Let's face it, right now there are more questions than answers. Will techs charge higher? Is it time for value stocks to come back from the dead? Or is the broader market just going to take a breather and drift for a while? No one knows for sure, but we asked high-profile value manager Wally Weitz what he's buying today. We picked Wally for this week's Streetside Chat because he's not afraid of taking big bets. In the early 1990s, he overweighted cable and telecom stocks in his (WVALX) - Get Report Value fund. That's led to a 24.2% annualized return over the past five years, beating the S&P 500 and a cool 99% of his peers, according to Morningstar. A year ago, he had a third of his fund in cash. Since then, he has sunk much of that money into banks and other financials, which now comprise about 40% of his portfolio. He says he was early, but thinks the move will pay off. Since January, his fund is off 5.2%. He also sees plenty of "value traps," cheap stocks that will probably get cheaper. Whether you think he's right or wrong, you'll be better off knowing what he's thinking. Weitz spoke with TSC Personal Finance Editor David Landis, Deputy Personal Finance Editor Stephen Schurr, Senior Writer Ian McDonald and Staff Reporter Ilana Polyak.
: In looking at the value funds portfolio, it's a pretty big financial stake. You say it's around 40%?
: I think that's about right, broadly defined financials.
: In starting off, could you talk to us about what you see in the sector that makes you excited about it, and some of the names, specifically, that you like.
: I've always been comfortable with financials, thinking that their business was, more or less, understandable. And I think there are a lot of people that are not comfortable with financials, or that periodically get uncomfortable when credit risk is in the news, or when the
is raising interest rates; they tend to be victims of black-and-white thinking. When the Fed started raising rates, the assumption was that all financials ought to be sold and, I guess, there's some logic to that.
But beyond being logical about it, I think in the past financial stocks have always gone down when rates were going up and so people just assume it's going to happen again and make it a self-fulfilling prophecy. So if the Fed started raising rates last summer, some of the companies that I really like as long-term businesses are getting cheaper and cheaper. So I took cash positions at that point -- we're in the mid-30% range down to the 10% range by the middle of the first quarter of this year -- mostly by buying financial companies.
: What triggered the move, and, more specifically, what are some of the names that were screaming values to you?
: Part of it was seeing a two-tier market that had been developing for years really start to get extreme in the summer, especially in the fourth quarter, seeing tech stocks and the Internet fever kind of stocks really up on a spike and making me queasy about the general market, and so I was looking for what you might call places to hide -- comfortable, solid businesses that were cheap at current prices. And even if it took a while for anybody to care, it gave us a pretty good chance at two-, three-, four-, five-year holdings that would maybe average 15% a year.
So, I wasn't necessarily looking for the flashiest, fastest-growing, but I was very comfortable with things like
Golden State Bancorp
, which has a story of its own but is selling in the low 20s; I bought it all the way down to 13 or 14 recently. Washington Mutual is in the low 30s, we brought it down to the low 20s;
North Fork Bancorp
from the high teens to the low teens;
from high 20s to the mid-teens. Obviously, I was early on all these.
There's a story with each one of those, but basically it's very low P/E, some growth and management that I trusted to stay out of interest-rate and credit-risk trouble.
: What do you anticipate coming out of the Fed meeting next week, and do you think that it's already priced into the stocks in your portfolio?
: I don't think I have anything to add to the speculation about that. What I hear, the consensus seems to be drifting from a sure 25 basis points to a sure 50 basis points and I don't have any reason to quarrel with that, but I'm not really basing anything on the outcome of that.
I mean, if the rate increases go on longer and the rates go higher than anybody expects, then there'll be another wave and another wave of selling, I suppose, and I'm working on the presumption that over a five- or 10-year period, the occasional spike like this doesn't do any serious damage to these companies. I buy 'em at a discount to their business value, and eventually they'll sell at or above their business value, and that's all that matters to me.
: In your recent annual report you talked about value traps. I think in the current market, people are probably looking for values and may just take a knee-jerk response to measures like P/E, or any stock that has been out of favor for a while. Could you offer any cautions against certain sectors or individual companies that you think are value traps that you're going to stay away from?
: Well, I'm hesitant to say be sure not to buy XYZ stock or XYZ industry. I think there are a lot of really mediocre businesses out there and I think the reason that my portfolio has tended to be heavy with financials and media companies and communications companies is those are the kinds of things that generate free cash flow.
And I just don't see that in manufacturing or food processing or a lot of retailing companies that have trouble really making progress. Steel, aluminum, commodities, etc. The really great businesses are few and far between, I think.
: Looking at your portfolio holdings, it looks like you're also staying away from technology, and in your latest shareholder report, you accuse some portfolio managers of investing in things that they don't really have much knowledge of or background in. Are you saying that you don't have much conviction in your own knowledge of technology and are you staying away for that reason?
: When people say, I stay away from technology because I don't understand it; I've said that and I think for a long time, what I meant at a conscious level was, I don't know how a disk drive works. I only recently realized that music CDs are read from the bottom and that's why you could have a whole picture on the top, so I'm not a technical person, but that's not really the problem for me. I think I could probably learn enough about at least what the terminology meant.
But the problem for me with tech companies is not the technology itself; it's the fact that they change so fast. One company that's dominant
because it has the best kind of disk drive or the best kind of routers, whatever, tends not to be the same company three years from now. And when I'm looking for a business that I can have a pretty good idea of what they'll look like and where their place in the world will be five or 10 years out, that just seems to preclude most of the technology world.
It just so happens that
has held its place for a number of years and a few other companies have, but I don't know how to predict that. And yet, if we have a bank that has a certain amount of assets that are deployed by a sensible management that's cost-conscious and investing in good assets, and making a good return on investment and investing that in more of the same, there's a pretty good chance that five years from now it'll look like the same thing only bigger, or they'll be taken over.
My quarrel with today's market is that even the best of the best, you know, probably can't keep growing 25% to 30% a year. With the compounding effect,
would be bigger than the planet if it grew at its current rate for another 15 or 20 years. So the growth rates aren't likely to be sustainable and the price you pay today is too high to leave any kind of margin of safety.
: When it comes to value investing, everybody has a different angle. Could you describe what your definition of a value stock is?
: It's really hard not to lapse into cliches when you're trying to do that, but in a way I think of the distinction
between growth and value, in some ways it's a totally artificial distinction. A company that's growing can be good value at one price and not good value at another price. I think of value investing as bird-in-the-hand investing, where you measure the underlying business value of the company you're looking at to an intelligent and informed buyer who is thinking about buying the whole thing, wanting to own it indefinitely. And if you can figure out, roughly, what that person would pay, and if the stock's available at a big discount to that, then you've got a bird in the hand. It's already worth more than it's selling at.
If it gets more valuable, that's fine. If somebody discovers it tomorrow, that's fine, but it doesn't have to. You can still make a good return by holding it for a long period of time because the company would slowly grow in value and maybe close that gap. Where, on the other hand, growth investing would be a two-in-the-bush idea where the company's a great idea, or has a new invention, or a new market that it's exploiting has such promise that you can pay a premium price today, based on what you think it's going to grow into.
: Would you rattle off two or three recent purchases that you've made that you feel confident about, and can you tell us a little bit about those companies and why you like them?
is a real simple example. These are luxury hotels -- Four Seasons, Ritz-Carltons, Marriotts -- that are generating; they're in existence, they're well-financed, they're operating well, they have cash flow. If you made a conservative estimate of actual property values that these things can be sold for quickly, you'd get a number something like $13 or $14 a share. And that's just based on a 10.5% cap rate of the company. You might say 9% to 9.5% was the right number and that that would give you a price of $16 or $17.
I have a hunch that with one phone call, they could sell the entire portfolio for $13 or $14 a share. OK, the stock's at $10, we're buying it a little bit lower but it still works at $10, I think. So $10 is a 25%-35% discount to the overnight liquidation value. Since this is in
real estate investment trust format, they pass through most of their cash flow so the dividend is 8.4% at the moment, it's an 84-cent dividend. The properties are growing very gradually over time. They don't get to retain capital, because they pay out most of it as dividends, but they do have a little bit of excess cash flow from excess depreciation that doesn't have to be spent on maintenance. And they can add on a wing, or add a spa, or buy an occasional new property, maybe there's some inflation that increases the value of real estate over time; I'm not counting on any of that.
I think you could make a case that the value of the properties grows at 2% or 4% or 5% a year, on average, over time. So you add together an 8.4% dividend -- that's the bird in the hand -- you have a $13 or $14 business value that's growing at some rate and even with no closing of the discount, if the gap stays at 25%-30% forever, you still would get an 11%, 12%, 13% or 14% total return. But periodically, people get interested in real estate and it might very well sell at or above that, whatever the adjusted asset value is.
So you get the closing of the gap from 10 to 14, maybe that takes several years, but there's a whole bunch of different positive ingredients that add up, to me, to the high probability of a total return of at least 15% a year, over a period of years.
And that's not exciting, but it's kind of grind-it-out value investing to me. And incidentally, 15% has been starting to seem normal, the S&P's done that kind of growth for the last 25 years, and I'm pretty sure that's not going to be normal going forward. So if we can get 15% on most of our portfolio and subtract the inevitable mistakes, 8% or 10% or 12% a year, in a 2% or 5% world, we'll earn our keep, anyway.
: How about another bank stock?
: Golden State is a thrift in California that gets no respect at all. Earnings are about $2.75 a share. It ought to be an attractive franchise for somebody that sells at five to six times earnings. They've done everything that they said they would do.
I think it should be worth mid-20s to an acquirer at some point, they've said that they're basically putting it together to sell. Huge reserves, there shouldn't be credit problems, the inverted yield curve is squeezing their profit margins a little bit, but still they're earning in the high $2 range. And I'm talking cash earnings here.
: Other value managers have suggested that since the valuations have gotten so low in some of these value stocks that the markets are primed for increased leveraged buyout activity. Is that part of your thinking behind the stocks you're buying?
: I wouldn't buy a company I didn't like, just because I thought somebody'd do an LBO on it. I think it's the other way around. When you think about the business value, when you're looking at a potential stock to buy and you're thinking about what the value to a business person would be, 95% of the time it's all theoretical and it just points you towards good businesses at a reasonable price and the market recognizes that, eventually, if a stock goes up.
We have an investment in something called
, which invests in Old Economy companies and usually takes a -- they do mezzanine financing for the most part -- but they take an equity kicker, and they've started talking about deploying some of their capital towards leveraged buyouts. They're not unfriendly deals, but they're helping management take their companies private.
But, I expect there will be more of that happening if these stocks stay down. I'm not looking for a crummy business, just because it may go private.
: One other thing that's intrigued us: We've seen on a lot of Internet message boards and hear from folks that there's kind of a gray market out there for shares of closed funds, and one that we see quite often is
Weitz Hickory. What do you folks make of the fact that people are trying to get into the fund through the back door? Is it flattering? Is it annoying?
: And do you allow it?
: Well, you can't really stop it. It happens. And some of it happens, you know, locally, here. It's a little easier for people to find each other.
I mean on the surface it's flattering, I guess, that somebody wants in so badly. On the other hand, a lot of people want whatever it is they can't have. I know of specific cases where people finally find a way to get in, and find they've bought at an interim peak, and then they're disappointed a month later.
So, I kind of wish it wouldn't happen. In a way, I feel a little bad that we can't be accommodative. I think it's a good fund; I don't run it, Rick Lawson runs it. I think it's a good fund, I own it myself, and I'm glad to own it. I think it will do well over time.
It really wasn't a black-and-white issue to close it, but he really felt that there was a barrier to performance that comes with size, and wanted to close it when it got to $500 million and I agreed with that. Since then, it has gone up to $900 million and back down to $600 million. There was nothing magic about $500 million. I'm not sure anything's that great that you have to stand on your head to get in the back door.