill Large Cap, and the manager is Charles Bath. Bath joined the tiny fund in September, after running the $1.5 billion
Gartmore Total Return fund (formerly the Nationwide Fund) since 1985. From 1978 to 1998, his fund stayed in the black. Then, in 1999 -- when pimple-faced fund newbies were posting triple-digit returns -- Bath posted a fractional loss because he stuck to his investment guns. He says he's proud of his performance in 1999, and he's overjoyed to be taking his expertise and impressive record to a new shop.
Why does a fund manager skip out on a $1.5 billion fund to manage an unheralded fund with $3 million in assets? Why did he bypass the 1999 mania? Looking forward, why does he say tech has no place in his value fund? To find the answers to these questions and more (and a lot of stock picks), read on.
1. These days, people are finding value in funny places -- semiconductor-equipment makers and telecom outfits, for example. How do you define value and where are you finding it?
We define value as any stock in the public marketplace where you find that it's less expensive than what the company is worth. Now, what's a company worth? Whatever an informed buyer would pay for it. It may be reflective of nothing more than well-priced earnings or well-priced cash flow, or it may be a discounted asset value.
I'm a large-cap fund investor, but I'm finding the most value in sort of the smaller end of the large-cap universe, if you will -- stocks around the $4 billion to $5 billion market capitalization. I'm finding the best values away from the megacap stocks.
Tenure: Managed fund since Sept. 23, 2002
Assets: $3 million
Top Three Holdings: Belo, Pittson Brink's Group, Devon Energy
Expense Ratio: 1.4% (Category average: 1.45%)
Diamond Hill Information: 888-226-5595 or diamond-hill.com
Source: Morningstar, Diamond Hill
2. What compelled you to make the change from managing a $1.5 billion fund ...
... to a $3 million fund? (laughs). Most normal people work the other way.
Some friends of mine have been involved in Diamond Hill for a while, which is a relative startup. I'm 47 years old, and it was a time in my life where I felt, "If I didn't go now, I'd probably end up asking years later why I never made a move." It was a now-or-never thing. Also, I'm very attached to the Columbus, Ohio area, and this was an opportunity to try to build a business in Columbus.
3. Gartmore Total Return previously known as the Nationwide Fund was one of only two funds to manage 20 years in a row of positive performance from 1978 to 1998. Yet in 1999, a year in which it seemed just about anybody could have a great year, your fund lost 0.4%. What were you thinking at the time and did you feel like you were making the right moves?
I don't want to sound too self-serving, but I wouldn't invest with anybody who had a good 1999 (laughs).
In many ways, 1999 separated value investors from momentum investors. We are not going to have another 1999 for a decade, if not decades -- well, possibly for the rest of our investment lifetime. Sadly, some of the best managers of our generation were lost to 1999 (laughs). Julian Robertson closed out his hedge fund, other good fund managers left the business. I was flat in a year when the
was up more than 20%. That's not good, but when you consider the alternative, which was losing investors a lot of money in the subsequent years because you let down your guard on valuations, I'm actually quite proud of the way I managed the fund during that entire time.
Interestingly, you positioned the fund well in 1999 for the coming downturn -- lightening up on technology. But then Gartmore added a co-manager to the fund and the fund still managed to lose a bit of money in 2000 and 2001. Did you lose the ability to manage the fund as you planned to in 1999?
Well, anytime you have a co-manager you lose the ability to totally run a fund as you might like.
4. OK, let's move to the new fund. Does running a large-cap fund with a mere $3 million in assets give you more freedom? Also, how much do the current holdings in Diamond Hill Large Cap reflect your investment strategy?
It does, but with my style, I tend to have a fairly low portfolio turnover. I look for a few businesses where I'm there because the growth of the company is present, combined with low valuations. I think my style lends itself to managing large amounts of money. Yes, it's easier to manage small amounts of money, but I was running various funds at over $4 billion and I felt that I was able to do that, and I look forward to doing that again! (laughs). Yes, it's a little bit easier to do that, but I think on the margin it's not as significant because of my style of investing.
Does the fund look fairly close to what you wanted?
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Yes. I have been able to change it around to what I want in the few months that I've been here. My colleague, Ric Dillon, and I have known each other for 20 years. Before we worked together we would discuss investments regularly. We share similar investment philosophies. The fund looks like I want it to. Rick is concentrating on the small-cap area now and I'm focusing on the large-cap area. It's my fund now and it reflects what I want and the way I want the fund to be invested.
So investors drawn to the fund don't have to worry about major turnover?
Any turnover that would happen when I arrived is behind us now.
At the end of the third quarter -- right about when you took over -- the fund had about 20% cash. Are you still at those levels or was that just anomaly to let you put money to work?
Yeah, the cash is lower than that. The cash is moving between 10% and 15%; we're putting it to work.
Right now, the fund has 37 holdings. Are you going to be adding to that as more money flows in?
That's about where I'd like to be, in a 40 to 50 stock range. If I get money I can add a few more names. But when I ran the Nationwide fund, it got up close to $2 billion with about 50 to 70 names. My history has been to maintain control over the number of holdings in a portfolio because you can dilute your efforts by being too diversified. Certainly, 40 to 50 names gives you plenty of diversification and good ideas can really have an impact.
5. According to Morningstar, you have no holdings in software, hardware or telecommunications. Do you think the run-up in these sectors this past month is misplaced?
About a month ago, some of these stocks had been down so low that they were close to our target prices. But then the market took over so fast, we sort of missed them, but now they're up 50% (laughs). Yes, I think that's the case. I mean, 50%, if you think about it, maybe in the 1990s that was somewhat normal.
I think that if you can make 50% over four years, then that's pretty great. In tech, we've made that in four weeks now. I think that these stocks have gotten ahead of themselves now. They don't appear to be the market leaders to me. Bear markets tend to define changes in leadership. I tell people I don't know where the next leadership of the bull market is, but I think I know where it's not going to be (laughs). That's a group I'd like to participate in at the right price, like any other group. It never got to my price before it took off. So, I'll be waiting again until it does get to my price.
The best part of the business is the corporate security and data security. They provide off-site security systems for corporate-data centers. They're a leader in that business. It's a growth business and generates lots of free cash flow with the management's ability to manage that cash flow.
I owned the business in the past and I've liked it. The stock got very cheap in this most recent sell-off, but it's running back quite a bit recently.
The technology space has often led to the services business because they tend to participate in the growth of the industry, generate more free cash flow and more steady, less cyclical growth than, say, the hardware names.
Plus, they're a very well-positioned and well-run company.
6. What sectors look strongest for you going forward and is this at all based on any kind of macro assessment of the market and economy?
In much of my career, I've had very large weightings in a couple sectors -- including consumer staples, food, beverage, tobacco, household products and healthcare -- specifically pharmaceuticals. More and more, I'm not finding attractive evaluations there on a relative sense. Those areas for me are particularly underweight compared to where they were before.
Where I'm finding the most attractive names are the old-line industrial-type companies. Many of them have been abandoned or ignored. They've lacked the sex appeal of the 1990s. Many of them came down in the 1980s. In fact, many of the stocks are trading lower prior to the crash of 1987 and so they were ignored. The excesses of the 1990s didn't really occur in this space. I think we will find that the excess of the 1990s will be with us for a while and perhaps be a drag on returns in some areas of the marketplace. The basics of it: too much capital in a certain area chasing a higher rate of return. That flood of capital will drive down those rates of return and a lot of capital has not entered these industries.
is a stock I own. It's trading at $20 a share; it was trading at $28 in 1987. So, 15 years of doing nothing, part of it is justified. But I think now there's a new management focused on its core businesses and on earnings again. Needs a little cyclical help, but I think they'll get it. Brunswick is indicative of where you'll find the attractive valuations.
is another unusual company; they make rail cars. It tends to be a fairly cyclical business, as you can imagine. The last cyclical peak, they earned $4 a share. Now, rail cars fell off the cliff in the last couple years. Well, the last couple quarters rail-car orders have improved. Now, if you wait until you see the earnings come through, you'll miss the stock. The stock is still trading below book value, so that's another unusual, more industrial old-line company -- another example of where I'm finding opportunities. This stock is still trading at half of where it was five years ago.
When did you pick that stock up?
A couple weeks ago -- when the third quarter was reported. One of their competitors reported earnings and orders before Trinity did. When they started reporting quarters that were very strong, is when I started buying Trinity.
Centex is a homebuilder. I think people are overly concerned about home building. I think, in part, because everyone's focus is on the high end and that's because in money management, that's the type of home everybody's in. But in Middle America, the housing market is quite healthy -- driven by low interest rates. I see no reason to be overly concerned about it. You're always concerned about a cyclical business, but I see no reason to be overly concerned about the homebuilding business.
But it's trading at six times earnings and barely above book value, that's a pretty attractive evaluation to me.
A lot of people have voiced concerns about the homebuilders -- the rising cost of land, the slowing market. Do you like the sector across the board or is Centex the exception?
Centex is my only homebuilder. I think it's the best in the group, but others may differ. Across the board, they're all relatively cheap. They all reflect concerns about a housing recession, which I don't think is going to happen. But if a housing recession does happen, valuations are cheap enough that you shouldn't be hurt too badly with the stocks.
How about Conoco Philips?
I find the energy stocks, in general, a bit underappreciated. I hope we don't go to war with Iraq, but everyone knows it's a possibility. People have shied away from them. The thought process was: The last time we went to war with Iraq, oil prices went down and it was bad on the energy sector. I feel that supply-demand outlook is much more favorable in the industry this time than it was last time. Perhaps on a near-term basis energy prices will weaken, but I think the fundamentals of the industry were much better than they were last time. Conoco Philips is one of the cheapest integrated energy companies.
8. Your fund is pretty tethered to the relative health of the consumer. Are you concerned about what will happen if the consumer stops propping up the economy?
I guess I am, yes.
But I've tended not to try to put a macroeconomic overlay on the fund. I feel I have more insight into valuations than a macroeconomic overview. If you buy at the right price, you're protecting yourself from any sort of economic hiccup. If you have markets decline, time will be your friend and you'll be able to wait for the economic recovery.
Yes, I am concerned about it, like so many other things, but I tend to monitor it more on a company-by-company basis and it seems to me that, coming out of the third quarter, things seem to be better than people thought. While people are wringing their hands over the economy, Corporate America's earnings reports coming out of the third quarter finagled the margin better than they thought they were going to.
Let's talk on a company-by-company basis, then: Tell me what you like about Countrywide (CFC) . Again, are you concerned at all about a declining housing market?
I'm concerned to the extent that they tend to be driven by a refinancing cycle and the refi cycle is slowing down. It's really interesting the way it works: The refi cycle puts a little business on the books, but when the refi cycle slows down it improves the retention rates of the business on the books. It's a cheap stock, it's a good business and they're an underappreciated company. Yes, I realize that there's more risk on the refi cycle. If that's behind us, that will slow their business down, but that's not going to happen for a long time now. The stock is staying cheap and they have to continue to get the numbers. So, I'm not really concerned -- every company has issues, but I think evaluation is cheap enough for us not to be as concerned about it unless the evaluation was higher.
What about Maytag (MYG) , another consumer stock? What's the growth potential here, and why doesn't the rest of the market see what you see?
That's a good question. The earnings came through well in the first half of the year, but then at the end of the year, things slowed down and, in the aggregate, earnings growth was quite strong. But what everyone focused on was: Oh my God, they missed the numbers at the end of the year so the stock got killed.
It's a company with a very strong market niche in its core products, with its high-end appliances. Perhaps they strayed a little bit, focusing on other areas that might provide consistent growth, such as lower-end appliances. The new management is refocusing efforts on the high-end.
In fact, I remember in the 1980s Maytag used to sell almost at a market multiple because they were at the high end. We're nowhere near that now. I'm not saying they deserve that, but I think they deserve more than 10 times earnings and four times cash flow.
Valuation's a big part of why I like this company; it's a big holding in the portfolio. I suspect it will continue to be a large part of the portfolio because I think it was sold down for reasons that were perhaps too short term. The key story in my mind is: They're refocusing the business on their core and their ability to drive a higher return at a more cyclical return and get a higher evaluation.
You've done well with Black & Decker (BDK) in the past; it's up about 18% this year. Are you concerned that it's getting a little pricey?
Not really, when you consider the market is up 20% in the past six weeks. Relative to the market, I don't think it's that expensive. In fact, its earnings have come through quite nicely this year. I find its valuation quite attractive.
9. Do you have any specific sell discipline as a fund manager?
Certainly, the easiest one is the valuation call. If I buy a stock because it's cheap and it runs up to the point when it's no longer cheap, then I'll be certainly more apt to sell the stock. There is no solid line; like say if a stock is $19.95, it's cheap, but $20.05 is expensive and sold. If it tends to be more fluid, I'll sell a third and if it goes up then sell another third and another third because I don't pretend to have an exact answer.
The second way: If the fundamentals change and I feel I was wrong in the valuation, or the franchise is down, I'll sell those relatively aggressively. In other words, if often you're admitting you've made a mistake or the situation has changed since you purchased the stock then the stock should be sold because the reason I own is not the same as it was before. I think my tendency over the years has proven right -- selling aggressively is the thing to do.
Then there's a third way: Let's say, as an example, Conoco Philips. If for whatever reason ExxonMobil became much more attractive and I didn't want to change the energy weighting, I could just swap out for ExxonMobil. Basically, I look for names you own vs. names you don't own.
It's all management judgment. I don't have any concrete rules -- you know, stock's down 10%, it's sold.
How long do you hold a stock? What's your time horizon?
The two stock's I've had the greatest success with, one stock was held for 14 years and the other for 13 years. The first was
and the second Warner-Lambert, which was bought out by
Do you own either now?
I don't own Pfizer. And Schering-Plough I do not own for much of the reason I bought it. When I bought Schering-Plough in 1987, after they'd had a few years of disappointing results because of a big product that went bad and they didn't have anything to replace it with. When Claritin was approved, it grew the earnings in the company for more than a decade; as investors we did very well. Now that Claritin has gone off patent, they're replicating the problem they had before, but they haven't gotten the new product yet.
They have a new cholesterol drug jointly managed with
, which looks reasonably interesting. But the cholesterol market is just too well penetrated and there are issues around their cholesterol drug. I'm concerned that it will not be as successful as people hope. So I don't think that product line will boost Schering-Plough's growth.
But if I find another great 14-year situation, I'll jump in (laughs).
Schering-Plough brings up another question because it has some SEC Reg FD disclosure issues. How much do you factor these headline-risk items into your investment philosophies?
It's just another variable to be put into the mix; you don't ignore it. In fact, with Schering-Plough, they have exacerbated their policy because of manufacturing issues with the FDA. They had hoped to get a substitute product for Claritin on the market to transfer their Claritin patients into a product called Clarinex, but because of manufacturing issues with the FDA they didn't have time and weren't able to do that and that became a huge issue. So these are issues that cannot be ignored, but you also can't say that, "Gee, because there was a problem with the FDA there is not any price that I will buy the stock." Of course there is a price. But the price goes lower the bigger the issues are.
10. What's the company you feel most comfortable sleeping at night knowing it's in your portfolio?
is a company I have liked for quite some time. It probably got too much negative press lately over a slowdown in earnings. I like the management, but Wall Street views it as kind of stodgy.
We need to be more independent in our analysis of management. Merck's management has done a lot for shareholders over the years. Merck stands out in terms of owning the stock for a very long period of time.
Are you concerned about the competition Merck faces from generic drugs?
They have some important products going off patent, which has been a drag on the company. But they have a lot of relatively new products that can drive the growth for some time. A lot of those issues are behind them now.