Friday, September 21, 2012

Mason Hawkins: Competitively Advantaged Businesses Selling at a Discount to Value

Mason Hawkins, chairman and CEO of Southeastern Asset Management, the advisor to Longleaf Partner Funds, recently answered questions from GuruFocus readers.

Here is a quick summary of just a few of the noteworthy things he had to say:

- They look for financially strong, competitively entrenched/advantaged businesses selling at a significant discount to intrinsic value.

- They like to limit their portfolio to 20 investments and consider that number of securities adequate diversification. In fact, Mason Hawkins says statistical evidence shows there is little incremental benefit of additional holdings beyond 14 different stocks in different industries.

- They like owning businesses run by management that is competent both operationally and in terms of capital allocation.

Check out the Q&A in its entirety.

An excerpt:

"We view quality through the lens of a business owner. We want to own companies with the following qualitative characteristics. 1) Unique assets having distinct and sustainable competitive advantages that enable pricing power, long-term earnings growth, and stable or increasing profit margins. 2) High returns on capital and on equity as measured by free cash flow rather than earnings. 3) Capable management teams with operating skills, capital allocation prowess, and properly aligned, ownership-based incentives."

Hawkins also said that that their long-term horizon allows them to buy quality businesses at large discounts to value when earnings, for any number of reasons, happen to be reduced short-term. It's not a small advantage to be thinking a number of years out when so many market participants are focused on very near-term price dynamics.

In The Superinvestors of Graham-and-Doddsville, Warren Buffett made the following point about the "intellectual origin" of "superinvestors":*

"In addition to geographical origins, there can be what I call an intellectual origin."

He then adds that, in the world of investing, you'll find that a disproportionate number of successful investors...

"...came from a very small intellectual village that could be called Graham-and-Doddsville."

Buffett considers Ben Graham the "intellectual patriarch" with each successful investor applying or building upon the the theory in his own manner. Yet, while each may put the fundamental ideas of Graham-and-Dodd to work in somewhat different ways, they have a crucial thing in common:

"The patriarch has merely set forth the intellectual theory...but each student has decided on his own manner of applying the theory.

The common intellectual theme of the investors from Graham-and-Doddsville is this: they search for discrepancies between the value of a business and the price of small pieces of that business in the market."

Many market participants expend lots of energy figuring out (or attempting to) what direction a stock price might move in the near-term (or even the intermediate-term) and try to profit from it. It's fine and even necessary that some participants are involved in that sort of thing (though I do think the proportion who speculative versus invest longer term has become a bit extreme in favor of speculation).

The emphasis of a speculator is the correct judgment of relatively near-term price action.

The emphasis of an investor is judging value and how compounding effects will impact that value -- generally over a much longer time horizon -- then paying a price now that will produce a good result if that judgment turns out to be sound.

The price paid also must provide a margin of safety for the unforeseen and unforeseeable.

I think it is safe to say that those who primarily focus on making correct judgments about price action, especially those with an average holding period shorter than 3 to 5 years, are probably less influenced by Graham and Dodd and the many investors that have since built upon their theoretical framework.

There are exceptions, of course, but discrepancies between business value and price mostly need to play out over many years. Near-term price action are just votes that, in the near-term, reveal not much about how the price/value discrepancy will be resolved.

The hard work for those heavily influenced by Graham and Dodd is in figuring out what something is worth not trying to figure out what the stock will do. The stock will generally do just fine in the long run if business value was judged well.

Buffett later went on to say...

"Our Graham & Dodd investors, needless to say, do not discuss beta, the capital asset pricing model, or covariance in returns among securities. These are not subjects of any interest to them. In fact, most of them would have difficulty defining those terms. The investors simply focus on two variables: price and value."

Well, Mason Hawkins and his team seem also very much focused on the variables of price and value. In one of his answers, Hawkins mentioned that they have...

"...a master list of appraisals for 600+ good businesses that we would like to own at the right price."

That's a rather expansive "master list" yet they still end up with a nicely concentrated portfolio when it's all said and done. In my view, owning shares in fewer businesses for a very long time means that big surprises become less likely over time as familiarity with the business and industry grows. So, as a result, there's less chance of getting the valuation very wrong. So my own preference happens to be owning fewer quality businesses for a very long time.***

While that may work for me it is just one of many ways to go about it.

Searching for discrepancies between price and value is the common theme but the specific approach for each investor is necessarily not one size fits all.

There's a wide range of effective ways to get results. For example, Walter Schloss, one of the 'superinvestors", often had a rather large number of stocks in his portfolio. His style is very much unlike Warren Buffett's and Charlie Munger's strong preference for portfolio concentration. It's not unusual for the Berkshire Hathaway (BRKa) equity portfolio to have 60-70 percent and, at times, even more allocated to just five stocks.

Like anything else, the best approach is consistent with individual limits and capabilities, realistically assessed, instead of wishful thinking or overconfidence.

"The first principle is that you must not fool yourself, and you are the easiest person to fool." - Richard Feynman

Some might prefer more or less diversification.

Others may be a bit more or less active.

Maybe a particular knowledge or expertise lends itself to investing in certain types of businesses or industries.

The list goes on.

There are many variations always come back to the common theme of a focus on two variables: price and value.

Adam

* The "superinvestors" mentioned by Warren Buffett include: Walter Scloss, Tom Knapp (Tweedy Browne), Ed Anderson (Tweedy Browne), Bill Ruane (Sequoia Fund) , Rick Guerin, Stan Perlmeter and, of course, Charlie Munger (plus two funds managed by multiple managers).
** That doesn't mean those participants who may be generally more price action conscious don't, at times, use valuation as part of the justification for their trades. Market participants of all kinds draw from a variety of influences.
*** It's an approach that starts and ends with recognition of my own limits. Lower portfolio turnover, higher portfolio concentration, and generating returns primarily from increases to per share intrinsic value of the businesses themselves over time is what has worked best. Beyond the benefits of lower frictional costs, less moves means fewer mistakes. So, as a result, I buy the shares of a limited number of high quality businesses -- those I find understandable that are run by capable owner-oriented executives -- whenever they sell at a plain discount to my estimate of value. From there it is mostly about waiting as long as necessary for the right price then, when the price is right, buying a meaningful amount with the intent to hold long-term.

The Superinvestors of Graham-and-Doddsville
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