Whitney George has joined Sprott, bringing over two value-oriented funds currently with around $285 million in assets.1
He says that investors have lost sight of the businesses they own because they’re looking at indexes, not individual stocks.
George says this opens the door for value investors in the school of Graham and Dodd or Warren Buffett (click here for the audio).
Henry: How would you describe your value investing philosophy?
Whitney: In the mid-'80s, I started paying very close attention to the Warren Buffett (Trades, Portfolio) style of investing –Â value investing.
I wouldn’t characterize it as "deep value" or buying "cheap" companies so much as buying high-quality businesses at really good absolute valuations with a long-term investment horizon.
For me, a quality company has a very strong balance sheet that can weather any kind of economic conditions and take advantages of disruptions. The company has a business that generates high returns on capital and therefore can generate lots of free cash flow. It can then use that free cash flow to grow the business or return it to shareholders –Â whichever is most appropriate at the time.
What should a company you invest in be doing with its cash? When should it be paying its shareholders dividends, reinvesting in its own business or doing buy-backs?
It all comes down to the math. We are not looking just at quarterly results. We look at longer-term results over cycles. If a company has a model that generates a high return on capital and they can sustain it and grow it –Â if opportunity still exists –Â then we would like them to continue to expand, to take market share, or maybe even make acquisitions as a way to growing their business.
Very often, though, businesses mature or conditions deteriorate or become more competitive. If a company can’t sustain good returns on its capital, we would like them to return that capital to shareholders. The best way to return it would be opportunistically through buy-backs when prices are low and shares have an attractive valuation, but barring that, dividends are another good way for excess cash to be redistributed.
Don’t a lot of people prefer buy-backs over dividends because you benefit from an increased share price instead of a distribution? For instance, because you have to pay taxes when you receive dividends?
Well, capital gains and dividends are treated at the same tax rates so it really depends on the valuation.
You don’t want a company buying back its stock only to drive its price higher or prevent it from falling so that executives can exercise their stock options, which, of course, is one of the popular uses for buy-backs. What you really want is for a company to be buying at good valuations –Â the same ones that you, an investor, might want to buy at. If the market is not allowing that (because the share price is high), then they should return the capital in the form of dividends so investors can redeploy it in other places.
What about cash on balance sheet? Do you want companies to keep a lot of cash on their balance sheets? Are you concerned if they are keeping too much?
Yes. Cash can build and become excessive and sometimes that’s a sign of management that may be a little unmotivated. It’s not necessarily a bad thing. In fact, cash on the balance sheet is a byproduct of having a really good business that generates a lot of free cash.
In smaller companies, there are also strategic reasons for holding cash as their customers might want to make sure they’re going to be staying around. So you have to view that in the context of the whole business model.
But certainly cash holdings can be excessive. We don’t seek out companies because of cash. We seek out companies that maintain strong balance sheets so they can be positioned well for any kind of environment. Beyond that, it’s up to the management.
Of course, if you carry too much cash on your balance sheet, your returns on assets are going to be depressed. So it really depends, and it goes industry by industry.
As a value investor, is your approach to look at current returns relative to their market valuation?
What we’re actually doing is looking at returns and businesses over long periods of time –Â over cycles and throughout the company’s history.
You don’t get to buy stocks inexpensively when everything is going well.
Very often the companies that I’m looking at are going through some sort of painful phase, whether it’s a bad market or a new product launch or something that is causing investors to be disappointed in the short term. I try to find those companies that we expect to return to historic kinds of operational performance and returns that we can buy at a depressed price because many people have a very short horizon. In contrast, ours is three to five years.
So opportunities occur when investors overreact to something the company has gone through in the short term, when the long-term prospects still look good?
Yeah. I mean bear markets obviously create opportunities. Corrections create opportunities. Good companies that were growing rapidly where the growth slows can be a favorite area for us, because they will have a large investor base of growth investors who become disappointed as the growth rate slows. In the small cap world, something that grows at 15 percent isn’t even considered a growth company. Of course, it would be if it were in the S&P 500.
But at slower growth rates, a business can actually be even better and generate more free cash. Because it doesn’t all have to get plowed back into growth, they can share it with their shareholders. That growth slowdown often causes a lot of disruption in the stock price and sometimes creates excellent long-term opportunities for people like me.
Do you see yourself in the same school of investing as value investors like Ben Graham or Warren Buffett (Trades, Portfolio)? Do you think you’ve updated those principles in some way? How closely do you stick to the original precepts of value investing?
I think that my views have evolved. It’s somewhere between where Grahamand Dodd taught Warren Buffett (Trades, Portfolio) to where Warren Buffett (Trades, Portfolio) put it into practice. I would never think of myself as ahead of Warren Buffett (Trades, Portfolio). I’m probably lagging all the time. He is actually investing in industries and places where I don’t have a great deal of interest. I’m more in the old-fashioned 1980s, 1990s kind of Warren Buffett (Trades, Portfolio) mode where you’re trying to buy wonderful businesses at very attractive prices.
It would be hard for me to get excited about utilities and some regulated businesses where he has invested recently, but he has a different set of circumstances than I do. So I’m more old-school Buffett-style value investing.
Why do you think that the value investing approach is still useful today?
Well, actually, it’s not so much in favor currently and certainly I’ve gone through periods of out-of-favor-ness, like in the late '90s.
The attractiveness of the value approach is rooted in the math and the fact that you’re buying into a business.
The price you pay has a very large effect on the total return that you’re going to earn. Buying low and selling high is a pretty fundamental idea but is very difficult to practice because it requires you to be out of sync with what everybody else is saying and doing at the time.
Active investing right now is very out of favor. The ability to actually pick stocks and do better than indexes is something that people are really questioning right now. But there are market phases, and these things come and go. If you are patient and stick to your discipline, I think the long term results will bear it out.
It’s not just value investors that are out of favor relative to passive strategies. It’s all active investors.
As a contrarian, there’s some appeal to that.
Why are value investing and active investing in general out of favor right now?
Well, active styles are out of favor because we have been in a bull market for such a long time now. A value investor is a risk manager. He’s trying to manage some of the risk in the portfolio.
When you’re managing risk in a straight-up market, you are basically just detracting from the returns. The longer the market goes up, the more people start to not worry about risk and just to seek return and the less favorably they view risk managers, active investors and certainly value investors.
So for the last five years, being cautious has been the wrong decision and somebody who just put their money in an S&P 500 index has done very well. The longer that persists, the more popular it becomes, and it becomes self-reinforcing. More money comes out of active management styles, goes into index funds, propelling them even more and supporting that style.
It will continue to work until the day it doesn’t. But in the very long term –Â I would say three, five, ten years – the most successful investors have practiced some form of value investing.
Does the fact that people prefer passively managed funds right now help or hurt you in terms of finding the best opportunities for your funds?
Well, it creates dislocations in the market which then create opportunities, but it makes it very hard to raise capital.
Active managers are continuing to lose money to the passive strategies as we speak.
This tends to put more money behind stocks that are in the benchmarks and less money into stocks that are outside of indexes like the S&P 500 or the Russell 2000. It tends to boost the valuations on well-represented industries that have momentum, like biotech and social media.
It will be a depressant for those companies that don’t happen to be in the benchmarks, to the point that they could become very attractive businesses for a value investor.
Right now, people say the market is expensive, based on historical PE, but that’s the whole market. There’s a lot of disparity between valuations. There are lots of unloved, inexpensive stocks out there at the same time that the popular averages are looking reasonably fully priced.
So the fact that we’re in a bull market doesn’t reduce the field of opportunity for undervalued small-cap stocks that you’re looking to own?
No. If you’re a small-cap investor looking at the Russell 2000, the valuations look high, but more than a third of the benchmark is made up of loss-making companies. So, obviously, to offset those loss-making stocks and have an average that’s at 20 or 25 times earnings, you’ve got to have some companies that are trading a lot cheaper than the index. An active manager’s job is to sort through that and select those investments that are attractively priced and not own the whole basket.
Why did your value investing approach seem like a good fit with Sprott?
One of the things that motivated me to leave Royce after 23 years is that there is pressure on the mutual fund industry to conform to, to compete with and to keep up with benchmarks. In my own personal investing life, that’s not really the objective.
What I want to do is preserve my own wealth and compound it at what I feel is a comfortable rate, exceeding inflation, as opposed to chasing numbers that I don’t think are sustainable.
Sprott has a kind of alternative, absolute-return approach in its products, is very mindful of risk management in their diversified products and has a very interesting franchise in passive precious metals-related sectors in the United States.
So I saw an opportunity to better align my own investing style, bring a couple of products along with me where I’m the largest shareholder and be able to invest without the pressures of beating some benchmark that may or may not be relevant to me.
So it’s more about implementing the ideas that you believe in as opposed to trying to beat a benchmark?
Absolutely. There’s a lot of career risk in making non-benchmark bets, which to me creates opportunity. The mutual fund business is highly regulated and heavily scrutinized and Royce has done a fabulous job with actively managed funds. It’s a fabulous organization and has had a fabulous history, which I expect will continue. But I wanted to align my investments closely to my own style and Sprott is providing me with an opportunity to do that.
Within the value-investing space, do you experience a lot of competitive pressure? Are there a lot of investors like you who are going after these value opportunities?
I think it’s very competitive, but the competition is not amongst us. As a group, we are all losing share to passive strategies or to alternative strategies. What I find is people are doing less and less research on individual companies. They have typically lost sight that shares of stock represent a share in a business. You wake up every morning and Bloomberg tells you: “Why buy a stock when you can buy the whole sector?”
So I think there’s less deep fundamental business research going on now because there’s less appetite by the investing public for that.
Where it still does exist is in the hedge fund industry where they do very deep, intense research. But it’s all geared towards monthly returns because that’s the way they are measured.
It’s not a long-term approach and that’s where I think the opportunity is. There’s not competition really among us active managers trying to get value, or growth at a reasonable price. Our competition really is alternative styles and passives right now.
Thank you for speaking with me, Whitney, and I look forward to having another discussion with you further down the road.
That would be great, Henry. Thank you very much.
