We are fortunate to meet a lot of interesting people in the investment business. Whether it's through the Value Investing Congress, Real Money.com (where I am a contributor), Seeking Alpha, fellow deep value bloggers, or Cheap Stock subscribers, there are a great deal of very smart deep value players out there.
We first met Art Patten, President of Symmetry Capital, through this website, and have had several meetings with him since then. His insights into the world of deep value micro-cap investing are very interesting, and his investment philosophy is complementary to what we espouse at Cheap Stocks,
We thought he'd be perfect for the first interview ever published on Cheap Stocks, and recently sat down with him.
1. How would you describe your investment approach and philosophy?
Our general investing philosophy is that market efficiency is not some well defined state, but rather a continuously unfolding process that is impeded by various institutional, structural, psychological and other factors. That provides a suitable foundation for both passive and active styles of investing. In our active investing, we're contrarian and opportunistic. We have a deep value, small/micro cap bias, but there are minimal constraints on what we can own, thus the label on our Opportunistic Portfolio.
Since value is a function of the price you pay for something versus the cash flows you expect to receive in the future, we have no problem being a bit eclectic in our security selection. If we come across a story that makes sense, or find one that fits into a larger investment thesis, and the related asset appears to be under valued, we'll try to fit it into our portfolio. We're also public policy junkies, and incorporate a fair amount of top down analysis into our process.
Our business philosophy is to work and invest intelligently, to put clients' interests absolutely first, and to try to do the right thing for capital markets whenever possible. Unlike much of the industry, we don't want to work our tails off (or claim to!) in the pursuit of 100 or 200 basis points of long term out performance, even though the compensation tends to be better. To play that game, you have to be willing to convince your clients pay you an active management fee for index like returns or worse. We won't do that. We won't ask clients to pay us an active management fee to play a loser's game on their behalves. To earn our active management fees, we try to stack the odds of success in our favor as much as possible, which we do by exploiting certain institutional and structural market factors – we're attracted to securities with low or no analyst or sell side coverage, low prices and/or market caps, turnaround stories, a recent emergence from bankruptcy, and so on. Those types of factors will tend to keep large buyers, the financial press, and hot dollars at bay while we do our homework.
Ideally, we'll find and invest in things that eventually attract those folks, to whom we'll happily sell once our thesis has played out. We're skittish about momentum and crowd following, and if we aren't the first to the party, we at least try to be early, or join in when no one else is willing to, and leave when it starts to get crowded. That's where we tend to find the fattest, juiciest risk premia. It's risky, but over the long run, we think it offers high relative returns, and attractive risk adjusted returns.
Our approach probably limits the scalability of what we do, but that's OK. We love the work, and we're confident that we're doing the right thing, both for our clients and for the investment profession. Until we start facing Warren Buffet's problem of being too big to go fishing in small ponds, we'll stick to our knitting.
2. How have you gone about building Symmetry’s Opportunistic Portfolio?
My professional background is in institutional portfolio design and management, so we're always thinking about the portfolio as a whole, about how any one piece fits with all the others, and what the net effects are likely to be. In normal times, we're relatively concentrated, perhaps 10-20 holdings, but in the fourth quarter of 2008 and the first quarter of this year, we saw so many companies go on fire sale that we ended up with quite a few more than that in the portfolio. We've been careful to avoid becoming closet index huggers. Something still has to look pretty cheap for us to invest.
We now have around 50 holdings, including some high yield corporate debt and convertibles. The debt securities make up roughly 25% of the portfolio, and most of them mature in 2010-2013, which made sense to us from a top down perspective. We believe that after one or two years of healthy upside, equity markets will encounter some serious chop. If all goes well with the debt holdings, our clients will have some fresh cash to put to work as that paper matures, with a nice return of principal in the meantime. We didn't expect to have that large of a stake in debt securities, but I'm proud to say that we were true to our active strategy's name – we were very opportunistic in late 2008 and early 2009, which led us to credit as well as equity markets.
3. What is your current macro view on the markets, and how has that manifested itself in the construction of this portfolio?
We think a lot about the policy environment when developing our outlook. We find most comparisons to the Great Depression overblown, primarily because today's global monetary system is so different from the one that existed then. If the world's central banks managed to push the nominal price of gold to $500 or less and keep it there, and if globalization came to a sudden screeching halt, then we would look to the early 1930s for guidance. Until then, we're still in a post World War II economy. We've been saying for some time that we're seeing a repeat of the 1970s, with some early 1980s flavors and a few important differences. In the seventies, harmful economic policies were compensated for with easy monetary policy, which caused domestic business cycle and price level volatility, and fostered marginal investment in faster growing places like Germany, Japan, emerging Asia, and others.
The current episode is a lot like that period, but with three important differences – globally tradable goods like commodities are now a much smaller factor in the domestic price level, U.S. demographics are much different, and the U.S. is unwinding a massive credit expansion and debt overhang.
Although primarily remembered as a decade of stagflation, the 1970s was actually a decade of fits and starts, with periods of inflation, deflation, rising and falling employment, and volatile financial markets and business cycles. We don't expect to see the same kind of domestic price level volatility this time around for the reasons I just mentioned, but inflation will take a toll in some parts of the world, especially in areas where tradable goods like commodities are still a large component of spending, and where households, and in some cases governments, are under severe financial strain. We wouldn't be surprised to see more food riots in emerging markets in the years ahead, as we did in 2008. And like the 1970s, we definitely expect to see rising volatility in economic output, worldwide. The dramatic contraction in the fourth quarter of 2008 was a powerful example, and the coming years will be a stark contrast to the “Great Moderation” of recent decades. Volatility will be made worse to the extent that policymakers foster economic uncertainty, as this makes investment decisions that much harder for businesses to commit to.
Most importantly, if our tax and regulatory competitiveness continues to decline relative to the rest of the world, we are likely to see another relatively jobless recovery in the U.S. That will tend to work against domestic asset values, including the value of human capital, and it will hamper the country's capacity to fulfill on looming commitments like entitlement spending.
That being said, we think that the actual policies that come out of Washington will be better than is sometimes feared, a sentiment that might have contributed to the rally off of the March lows. However, it remains to be seen whether policy will be constructive or destructive on net. For example, while health care reform is properly described as aiming to reduce a significant drag on business, this rarely leads to a broader discussion about how to make the U.S. a more attractive destination for business investment.
And it's all but guaranteed that the cost of government as a percentage of GDP will rise in coming years, perhaps decades, to levels not seen in half a century. The policy outlook becomes all the more important when you consider that the Democratic party looks likely to consolidate its control in coming years. That's another contrast to the 1970s. This is due not only to President Obama's charisma, but also to the Republican party's state of utter disrepair. There is a very high probability that Senate Democrats will expand their super majority in the 2010 elections, which leads us to believe that centrist and conservative Democrats will be the best hope for sound and rational economic policies.
If they perform reasonably, the Republican party could wander the political wilderness for some time. So there's going to be an ever present risk of the more economically harmful ideas in the Democrats' tent gaining traction.
As far as actual market data go, it looks to us like we are going to see an unexpectedly strong upswing in GDP in coming quarters, but with significant uncertainty beyond 2010. Our biggest concern, which seems to be more than just a remote possibility, is subsequent waves of credit spasms. We don't expect anything like the post-Lehman environment, but if our jobless recovery prediction works out, there's still plenty of residential, consumer, and credit debt that has to be worked out. That's going to require some significant investments by debt servicing businesses, which might not have a positive net value. It's going to divert a good deal of resources that might have been better invested elsewhere.
And without expanding or at least normalizing household incomes, we could see a significant wave of chapter seven filings before everything's said and done. We don't know how the ultimate costs will be shared among banks, taxpayers, and private investors, but without meaningful job growth, this overhang will be a stubborn drag on the domestic economy. In parts of the world where those factors are not in place or not as severe, we expect better economic performance in coming years – not decoupling per se, but countries with competitive economic policies and more attractive demographics should outperform in the years ahead.
In our portfolio, this outlook manifests itself in several ways. For example, we aren't shy about investing overseas, including emerging markets, although we currently do so through USD denominated securities like ADRs. We also think exposure to cyclicals like industrials, technology, and energy makes sense given the state of leading indicators and some of the values we're seeing in our favorite areas of the market. We think commodity producers will see a period of renewed strength, if not this year, then in 2010. And we like having debt securities in the portfolio for the diversification and relative stability they should provide, expected returns on principal from depressed levels, and expected cash flows, which we will put to work as new opportunities present themselves.
4. When will you sell out of a name?
When the market has proven us right or wrong. Because of our portfolio mindset, we will trim a position when it exceeds a specified threshold, or bring it back to weight if it has fallen in value and still makes sense to us, as long as the trading expense makes economic sense. But the decision to close a position out entirely is based upon expected upside relative to potential downside, and importantly, on the opportunity cost implied by expected returns on competing opportunities in our universe. We prefer to invest for the long term, but being opportunistic sometimes entails a shorter holding period. If we're lucky enough to have a story work out in short order, we'll close it out. We also consider hedging when cost effective hedges are available, but that's often not the case with the stuff we buy.
5. What are your current top holdings?
A couple of busted but healing convertibles issued by small energy companies make up about 13% of the portfolio combined, and we believe they still have significant upside. We also have about a 6% stake in Royce's Micro Cap Trust (RMT), which we use as a proxy for the portfolio when appropriate, and when available at a discount to NAV.
For example, if a retail client has a marginal amount of cash to invest, and they pay per trade rather than per share commissions, we'll invest in a proxy rather than across multiple portfolio names, as that can generate significant savings for a client.
6. What led you to take positions in Thermadyne and Himax?
Thermadyne is a Saint Louis based global producer of welding and cutting tools and equipment. It's been a long term holding, and a company that I've personally followed since they emerged from Chapter 11 bankruptcy in 2003, after a string of highly leveraged and poorly integrated acquisitions in the 1990s. One of our favorite return recipes is a company emerging from oblivion, completely off of Wall Street's radar, with a product or service that's likely to see reasonable demand or better, and a management team capable of executing a lasting turnaround.
Thermadyne definitely meets those criteria in our view, although the shares have taken us on a bit of a roller coaster ride, and they're not without risk going forward. As an industrial company, they are heavily exposed to the business cycle, especially steel demand, and they carry a good deal of leverage, with assets of three times book value, and debt to market cap over five.
However, the forward looking market indicators we watch are supportive of a cyclical recovery, and we believe their international sales will continue to grow – they were up 15% in 2008 - and that they should see some benefit from domestic infrastructure expenditures beginning in 2010.
Most importantly, their operational trajectory continues to impress us. Since 2004, sales have increased at 7.5% per year, cash flow from operations by an average of $7.75M annually, despite capex rising at 6% per year, and the most recent quarter's free cash flow yield was around eight percent. Performance wise, they still have some catching up to do to with their closest competitors. But at a price to sales ratio of 0.10, and with their current management team, we believe they have plenty of raw material to work with.
Himax is a Taiwan based provider of flat screen video display components. This is a somewhat contrarian play on flat screen demand, highly speculative, in a very competitive industry, and with some complex interrelationships between a key supplier and the CEO, and customers who are also minority investors. We like that the company has consistently invested in R&D in an attempt to expand into other product markets, including projection and other displays. And while the trailing dividend yield is probably not indicative for the coming year, we feel that it does provide meaningful information about management's and the board's dividend philosophy and the likely direction of future dividend policy.
The voucher component of the Chinese government's stimulus plan is also expected to be supportive of the industry, although we like the story regardless. We could have bought a stock like Corning (GLW) as a “safer” blue chip play on flat panel displays, but Himax was a better fit for our approach – it's much smaller, and appeared to be more deeply undervalued and offer more attractive cash flows to shareholders – it's also an ADR selling in low single digits, which meant fewer institutional buyers to compete with as we entered the position.
7. Are you seeing any opportunities in the market today, and if so, where?
Nothing like we saw in March, but there are still opportunities. Equities as an asset class are more compelling than they've been in years, and based on early cycle indicators, we think that small cap equities are in a sweet spot. We also think there are still plenty of interesting net-net and real asset ideas out there, as you continue to highlight.
8. What do investors need to know about investing in deep-value micro cap companies?
Be skeptical, do your homework, and know how much you can afford to risk. That last one is really critical. We're careful to assess suitability for individual investors in our Opportunistic Portfolio, as this isn't the kind of approach that people should put all of their assets into. Ideally, people will only invest in volatile securities with surplus funds, funds that exceed their current and future liabilities. If people insist on speculating, being skeptical and doing the homework become even more critical.
Disclosure: The author does not have positions in any of the companies mentioned.