Being on the defensive has paid in 2011, writes Martin Steward. But the US is a confusingly mixed prospect for the coming year

“If you want to write something nice,” jokes David Daglio after 20 minutes gamely discussing all the punishment meted out to his portfolio this year, “Liz Claibourne is up about 100% this quarter.”

The fifth-largest holding in the US Small Cap Opportunistic Value Equity strategy that Daglio manages at The Boston Company Asset Management has had a storming Q4: new lines found favour with pinched consumers - even at higher prices. Margins expanded and earnings tidily beat expectations, sending the stock on a heady run from $4.48 to a high of $8.82.

But that final burst is only one-quarter of the story. Over the four months since the start of August it has swung down 30%, up 60%, down 30% again, and up 100%. There is not much standard about that kind of deviation.

Not surprisingly, the Boston Company’s overall volatility comes in around 31%, three percentage points higher than its benchmark. Compare that with the other strategy in this article: River Road Asset Management’s Independent Value Strategy has delivered volatility at just 13%, and its beta is a stupendously low 0.48.

“We are riskier than about 75% of our peers,” concedes Daglio. And his strategy feeds off market volatility: “We know these gyrating environments have always been great for fundamental investors like ourselves. We came off the similar period of 2008-09 very well; we owned a smattering of the high-end retailers through the crisis, and they were up six or eight-fold after it. We asked, are they sustainable, are they in the right place competitively, and is management doing the right thing?”

The Boston Company calls this concept ‘intrinsic value’. But thanks to the ‘opportunistic’ element of this particular portfolio, its trailing P/E ratio, at 14.6 times, is higher than the benchmark’s 12 times - and that is the standard Russell 2000, not the value index. We are not talking about value that the market can easily discern - or form a consensus on. “We are agnostic about trailing earnings: we are more interested in what the shape of the business today tells us about how it will earn money going forward,” says Daglio.

That involves a lot of focus on normalised or mid-cycle cash flows as the basis for valuation, but also catalysts for earnings growth. “We talk a lot about looking for catalysts that are probable, but not definite,” he says. “It’s where we can identify change in a market - either at security or industry level - that could rapidly change the competitive position of a company.”

Sometimes - as with Liz Claibourne - the stock price growth can be explosive, not least when strategic buyers descend to take a company private, which Daglio describes as quite typical for the ‘intrinsic value’ style. “We’ve had four through 2011,” he reveals, pointing to Monex Group’s acquisition of the multi-asset broker TradeStation and Charles Schwab’s bid for OptionsExpress. “They both had short-term earnings issues because of net interest margin pressure, but were well-positioned competitively.”

So these are volatile stocks and volatile stocks are not always the most intrinsically valuable, of course - in a market of strongly-positive momentum they begin to look expensive, as they did in 2006-07. This is why, after lagging the benchmark through those two years, Daglio’s portfolio outperformed through the crash of 2008. But, as he implies, it was the rotation into value again that really suited the true essence of the strategy: at 65%, its 2009 return whipped the benchmark by almost 30 percentage points.

And as markets capitulated to paying sky-high prices for the most stable, visible cash flows they could find in 2011, the tricky, less visible opportunities are the ones that are popping onto Daglio’s buy list once again. “We don’t wake up in the morning and decide to buy high-beta stocks,” he explains. “But right now the best opportunities we see do, on average, have higher beta. By contrast, electric utilities and consumer staples are trading at record premiums. That has hurt our performance through 2011.”

The top-performer over three years in the Mercer tables at the end of Q2, the Opportunistic Value strategy languished in 34th place by the end of Q3.

Daglio actually came into 2011 neutral on utilities and, in general, he likes that their return on equity usually outstrips their low cost of capital. But through Q2 he became concerned at the skew of risk versus reward as their steady, regulated cash flows were bid-up. Virtually all his exposure was sold before Q3.

“They are more expensive than they have been for 30 years,” he insists. “We will avoid a sector altogether if we perceive there to be significant capital risk - and even in a bull market these stocks won’t go up much.”

Daglio stresses that none of this implies a bullish top-down view - it is all about bottom-up intrinsic value. Indeed, he says the portfolio is at the lower end of its concentration range of 80-110 stocks precisely because visibility is so poor and it is challenging to find stocks that offer downside confidence.

Among pro-cyclical sectors it is underweight financials (1.2 times book value seems fair to Daglio) and materials (where he sees overvaluation as the Chinese growth engine runs out of steam). While that utilities underweight is one half of a sector tilt that sees industrials overweighted by 14 percentage points and consumer discretionary by six, Dalio observes that an industrials tilt at small-caps level doesn’t necessarily imply the very pro-cyclical tilt that it would in large-caps: “In our portfolio you’d find a company specialising in launching satellites, a couple of staffing businesses [employment agencies]. The latter have proven fairly counter-cyclical.” He also points to “moderate cyclicals” that can benefit through recessions from falling input costs, like distribution and logistics businesses, or chemicals companies whose costs have collapsed with the price of natural gas.

Nonetheless, alongside Liz Claibourne, Daglio’s top five stocks include barcode and point-of-sale technology firm ScanSource and DealerTrack, which provides systems for the automotive sales industry. In his top 20, we find carpet and furniture manufacturers and homebuilders. “The worst is over in US housing, and building products looks to be going through a nascent recovery,” he says, pointing to accelerating mortgage applications and US housing capacity that is 50% of the long-term requirement.

“We see lots of downside support, and industries going through enormous structural change as a lot of the smaller competitors are no longer around,” he says. “We think that means that return on capital will be even stronger over the next cycle than it has been in prior cycles.”

That is a scenario that would leave the River Road Independent Value Strategy seriously lagging the market. And yet, in many ways, the two strategies look very similar.
Recall the emphasis Daglio placed on normalised or mid-cycle cash flows as the bedrock for confident valuations. Eric Cinnamond, portfolio manager at River Road, says exactly the same thing. It is no surprise that both therefore value long track records. Daglio’s top stock is Hanger Orthopedic, which celebrated its 150th anniversary in August 2011. The average age of the businesses in Cinnamond’s portfolio is 50 years.

“In addition, of course, longevity suggests you are a high-quality market leader,” he says. “People wonder how a successful company can be around for 50 years and still be a small-cap. But many of these industries are niches that investors just don’t normally think about - you can own the entire cat-litter market and still not be above $500m in market cap. I view these quality stocks almost as perpetual bonds because of the consistent cash flows they have generated decade after decade - they are certainly not your usual small-caps. We are not trying to find the next Microsoft.”

This emphasis on longevity and quality has delivered impressive growth; River Road’s portfolio outstrips its Russell 2000 Value benchmark handsomely on return on equity, cash flow and EPS growth. But it is also the genuine value strategy that its name suggests - trailing P/E is actually a little lower than that of The Boston Company’s portfolio. How does it square that circle? As Cinnamond’s description implies, it is not about the contrarian risk-taking at the heart of Daglio’s strategy, but a very different kind of selectivity and patience. He says that no more than 300-400 names meet his ‘quality’ criteria in small-caps, out of a universe 10 times as big.

“I’d love to be fully-invested all the time, but there aren’t enough high-quality companies and they are not always selling at discounts,” he says. “But volatility always comes back, and I wait patiently with my buy-list.”

This is the strategy’s big differentiator - flexibility to hold its entire assets in cash. In practice, Cinnamond has never gone higher than 50%, but he did hit that level again recently, in April 2011. Even after the sell-off in August, cash only went as low as 38%.
“If I’m not being paid to take risk, I’m not forced to do so,” he explains. “And by limiting your mistakes, you don’t need to have 200-300% gainers to achieve a satisfying return.”

That is an important point. It would be very tempting to assume that it is the cash holding that delivers the defensive, 0.48 beta of this portfolio, and that it therefore has to swing for the fence in its equity positions. Not a bit of it. Strip out the cash, and the equities were up 2.3% for 2011 to the end of Q3, against an 18.5% loss for the benchmark. The cash optionality enables Cinnamond to buy at just the right time to squeeze the maximum yield from genuinely defensive stocks.

And right now Cinnamond is more defensive than usual, seeing the economy transitioning from “slow growth to slow-to-no-growth” as businesses struggle against a lack of visibility, and anticipating mean reversion from current high levels of profitability. “Stocks may look cheap on today’s profits, but if you normalise the margins, things begin to look different,” he warns.

He describes how he splits company risk into operating risk (essentially, cash flow volatility) and financial risk (balance sheet health), and can take either one but not both. At the moment, Cinnamond says that his top holdings are exemplified by his number-five, intravenous connector manufacturer ICU Medical, which presents neither of those risks. Trading at $45, it has stable revenues from a 40% market share in non-elective critical care, an 18% profit margin, $2.60 per share of annual free cash flow and $9 per share in cash on its balance sheet.

Healthcare is a sector overweight, and there are even bigger active bets in consumer staples and the most defensive processing technology sub-sectors with high recurring revenues and a recession-proofing theme: the toptech holdings include Total Systems (point-of-sale technology, but with a definite cost-efficiency tilt) and EPIQ Systems (which specialises in software for bankruptcy lawyers).

Even the supposedly cyclical sectors disguise a bearish slant. While materials is zero-weighted and financials severely underweighted, the portfolio is almost eight percentage points overweight in consumer discretionaries and has nearly 11% in industrials. But those ‘discretionaries’ include companies like Core-Mark, a logistics firm distributing mostly staples to convenience stores; and Papa John’s, which delivers pizzas, a “real recession food”, as Cinnamond puts it: “I recommend getting the extra sauce - it’s very good.”

Similarly, the industrials include Copart, the salvage-market leader which generates very stable cash flows from auctioning parts from written-off cars. Even Unifirst, whose business providing work uniforms one might expect to be vulnerable in an age of downsizing, is a secret anti-recession weapon - like Daglio’s logistics companies, it benefits from lower costs (whether natural gas for drying clothes or petrol for distributing them), but it also gets to recycle a lot of returned uniforms as workers get laid-off. “In fact, if we do see a pick-up in employment, margins might even contract as it produces a lot more new uniforms, which will have to be amortised at a higher rate,” Cinnamond explains.

This is without doubt the major risk that the River Road strategy is currently running, and it is exemplified by Cinnamond’s willingness to pay for utilities. The portfolio has a very slight overweight to the sector, and Avista Corp is its seventh-largest holding. Recall that Daglio (who weights them at zero) is convinced that utilities present a risk of capital loss.
“We’re a sitting duck for more QE and an extension of profits,” Cinnamond concedes. “We are very unusual, in that we are trying to mitigate risk in an area - small-caps - where many others gravitate to get risk.”

Clients know just how severe the underperformance can be when the market gets excited. In the Mercer tables for the period ending in Q2 2011, while River Road’s strategy was second out of 755 over three years, it had slumped to 678th out of 717 over the 12-month horizon. And Cinnamond knows what he would say to them: “The whole concept of relative performance is not something I have ever understood, and doesn’t fit with the notion of acting as a fiduciary, in my view. Aren’t we fiduciaries? When did we forget that?”