Rich Eisinger was into Warren Buffett back when Buffett wasn't cool.
In this week's
, the co-manager of the
Mosaic Mid-Cap fund is a firm believer in notions like sustainable competitive advantage, predictable free cash flow growth and strong management teams. We know what you're thinking: Everybody likes this stuff now. But Eisinger has a long-term record to back him up.
The no-load fund, co-helmed by Jay Sekelsky, has returned a
8.36% on average the past three years, ranking it among the top 5% of all mid-cap blend funds. Over five years, a 4.85% average annual gain places it among the top 15% of its peers. (Longer-term results aren't as hot, but they aren't germane: Mosaic parent Madison Investment Advisors acquired the fund in late 1996 and, as Eisinger says, "it didn't really have our ideas until January 1998.") The unsung fund is starting to develop a following: Its assets under management surged from $11 million to $26.2 million during 2002.
Because his bottom-up approach to stock-picking has nothing to do with "geopolitical risk" and other bugbears, Eisinger's outlook is refreshingly upbeat. It helps that he backs up his opinions with airtight analyses of top picks such as Waste Management, Costco and Laboratory Corporation of America. The strict Buffett Way adherent even found a tech stock to love: CheckPoint Software. Read on for his most compelling insights.
1. Mosaic Mid-Cap might not be familiar to all of our readers. Would you mind relating the fund's investment style?
We're strictly bottom-up, fundamental analysts. Madison Investment Advisors, which manages the Mosaic Funds, is a GARP, or "growth at a reasonable price," shop. We sometimes refer to it as growth at a reasonable risk. We like consistent, sustainable cash flow growth. We are fairly concentrated compared to most investment managers -- we own 25 to 35 stocks in the fund.
Personally, I'm a longtime student of Warren Buffett. A few years ago, you didn't hear that too much. But now every manager you read about claims to be a Buffett student. I've been a fan of Buffett for a good 20 years.
Does your macroeconomic outlook have any affect on your stock-picking?
Tenure: Co-Manager Since July 1997
Assets: $26.2 million
3-Year Avg. Annual Performance: 8.36% (Top 5% of peers)
Expense Ratio: 1.25% (Cat. Avg: 1.34%)
Top Three Holdings: Markel, White Mountains Insurance, Odyssey Reinsurance
Information: (800) 368-3195 or Web site
We try to be 100% bottom-up stock pickers. We currently have about a 33% weighting in the consumer area. From a top-down approach, you might be concerned about the consumer at this point, and that might lead some to take a different sector weighting. But we're willing to be patient and we don't think we're any good at forecasting the economy. (Laughs.)
Having said that, I'm probably a little cautious now. When you forecast earnings, do discounted cash flow models and project a company's future, maybe subconsciously my economic beliefs come into the forecast.
2. How does the Buffett Way apply to your stock-picking approach -- do you subscribe to the "five years to forever" holding period?
We typically say three to five years, but when you're long term you're long term.
We look for a three main things: First, companies with sustainable competitive advantages. In Buffett terms, that's having a wide moat around the business. What gives you that wide moat? We look for market leaders in the industry with very high barriers to entry. We want companies with pricing power, and with very strong brand names or franchises.
Second, we want companies with predictable and dependable cash flow growth. To some extent, that's dictated by sustainable competitive advantage. So, we want a high degree of certainty in future cash-flow generation. We dissect the growth of a company -- how much is internal? How much is top-line growth? How much is through acquisitions? What is their ability to expand margins.
As an example,
is a company we've owned for quite some time. About 50% of their revenue is from the newspaper business, 20% is from the broadcast TV business, they have a small licensing business with the
comics, and the remaining revenue comes from the faster-growing cable TV business, which includes
Home and Garden Network
They own papers such as the
and the Albuquerque paper -- it's very easy to have a high degree of confidence in their future cash-flow generation. You can say the same thing about the broadcast TV business. And they use this cash flow to grow their faster-growing cable TV businesses. That's the beauty of their model.
The third pillar we look for is a high-quality management team, and what we really look for is wise allocators of capital. Companies have cash flow, and they can use that for many things: They can pay down debt, buy back stock, make acquisitions, offer dividends, or just reinvest the cash back in the business. We look for companies with a proven record of wise cash allocation.
It goes without saying, but we also look for very honest individuals, clean corporate governance and conservative accounting practices. We also want companies where management has fair compensation policies -- and, importantly, where their incentives are aligned with the interest of shareholders. In other words, management teams that are focused on enhancing shareholder values.
There's no easy recipe with assessing management; it's a lot of detective work. If the CEO was at a prior company, you can look back and see what he did there. Sometimes, just off conference calls you can come up with a feeling whether you like these guys or not -- straightforward, honest people who will be straight about the risks in their business.
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3. What happens when you find companies that meet your three criteria but the stock looks richly priced? Do you pick it up or wait for a better opportunity?
I'm glad you asked. Once we identify companies, we have a few demands. One is valuation. We want companies at reasonable levels. We're not merely a P/E shop; we use a number of different metrics, and they are different within varying industries.
We want to find companies with a 3-to-1 upside-downside ratio. We are willing to pay up for outstanding business models with terrific management teams, such as
Expeditors International of Washington
We also look at a number of balance-sheet measures: low debt-to-total-capital ratios. More importantly, we seek a debt-to-capital ratio that can be serviced easily by cash flow.
4. Expeditors is a big holding for you. This company seems to carry a price-to-earnings multiple that is always a little on the pricey side, but it keeps growing into it. What do you see for the company?
Expeditors, in my opinion, is an absolutely fabulous company.
They are in the freight-forwarding business, and really in the sweet spot because a great portion of their business deals with Asia to North America freight shipment. As you probably know, there's a tremendous trend of outsourcing of manufacturing to China and the rest of Asia.
There's not much in the way of capital expenditure at the company, either. They are a bit like a broker in the sense that they just rent the cargo space on aircraft and ocean liners. They don't own any of the actual transportation vehicles, unlike a
They have a very strong balance sheet. Also, they are at the industry forefront with their systems and technology.
As far as valuations, I agree that their valuation always looks rather full. But this is one company that in five, 10 years from now, you are going to look back and be very happy that you accepted the valuation and continued your position in the company.
5. In addition to Expeditors, you have a several companies that have been lauded for strong management -- Ethan Allen (ETH) - Get Ethan Allen Interiors Inc. Report, for instance. What do you like about that company and what are its prospects?
Ethan Allen is a very well-run furniture company, led by
Chairman and CEO Farooq Kathwari. They are also the cream of the crop in the manufacturing and retail side of the furniture business. They have the best margins in the industry. They have weathered the storms of the slowdown of the last few years much better than their competition, if you compare their numbers.
They have a very strong brand name, they are introducing new lines. A few years ago they were more of a traditional colonial-style furniture retailer. They have brought in more contemporary lines of furniture to appeal more to younger customers.
Kathwari runs a very lean organization -- there's very little inventory kept at the stores. Their balance sheet is pristine. Last time I checked, they had 1% or 2% long-term debt to total capital. And they have used the free cash flow to pay debt down in recent years.
This is a very fragmented industry. This is a company with a market cap of $1.1 billion; I see no reason why five years down the road Ethan Allen's stock can't double or triple in market cap and take more market share away from the industry.
The thing that's really unique about Ethan Allen is that they are vertically integrated, which creates a very strong competitive advantage. They have 15 or 17 of their own domestic manufacturing facilities, their own saw mills, their own designers, and their own distributions and logistics network. They have a lot more of their business under their own control.
6. You are still very light in technology and telecom. Why are you shying away from these sectors, and are you finding anything you like?
We recently bought
, a week or so ago.
Traditionally, we are very cautious of the tech and telecom area because it's difficult for companies in these sectors to meet the criteria of dependable cash flow and sustainable competitive advantage.
One of the questions I always ask is, "Can I start a business in my garage tomorrow and compete against these guys?" Well, when you're talking about Expeditors and
, it's difficult to invent a game that would compete against Monopoly tomorrow. But with a lot of these technology companies, the answer to that question might be, "It's not that difficult." A lot of these companies don't achieve returns on capital over and above their cost of capital over a long period of time.
Having said that, we are starting to see tech companies that are well-capitalized with strong cash flow. When you remove the cash from their balance sheet from the share price, CheckPoint is only trading at about 10 times free cash flow. Our analyst believes they will do about $1.05 in free cash flow. We think CheckPoint can grow at a mid-teens level when the economy picks up.
I should mention CheckPoint provides Internet security software, products for network firewalls and the like, and they really dominate that area of the business. You do have to be cognizant that they maintain their competitive advantage.
7. Any other companies you have been purchasing recently?
We started buying
Laboratory Corporation of America
Lab Corp. is the second-largest clinical laboratory in the U.S. ... running the gamut from routine blood analysis, substance-abuse tests, HIV tests. They really emphasize the higher-end cancer tests, they really want to be a leader in that area. They should earn $2.20 a share this year, which means the stock is at about a 12 P/E.
What we really like is that free cash flow should be in the $390 million range, which means the company is selling at only 10 times cash flow. You have a company growing earnings at better than 20% this year selling at 10 times free cash flow, and that's after the pop today
What gave us the opportunity to purchase the stock was last fall, they lost some market share in their home region of the Carolinas. They kind of took their eye of the ball there. The question is, was that temporary or a longer-term problem? We analyzed the company and felt it was a bump in the road, and they need to refocus.
Taking a longer view, this industry experienced intense pricing wars in the mid-'90s. There were several more competitors, six or seven. Now it's down to two big players,
and Lab Corp. We think the stock is exceedingly cheap here. The company is buying back stock. Listening to the conference call, it sounds like management thinks it's very cheap as well.
8. Markel is your top holding. What do you like about this company?
Markel is a specialty insurance company that really focuses on niches, which gives it more pricing power and makes it less susceptible to regulation. Some examples are health club insurance, judo studios, taverns, bars, taxicabs -- they are either No. 1 or 2 in most of their markets, usually No. 1.
I've followed this company for a long time. Management is really shareholder-oriented. They concentrate on producing an underwriting profit. Their real goal is to grow book value of 20% over the long run. There's a neat little formula: If they can maintain $4 in investments for each $1 in shareholder equity and break even in underwriting, which they just did in the fourth quarter, and they only get 5% returns on their investment over the long term, that equals 20% growth. Until they acquired Terra Nova in March 2000, they had 10 years of book value growth of 20%. There are only one or two other insurers who have done that.
They also follow the Berkshire/Buffett method where they invest the premium very wisely. About 15% of their portfolio is currently in equities; they are very skilled value investors. A guy named Gaynor runs their investment portfolio, and he has a great track record.
We also like that a third of the company is owned by insiders.
On a broader industry theme, the events of Sept. 11 actually sped up the hardening of the insurance market, meaning premium prices have just shot up. There had been a lot of excess capacity, and a lot of that is diminished. A lot of the business has gone to the higher quality underwriters, the better-capitalized insurers. Markel is one of them, and they have benefited.
This international acquisition was not well-received by the investment community. It's taken more time than we or I'm sure Markel would've liked to turn around this business, but it's getting very close now. For the first time in a while, the companywide ratio was under 100 in the fourth quarter. That means for every dollar of premium they take in, they are paying out less than a dollar.
9. The mid-cap arena is getting more crowded with erstwhile large-cap companies. Do you assess these companies differently, and are you finding any that you like?
A few months ago, I screened for companies with $1 billion to $15 billion in market capitalization, and I think there were 1,200 or 1,300 companies. So you do have a much larger universe than you do in large-cap. A lot of these companies are smaller than large-caps, so they still have room to grow, but they have stronger sustainable competitive advantages than most small-caps. So it's an area ripe for picking.
Two companies that we like are
( WMI), which came right down to a range where we could buy it.
Waste Management is the largest waste-removal company in the country; they haul commercial and residential waste. One of the things we like about the company is that it's kind of an asset play. They own a lot of landfills. These days there's a real high barrier to entry to open a landfill due to regulations and environmental groups.
The company is also a real cash cow. It should generate close to $1 billion in cash. So if it has about a $13 billion market cap, we think it should do about 13 times cash flow. That really lets me sleep easier at night, when a company is generating that level of cash flow.
Of course, the company had a big accounting scandal a few years ago. So, when some people here Waste Management, their jaws drop open. But a lot of times -- not all the time -- when a company goes through a scandal like that, they emerge as one of the cleanest corporate-governance operations. They got a new CEO, Maurie Myers, who we're very high on. They have implemented conservative accounting practices. We are very confident that they have almost gone to the conservative side.
They have three businesses: residential waste management, commercial, and then this specialty business with construction. If someone is constructing a big building somewhere, they contract Waste Management to remove the trash. That business has really slowed with the economy. We think it's going to take a little strength for that business to pick up, but at these valuations we feel confident sitting on the stock.
How about Costco?
One thing we always examine in retailing, it seems like a lot of the country is over-stored. You have too many stores and too much competition. We're always cognizant of room for expansion. We think the warehouse-club retailing business still have considerable room for Costco to open new stores.
Costco is really the leader in this business. The other two big players are BJs and Sam's Club, which is owned by
. Off the top of my head, Costco is the only company I can think of that is beating Wal-Mart at something. Their margins and same-store sales have consistently topped their competitors' over the years.
They also have excellent cash economics, as I like to call it. Their accounting revenues really understate their cash revenues. They get a tremendous amount of cash up front from membership fees, and they have really high inventory turnover. They really have the low cost operating model in the business.
The beauty of the business is that it doesn't cost much to build them; there's not much decor that goes into the store. They sell fewer numbers of items than a lot of their competitors, but they sell them at greater volumes.
When the economy recovers, we think Costco can easily return to 13%-15% earnings growth. They are currently selling at 16.5 times forward earnings; the median for the last five years was about 26 times. If we can get anywhere close to that, I think we've got considerable upside.
10. Do you assign a firm price target, and does that always trigger a sell?
When we purchase a stock, we write a thesis report -- basically, four, five, six bullet points explaining why we own the stock. We also assign a confidence level rating of 1 to 5. We don't purchase 1s and 2s. This rating depicts our confidence that our thesis will play out. A company like Expeditors has proven itself; that's a 5.
When a company reaches it target price, we go back and assess what we want to do: trim, sell or increase the target price. With a 5, you're most likely to give the company a longer leash. A 3, you're more likely to take your profits. This actually helps on the other side, too. Believe it or not, we have a stock that goes down or has a problem once in a while. (Laughs.) This helps us go back and reassess if the thesis remains sound.