Whitney George: You want to find ”sick” companies that are going to get better

29.4.2015, 22:28 -

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When I last spoke with value investor Whitney George, he had just joined Sprott Asset Management.
Whitney is looking for great businesses capable of generating a lot of cash but that are going through a slump.
Temporary setbacks can cause shares in good companies to become cheap as investors exit the story.
Of course, you need to figure out which companies are genuinely good businesses that are likely to recover.
That’s why Whitney spends a lot of time looking at the talent behind the company, and trying to ensure that they’re aligned with his interests.
What brought a value investor with no specific interest in natural resources and precious metals to Sprott’s door? He was looking to move his fund to a new company, he explained. Sprott “checked all the boxes,” in his view.
We talked about applying value investing today, and how he ended up finding a new home at Sprott.
Henry Bonner: What got you interested in Sprott as an investor, and why did you decide to come over and join the company?
Whitney George: As a long-term investor in asset managers, I got to know Sprott during the crisis in 2008. I had actually done a lot of work with the predecessor Sprott Securities and so I knew a lot about Sprott’s research and idea generation.
My style is to try to find companies with strong financials, strong balance sheets, and high returns on capital. I am essentially looking for operating leverage without financial leverage.
Asset management is a business that I’ve been in my entire career and probably one of my favorite industries as an investor. But because it’s such a good business, you need a bear market for valuations to come down to levels where there are good opportunities.
Of course we had that across the board in ’08. It was a great time for investing in great businesses, particularly asset managers.
The first round (of investing in Sprott) was very successful and I got to know the company better and better. Through all this time, I’d gotten to know Peter Grosskopf (CEO of Sprott Inc.), Rick Rule and Eric Sprott. The management business is a people business and I found them all to be of the highest level of integrity.
When I decided to make a career change, my first call was to Sprott because it represented to me exactly the kind of organization that I wanted to spend the rest of my career with. There is the alignment of interest with customers which I share, as I’m the largest investor in the products that I manage.
Do you prefer to invest in asset managers in a particular sector, as opposed to the producers?
Well, at different times and different prices, I could be interested in just about anything. There’s not the same history in other industries, like mining and a lot of commodities-related industries, of earning sustainably high returns on capital and generating lots of free cash flow. They’re capital-intensive businesses. Asset management is people-intensive but not capital-intensive.
Asset management produces high returns on invested capital because it doesn’t require very much capital, and certainly it offers fantastic leverage to the various markets where they operate, whether precious metals and natural resources or emerging-market fixed income or private equity.
There’s a lot of upside in the model without a lot of capital required. They have the ability to generate a lot of free cash, which they can share with their shareholders.
What are some of the specific items you watch for when you’re looking at a new company?
When I invest in any company, it really starts with the company fitting the statistical model that I’m looking for. Typically you don’t get good value when everything is going right. Usually there’s some issue that’s bothering the market in the short term.
You look to understand what the current issues are, how the company got to be where it was to begin with. Its history, its philosophy, its management, its culture, and its governance are all part of the initial due diligence.
After that comes an assessment compared to peers. Is this a security that’s down by itself or is there a broader theme going on? Is this the best opportunity within that space to participate in whatever is causing the near-term angst? What are the conditions for that to change and what is a reasonable timeframe for those conditions to change?
You want to find sick companies that are going to get better and get through their problems.
Then of course you look at how management is handling those stresses. Are they being opportunistic? Are they expanding their franchise in a difficult environment or are they retrenching? Are they firing all their people to save costs as opposed to reinvesting in the business and being opportunistic at that point in time in their own cycle?
Do companies often have some of their best opportunities in a bear market? Is that where you see who the best companies are in a sector?
The answer to that question gets back to one of my favorite Warren Buffett’s quotes, “when they drain the swimming pool, you can find out who’s wearing a bathing suit.” Certainly difficult market conditions are a much better time to judge the core strength of a franchise, brand or a company, as opposed to when everything is going well and it’s easy to look good. So buying into a bear market clarifies the likely survivors versus the victims.
Do you take an activist approach? Do you try to help companies “fix” themselves?
For me, to take an activist approach would indicate that I’ve made a bad miscalculation. It’s generally not a good idea to invest in companies where you think you know how to run their business better than they do.
When I get into that position, it’s because I’ve missed something. I’ve made a mistake and usually there’s a better opportunity out there. It’s probably time to move on. It’s not that I won’t add my input or counsel where requested but it’s really not my job to manage other people’s businesses. It’s my job to invest in the best businesses I can find.
Does your experience as an investor, though, give you insights into what companies should be doing?
While I was at Royce, for 23 years, we had lots of cycles. By the end of the 90’s, nobody wanted small-cap investors or value investors. Everybody wanted big cap growth or dot-com companies and that was a very difficult period for Royce and Associates. But the play-book was the same.
They reinvested in the business through that difficult cycle. They added talent when talent was available. Of course, when things are going well it’s very hard to get talented people to make a change. When things are going very poorly, that’s the time to be opportunistic. I was a part of that at Royce in 2000, not knowing when things would turn or how it would change but just taking advantage of the opportunities that presented themselves, in terms of people, which created a fantastic outcome over the next 10 or 11 years at Royce.
Did the precious metals and the hard money thesis that’s behind a lot of Sprott investments motivate you to join Sprott?
It was certainly a reason why I was willing to invest in Sprott while I was a portfolio manager at Royce. I’m not really prepared to make a career of making a bet that the financial world is coming to an end and profiting. That’s not much fun in my mind.
However, I believe very much in a diversified portfolio. I believe in risk management. I believe there’s a high likelihood that the central banks in the world won’t get this all right and there will be hiccups along the way. Certainly I have been interested in hard assets for a long time, whether precious metals or energy. That can also include industrial companies and it can include brands. They can be very good hedges in an inflationary environment.
There’s an old adage, “Don’t fight the Fed.” People currently are taking that to mean “don’t fight them over interest rates.” Over the longer term, clearly the Fed and every other central bank is trying to create inflation and ultimately I think they will get it.
It’s kind of hard to determine when. Over time, owning gold in the right proportion has been an excellent balance to a diversified portfolio for non-correlated returns. Certainly if you look at the long-term picture, it has been good to have precious metals or some part of that in your portfolio.
I don’t think it needs to be 20, 30, 50 or 100 percent of somebody’s portfolio. Ten percent works just fine for me.
Do you worry much about what the Fed is going to do or what’s going to happen with the dollar? In a small cap world where you’re operating, is the broad economic environment much less important than company-specific factors?
It’s very hard to predict what’s going to happen next. I think it’s a lot easier to predict what’s going to happen three to five years out than what’s going to happen specifically in the next three to five months. The world is absolutely infatuated with trying to predict when the Fed is going to leave the launch pad or when the next move is going to be.
I see no value in doing that. My approach is to find great businesses, get an understanding of what I think they’re worth and buy them when they’re being offered at a discount. If it’s economically sensitive companies that are out of favor because people are worried about the next recession, for me that’s an opportunity.
I think in the next three to five years, rates will go up, but trying to predict which quarter it begins is something I leave to other people.
I understand individual businesses a lot better than I could ever understand the global financial system. Clearly there are stresses and excesses. Risk management is important to me. It’s unimportant to a majority of investors today as evidenced by the fact that indexing is so popular.
How often do you find that a company you own in your portfolio is just unable to overcome the issues that are making it sick and you have to let go? When do you know that it’s just time to walk away?
Probably more often than I would like to admit. You can often miss structural changes that take place. More often than not, it’s timing, which is why I like to invest with a three to five-year horizon. But even in recent memory, five years hasn’t been enough for whole industries to recover.
Usually I leave a situation when I believe that the strategy management is employing is value-destructive or they are doing something that adds risk. Like take on a lot of debt to buy back too much stock and change the balance sheet structure or make a strategic acquisition because their core business is not growing quickly enough.
I’m a very patient investor. Usually management or somebody will do something if things are going poorly. That can be a good thing, but very often it’s a change for the worse. The investment has not worked out and it’s time to move on.
Cutting losses is a big part of what we do. It’s really about how you manage the losses. Working with a team is very helpful in identifying the so-called ‘value traps,’ which are the worst things for a value investor: you buy a stock and own it for five or ten years and it goes nowhere.
It’s the opportunity cost of that investment that is destructive. With a short-term loss, you’ve identified something that you didn’t know earlier and moved on.
Having partners that help question and point those things out and get you to think openly about things that you haven’t thought before is very helpful in mitigating some of those traps.
Do you invest in precious metals and natural resource stocks?
I’ve been an investor with 10 percent or so or less for the last 15 years in the mining sector. It was a very, very useful place to be from 2000 to 2011. It has been a very unproductive place to invest, as we all know, in the last four years. Some of it is due to external circumstances. Some of it is due to individual company misallocation of capital.
Again it’s a capital-intensive industry. The opportunity to misallocate that capital is always present. Plus you have geographic risk that is a little different than what you might face with a domestic small-cap industrial company or financial services company.
It’s my suspicion that at this stage the market has already adequately priced in most of those risks after four years of declining valuations and an 80 percent sell-off broadly in junior mining companies. So being opportunistic and somewhat contrarian, I think it’s an interesting place to look for opportunities right now.
Do “blue chip stocks,” the big companies that trade on major stock markets like the New York Stock Exchange, tend to be more fairly valued than the smaller companies where you tend to focus?
I think that is the normal expectation. It is reasonable for somebody to pay more for the liquidity, stability and diversification that you get in a large-cap stock.
Small-cap stocks typically tend to be in just one business. They very often have concentrated customer risk. They are maybe reliant on individual executives. At large companies, you might have 20 different divisions. So it’s already a diversified portfolio within a single large-cap stock.
Normally you would expect a liquidity premium for the largest stocks and then as you go down the food chain into the micro-cap world, you should expected to be compensated for the lack of liquidity and the fragility of the underlying business with lower valuations.
A lot of that has gotten turned upside down in the last five years. It got turned around in ’09 for the first time since 1991. You saw some mega-cap stocks trading at absolute valuations that you would normally find in the micro-cap space.
In 2009, companies like Microsoft, Exxon Mobil and Franklin Resources all traded at 10 times earnings, which, given their size, was an exceptional opportunity to get those stocks personally in the portfolios that I run.
Even today, one could argue that the liquidity premium does not apply to Apple computer. If you net out its cash, I think it’s trading at a very low double-digit multiple, yet you can find all sorts of other securities, certainly in social media and in biotech, which are untested and fragile that trade at huge premiums.
I don’t think we’re in a normal environment. I think zero-interest-rates have skewed the way people value companies. They overpay for dividends in things like REITs and utilities because of the relative returns that they would get versus treasuries.
They overpay for growth because with zero-interest-rates, what happens 20 years from now actually impacts your valuation. In a normalized rate environment, where you have a discount rate, anything that happens after six, seven, ten years would not receive much attention in a value equation.
We’re seeing various kinds of strange dynamics in the market and again I think it is a function of living in a zero-interest-rate environment, or even negative-rate in some parts of the world.
Do you invest mostly in US stocks right now or are you looking at international opportunities?
I am looking wherever the best valuations and opportunities are now. I have a lot more experience in US equity markets, so the majority of the portfolio is going to be North-American-centric. Let’s throw Canada in there as well because again it has very similar dynamics.
But there are other developed markets in the world where I’m prepared to invest at the right valuations. In Northern Europe, given what the euro has done, whatever kinds of opportunities exist are now 20 percent cheaper just because of the up-move in the dollar versus the euro.
I don’t hedge currencies when I invest in foreign securities. In this case, we would be using a very strong currency to buy great companies where the currency is weaker. That’s part of the whole valuation equation. It happened during the financial crisis, where European small-cap stocks were hit harder than US stocks and then the currency appreciated. Our currency was 25 percent more valuable, so you got a lot more bang for your dollar.
For the small-cap space, the US is the only country where it’s an asset class. In the rest of the world, some countries are just getting accustomed to equities. In those that have mature equity markets, small cap is an opportunistic part of the market and people are very quick to run for the hills when the markets get risky. That volatility for me creates some interesting opportunities.
You mentioned that financial companies are people-intensive, not capital-intensive. How do you recognize companies with the right environments to attract the best talent?
I wouldn’t say that financial companies are not capital-intensive. Banks are very capital-intensive. Insurance companies less so, brokerage even less. Asset managers require the least amount of capital, but probably the greatest amount of talent.
So the things that you look to are the history and the ownership structure. Are these companies going to be managed sensibly? Are the founders still major shareholders? Corporate governance and compensation systems are very, very important because at the end of the day, people do what they’re paid to do.
You want to make sure that the employees are aligned as best possible with the shareholders because that’s your best chance of capturing the kind of returns that are available, as opposed to the employees capturing them and not the investors.
So I think corporate governance and compensation schemes are particularly important when you are investing in human capital.
Do you see generally superior management in companies where the original founders or insiders are major shareholders?
I would definitely favor owner-operated kinds of businesses. That creates the best alignment for me as an outside shareholder. I’m eating the same cooking that the founder or the CEO is, and that’s a much more comfortable position for me.
A company where there isn’t any insider ownership, but option schemes, is essentially a “Heads, I win, Tails, you lose” proposition for the outside shareholders. Executives are incented to get the stock price up so that they can be highly compensated. They take risks that they wouldn’t necessarily take with their own money to accomplish that.
That shows up when you see companies buying their own stock at inflated valuations and issuing lots of options. That’s very much part of the market. It’s very often how people are compensated but that’s something that I typically shy away from.
When doing valuations in business modeling, I always pay very close attention to the number of diluted shares outstanding and the insider ownership. It’s part of understanding the governance of the company.
Whitney, thank you for speaking with me. I’m glad to be working with you. I hope to speak with you again soon.
My pleasure and thank you again for your time.
Thank you.
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