We recently had the pleasure of interviewing Scott Barbee, portfolio manager of the Aegis Value Fund (MUTF:AVALX), one of the most successful Graham-and-Dodd-style mutual funds in the U.S. Prior to leading the effort to establish the fund in May 1998, Scott earned an MBA at Wharton and worked as a securities analyst at Donald Smith & Co. and as an analyst and broker at Simmons & Co.
The Aegis Value Fund, which focuses on small-cap domestic equities, has nearly doubled the performance of the Russell 2000 Value Index since the fund’s inception in 1998, reporting a compounded annual return of 9.3% versus an index return of 5.3%. During the year ended June 30, 2010, the Aegis Value Fund returned 53.5% versus an index return of 25.1%. At June 30th, the average market value of companies in the Aegis portfolio was $651 million, and the average price-to-book value ratio was 0.66.
Key excerpts of our exclusive interview with Scott Barbee follow.
On The Mutual Fund Business
The Manual of Ideas: How did the Aegis Value Fund get started? What was the tipping point at which you felt like you had a sustainable, growing business?
Scott Barbee: The Aegis Value Fund grew out of my interest in deep value stocks that began while I was working at Simmons & Company, an oil-service investment-banking boutique. When I started in the Securities Group at Simmons, one of my tasks was to gather statistics on a variety of oil-service companies. I purchased a stock screening tool and began looking at and purchasing Benjamin Graham type net-net companies of various kinds for my personal account. Soon after, I decided to attend Wharton where I was lucky enough to have John Neff as one of my professors. While I was in school, I started working with Donald Smith & Co. who has used a deep value strategy very successfully for many years. After school, I joined a small firm based in Arlington, VA that had once been an office of Kahn Brothers. Irving Kahn, who founded Kahn Brothers, was once Benjamin Graham’s teaching assistant at Columbia. The year after I joined the firm, I wanted to start a primary investment vehicle, so we started the Aegis Value Fund.
The tipping point probably came in 2001, when money started flowing back into value funds after the tech bubble had burst. We had started the Fund in the spring of 1998, just prior to Long-Term Capital’s implosion, and the first few years were a particularly difficult time for value investors. Tech stocks had gone wild in the ensuing low interest rate environment as the Fed bailed out the LTCM lenders. We didn’t own much tech in those years, as those companies were so expensive at the time, and it was very difficult to get any client interest in what we were doing. Fortunately, we stuck to our guns. When the tech party ended, our remaining clients were perfectly positioned in the crown jewels of the “old economy,” and we ended up doing very well in 2001 and 2002, years which were quite difficult for the broader market.
MOI: In the fickle investment business, thirteen years is a long time to have managed the same investment vehicle. Your market-beating track record could have steered you toward the higher-fee hedge fund model. Why have you stayed loyal to mutual funds?
Barbee: That’s a good question. We originally started up as a mutual fund because we believed that we could build a strong public track record that over time would attract a group of like-minded clients. I was certainly more interested in managing money than in marketing for clients, and back then I did not have the needed universe of wealthy connections ready and willing to contribute capital to start a hedge fund. Our original premise worked out fairly nicely, and we are now fortunate to have a good group of loyal clients from across the financial spectrum who have found us and who have stuck with us through some fairly difficult periods.
However, I have become increasingly worried about the deterioration of the competitiveness of the actively managed mutual fund business. The public policy approach with respect to mutual funds has not been helpful. As a minor example, consider that Sarbanes Oxley has substantially raised the legal risk incurred when communicating with public shareholders in the annual reports, so our shareholder reports are now significantly abbreviated. Mutual funds are now forced to have four Sarbanes Oxley meetings a year — meetings that are almost a complete waste of time. Hedge funds have, until now, avoided many of these kinds of burdensome regulatory requirements, allowing the managers to focus more exclusively on earning returns for their clients.
Mutual funds have also lost ground in recent years to the highly commoditized index fund business. While investors could certainly do far worse than index funds, some of which are fairly low cost, many are taking the idea of indexing too far. True cap-weighted index funds are notorious for buying high and selling low, and I generally wouldn’t recommend index funds over active value investing. Yet academicians like Burton Malkiel, who have done some intelligent work with regard to broad market efficiencies and investor pitfalls, typically extend efficient markets arguments to contend that it is impossible, other than by pure luck, for any investment manager to beat the market over time. Many long-time practicing value investors are quite pleased to have realized that this view is incorrect. For example, since we started our fund in May of 1998, we’ve beaten the S&P 500 by over 800 basis points per annum and the Russell 2000 Index by over 550 basis points per annum.
We would dismiss views of Malkiel and be on our profitable way but for those who are trying to use these academic views to demean our work as a justification to encourage regulation of compensation in the mutual fund industry. If Jack Bogle and other like-minded folks have their way, there is a risk that the whole mutual fund business turns into something like a regulated utility, with management fees regulated either directly by fiat, or indirectly by independent directors frightened by risk of possible litigation. Whether intended or not, the result seems to be a bifurcation of the market for financial management into index funds and hedge funds, with all but the very rich left with fewer options for real active management. When middle-class investors, because of misguided government policy, are left with limited money management options outside of index funds, I think it can lead to distorted capital markets in ways that will eventually damage middle-class returns and dampen their overall faith that our capital markets are a level playing field.
MOI: Proponents of reform use as one of their main weapons the fact that most mutual funds underperform the indices on an after-fee basis. Clearly, many mutual funds are not adding value and gaming the system to an extent, either by making shareholders pay for marketing or by closing underperforming funds only to open new ones. Are there changes that would allow funds that add value to thrive while putting out of business funds that do not add value?
Barbee: I think the free market itself does a pretty reasonable job at rewarding fund winners and punishing losers.
With regard to mutual fund fees, I believe consolidation in the brokerage and asset custodian industry during my career has led to increased demands on funds for “pay to play.” Some funds might now pay as much as 50 percent of their fees out in these kinds of rebates to the various custodians to avoid exclusion from their custodial networks. Some brokerage custodians directly rebate a portion of these fees back to their clients, and other custodians use some of these fees to indirectly subsidize the trading and back office expenses of their financial advisory firm clients and direct customers.
Unfortunately, however, it always seems to be the fund manager who is criticized in the press for the fund fee pressure that rebate demands create. I certainly applaud those financial advisors who are willing to hold a client’s assets at multiple custodial platforms in order to find the best funds available for their clients regardless of custodial platform. Usually this means an advisor has to do a lot more client hand-holding and expensive back office work themselves. Fortunately, I think multi-platform advisory software is getting better, and over time more advisors may be managing client assets more efficiently over a multitude of custodial platforms, which may result in more brokerage custodian competition and reduced fund fees over time.
On Graham-and-Dodd-Style Investing
MOI: Once you’ve identified stocks meeting your quantitative criteria, how do you decide which companies deserve your investment dollars?
Barbee: After passing our quantitative screen, we examine the company for attributes that we consider to be promising. These include insider buying and insider ownership, share repurchases, recent restructurings and cost cutting, or other similar events that the market may not be fully appreciating.
If we are satisfied after our initial analysis, we will lay out the financials in a spreadsheet, which typically includes recasting the balance sheet and income statement over recent years. During this stage, we are looking for hidden or undervalued assets and trying to ensure that the assets aren’t overvalued. We are also trying to determine the company’s normalized earnings power a few years out. Concurrently, we read the SEC filings, conduct conference calls, and review other corporate documents including investor presentations to learn as much about the business as is available to the public. We gather our questions and frequently speak with management.
We generally like to buy companies trading at a significant discount to their asset values and at mid to low single-digit multiples of normalized earnings two to three years out. This way, the assets provide downside protection while the earnings potential gives us upside.
MOI: What has driven your strong preference for American-domiciled companies, as reflected by the portfolio composition of the Aegis Value Fund? It seems that Graham-style bargains abound in countries like Japan and even in some emerging economies.
Barbee: There is a confluence of issues that keep our search focused on the home turf. We have, on occasion, attempted to speak with foreign companies and have found, for our small firm, the language barrier sometimes to be an issue, preventing us from becoming fully comfortable with management responses. We are also increasingly less satisfied with the political climate across the world, although I suppose one could argue the same is unfortunately increasingly true here as well. Generally we find it difficult enough focusing on assessing political risk in the U.S., and today we just don’t have the resources needed to add a wide variety of foreign markets to the mix.
We are fairly confident, however, in making investments in companies based out of the UK, Bermuda and Canada, and we do have a select few equity investments in these countries. In fact, in our high yield fund, Aegis High Yield (MUTF:AHYFX), we have found significant inefficiencies in the debt markets north of the border.
MOI: Can you elaborate?
Barbee: We have invested in the debt of two Canadian public REITs, which we bought at yields that were quite high for the strong level of real estate assets and cash flows supporting the issues. We also liked the fact that they were Canadian dollar-denominated investments. In one case, we thought the equity was a solid investment as well, and purchased the stock in the Aegis Value Fund.
MOI: You have written that “great stock purchases are often made in the face of uncertainty and despair. The key to reaping the advantage of those superior long-run returns is to remain invested and patiently focused on the fundamentals following periods of market illiquidity and panic selling…” Notably, you adopted a bullish tone in your letters after equity markets had crumbled in late 2008 and early 2009. What gave you the confidence to stay fully invested, and what kinds of adjustments did you make to the Aegis portfolio at the time?
Barbee: Our confidence was driven by the valuations, which had become absurdly cheap. At the time, we believed the majority of our companies could survive a prolonged deep recessionary environment as they, by and large, were not highly levered and were conservatively managed. A few of our holdings, in fact, were trading below the net cash on their balance sheet, and while their operations were stressed, the companies’ survivability was unquestionable.
It was not hard to conclude from the extraordinarily low valuations that there would be a turn, which helped us in getting through our own mark-to-market anxieties. In regards to our tone, the pessimism had become so extreme, and the valuations so low at the time that while we didn’t know when the tide would turn, we believed purchasing equities at that point would prove to be rewarding over time.
My own primary source of stress was the redemptions which were occurring. I worried that if the market stayed suppressed for an extended period before recovering, even though we might be vindicated, we may not have much capital left to manage. In my letter to investors, I was trying diligently to keep investors focused on the extraordinary valuations and potential for long-term appreciation and not to be overly focused on the severely distressed marks they were seeing in their monthly statements.
Few adjustments were made to the portfolio at the time, besides the unfortunate task of choosing stocks to sell to meet the significant redemptions we faced. We attempted to use the liquidations to our advantage by selling the securities that we wanted least. Towards the end of the panic, we functionally ended up with our top picks that consequently performed well as the mood brightened. But by and large, we held on to the same companies entering the crash as we did coming out.
On Inflation, Investor Mistakes, and Good Reads
MOI: You have expressed concern regarding the inflationary consequences of the Fed’s unprecedented balance sheet expansion during 2009. In your January 2010 letter, you opined that, “the Fed is likely to be unwilling to increase interest rates in a sufficiently timely manner to avoid higher inflation.” When it comes to investing for inflation protection, do you believe investors who favor companies trading at discounts to tangible book value might be at a disadvantage vis-à-vis investors who prefer companies with intangible assets and perhaps greater pricing power? After all, Warren Buffett has written that the need to replace physical assets in an inflationary environment represents a significant drag on the cash flows of capital-intensive businesses…
Barbee: Today, the market seems caught in a cross-current, caught between the deflationary forces of debt deleveraging and the potential inflationary effects of monetary base expansion. We believe history has shown that in the past, there are more examples of these kinds of situations resulting in an inflationary wash-out than a deflationary depression. Simply put, when politically connected entities are highly leveraged, and the government can create dollars at very low marginal cost, it is difficult to see how serious deflation will ever be allowed.
With respect to value stocks, we have studied the question of how deep value stocks perform during periods of inflation: In the four periods during the 20th century in which inflation was greater than 8% on an annual basis, small cap value stocks as defined by Kenneth French returned 19% annually, while large cap growth stocks returned 7% and ten-year Treasuries only 2%.
Of course, the impact is also dependent on the industry in which the company operates. Our largest weighting by sector is insurance, and we are focusing investment in specifically short- to medium-tail insurers with short-duration assets in order to minimize inflationary risk. We also have large holdings in the oil and gas exploration and production and oil service sectors, both areas we believe to be superior to holding gold on account of the cash generating capability of the assets.
With respect to Buffett’s comments on asset replacement during inflationary periods, I believe Buffett was making the point about the failure of stated depreciation, which by accounting standard is based on pre-inflated original cost, to capture the true post-inflation economic depreciation of an enterprise’s assets. This can result in reported earnings significantly higher than true economic earnings. While this would point to adjusting reported earnings of these companies downward, I don’t believe it necessarily suggests an avoidance of investments that could be purchased at a discount to accounting book value under which assets are valued at pre-inflated historical cost.
MOI: What books have you read in recent years that have stood out as valuable additions to your investment library?
Barbee: Lately, I’ve been reading Secrets of the Temple – How the Federal Reserve Runs the Country by William Greider. The book gives a very detailed narrative of the activities and struggles of the Federal Reserve during the inflationary years of the late Carter administration and during Volcker’s tenure. For a guy like me, who was pretty young during that time, the book is a timely opportunity to achieve some vicarious experience of what the markets might look like during inflationary times.
I am also reading Stock Market Superstars: Secrets of Canada’s Top Stock Pickers by Bob Thompson, which chronicles the experiences of some of Canada’s better investors.
I just finished reading The Partnership by Charles Ellis, an extraordinarily well researched and lively book that chronicles the rise of Goldman. Ellis is a fantastic writer and a true veteran of the financial industry, and the vignettes in his book on the various struggles Goldman faced through the years hold great investing and management lessons for any financial firm.
Also, on financial firm management, while not technically a book, I would recommend Ray Dalio’s principles, which I dug up after reading a piece in the Wall Street Journal about Bridgewater. Dalio’s principles are available on Bridgewater’s website. Over the last 30 years, Dalio built Bridgewater into a $75 billion global investing powerhouse with over 900 employees, and has made himself several billion dollars in the process. That he would outline his management philosophy for all of us to contemplate is a true gift.
MOI: Thank you very much for your time and insight.
Barbee: My pleasure.
Disclosure: No positions