Value is back in style, but for some people it has never been out.
One of those is Tom McKissick, co-portfolio manager of the
TCW Galileo Large Cap Value Fund. Along with fellow portfolio manager John Snider, McKissick picks his value stocks with an eye to return on invested capital: looking at companies through the lens of their after-tax net operating profit as a proportion to the capital they've invested in their businesses. This, says McKissick, is the best way to see how good a company is at turning investments into cash.
Of late, McKissick and Snider have had a good run. Their fund was rated No. 1 by Lipper for the first quarter of 2002. With returns of 7.85%, TCW Galileo Large Cap Value Fund beat the average large-cap value by more than 600 basis points.
Here are some of McKissick's thoughts on value stocks.
1. Why do you use return on invested capital? Why not use other measures such as price-earnings ratios or price-to-book value?
Clearly, it's based on Graham & Dodd and Warren Buffett. I've spent a lot of time observing their successes. And what a lot of people don't know is that return on invested capital is exactly what Warren Buffett is all about. I think a lot of people think he's price-to-book.
Return on invested capital is essentially the EVA model -- economic value added -- the
Stern Stewart that looks at a company's cost of capital and the return on capital. It's really the principles under which these great value investors built their focus. The value of a business is really based on the cash flow it generates. It
really simple. It
. But we think there's not enough appreciation paid to that if you're just looking at P/E, price-to-book and dividend yield.
Managed Since: June '98
Assets: $143 million
One-Year Return: beats 66% of its peers
Five-Year Return: not available
Expense Ratio: 0.72%
Maximum Sales Charge: none
Top Holdings: ExxonMobile, CSX, Union Pacific, Praxair
Source: Morningstar, May 2002.
2. Then what do you think about industries with delayed returns on capital expenditures? What do you think of the cable industry, where companies are spending a lot on equipment, but saying it'll pay off later?
We have, in fact, looked at the cable industry and decided to pass because of that very dynamic. First of all, the evidence is that the investments they've made in the past have not generated a return on capital that is in line with or above their cost of capital.
Look at the capital intensity of the business. And it's always been a business based on, "We invest today, and we'll get paid tomorrow."
And that may be fine. That was the hottest stock format you could make two years ago, right? Free capital, go make it happen, the dot-com first-mover advantage, whatever it may be. Wireless telephone, same thing. These companies all had below-average returns on capital, yet their stocks went up. But there's a day of reckoning.
If, inevitably, shareholders do not see a return from the capital they are putting out there, then there's going to be a repricing of that particular equity.
If you look at the cable industry five years ago, these were the promises of the capital returns that were spoken: "We invest this capital, and we're going to get this return, and everything we're doing is getting a 15%, 20%, 25% investment return on capital."
It hasn't happened. These stocks have been trading down significantly. The reason why is there's been no proof to investors whatsoever that the capital that's being allocated will generate a return on capital above their cost of capital. This is why these shares are under pressure.
3. But cable operators are saying that in 2003 capex is going to come down. What's wrong with that?
They've been saying that for years.
If you talked to them two years ago, you would have heard that about 2001 or 2002. It's always pushed out a little bit.
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That, admittedly, is a bit of a turnaround situation we've been playing. We've been early on that. Our anticipation in the telecom area has been this: You have seen a stabilization in their returns on capital over the last two quarters, largely because the invested capital base has come down. They've cut their capital expenditures dramatically.
So if you look at the way our formula works: We want to own companies who in most cases are lowering their capital intensity, and their profits are stable to improving.
And in the case of the regional bells, our observation has been that the whole dot-com phenomenon and the entire bubble of capital that came into the telecom space created a huge problem. It put huge pressure on profitability for everybody in telecommunications. It was free capital.
Now you can't get any capital for any sort of funding whatsoever for any telecommunications venture whatsoever. Which means that capital is now receding from the industry. As you take capital away, returns will go up. As you put capital in, returns will drive down.
We think what's happening in the telecommunications industry is capital is clearly leaving. There's no question about that. We have not underestimated that. What we may have underestimated is the ability for the profitability of the regional bells to improve soon. The most recent evidence we've seen is that profitability is stabilizing. But we need to see a turn in order for those to be good stocks. It's not enough just to have the invested capital base come down.
We do pay attention to what's in the
S&P 500/Barra Value index. Exxon's the biggest name in the value index. Exxon also happens to be the best allocator of capital in the energy industry. If you look at their historical returns on capital, they're well above their cost of capital. Nobody has done as good a job as Exxon has over time. It's reflected in the way their stock has performed.
As great a company as Exxon is, we don't think it's an undervalued stock. We've actually taken some of the capital from Exxon and moved it into
. The ChevronTexaco equation is one where returns on capital are going to be improving, and the valuation doesn't yet reflect that. I think they're kind of taking the Exxon playbook, if you will, and implementing it into what they're doing.
6. Do you short stocks in the fund? Does it make sense to short stocks the way you look at them?
No, we don't. The way we participate in that is many times we'll look at names within our index that are big. And we don't want to own them.
7. What do you look at in cash flows to make sure they're accurate, to make sure they're representative of a company's business?
There's always the ability for misrepresentation. No question.
There are a couple lines of defense. The reality is that cash is much more difficult to manipulate than the income statement. And that's where we see the biggest sort of discrepancies. Revenue recognition, I think, is the issue that is probably one of the most difficult ones to actually see and recognize. Revenue recognition -- you can work magic with that.
What we focus on most of the time is making sure the income statement and the cash-flow statement represent each other. And if they don't, there might be something really off.
8. Are there certain things that look good to you that don't look great to the rest of the market?
The railroads to us look interesting.
We're attracted to companies that have mismanaged their businesses for quite some time. Because that is where the opportunity exists for change. And as a value investor you don't get to add any value to your mutual fund holders with something that is well beloved and on the front page of
We have to gravitate towards where, actually, returns for shareholders have been very poor for quite some time. And that's why the stock has done excessively poorly, and that's why there's maybe a catalyst for change, because maybe you as a management are saying, "Boy, we're doing something wrong."
This is the example of the rails. They're not a high-growth industry.
The reality is, we're very attracted these days to opportunities that exist in asset-intensive businesses. The reason why is that it was the asset-intensive businesses that did very poorly in the '90s.
The cash generation at these rails is improving, and we think their returns on capital will go from a low of, say, 4%, and they're marching up.
9. But isn't there the risk that industries which have been on their way down will stay down?
We want to focus on companies that have some sort of regional barrier, if you will, if we can find those. It doesn't mean we won't invest in a company that is a global commodity. But look what's happened to global commodities in general. Many companies in the U.S. have done a good job of shutting down and paying attention to the financial metrics we look at. Steel's been going through this for 20 years. But guess what's happening. While you're shutting down over in Asia -- with lower-cost labor, less environmental restrictions -- they're building one. So you're getting no net reduction in the overall industry capacity. So all you're doing is handing your market share to these guys.
Now the rails, as an example of what's different, is that you're not competing against a Japanese rail or an Asian rail. It makes no difference to your business whatsoever. You're regional.
The aluminum industry in general has been tough. However, Alcoa has managed their business in a manner that has driven returns on capital up consistently.
In every industry, you tend to find one company that does it exceedingly well. In the industrial space, it was
for the last decade. In the airlines, it's
. They're the only one that earns a return on invested capital above their cost of capital. In aluminum, it's Alcoa. In steel, it's
So that's where Alcoa fits. Now, the dynamics of the aluminum industry aren't anywhere near as negative as, say, the steels were for 20 years. There isn't as much global capacity exploding on the scene.
I don't want to leave you with the thought that we only would invest in a regional business. But we are attracted to some of the specifics of that.