Buy Low, Sell High - Any Questions?

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
May 15, 2012

IN THIS ISSUE:

1.   Value Investing Seizes on Market Inefficiencies

2.   Introducing Yacktman Capital Group

3.   Yacktman’s Seven Key Insights

4.   Yacktman’s Risk Management Techniques

5.   Performance Evaluation

Overview

Today we will delve into the world of “value” investing in stocks.  Many investors don’t really understand how value investing works, other than they’ve heard that legendary investor Warren Buffett is a value-style investor.  Put simply, value investing implies seeking to buy healthy companies that are trading below their “intrinsic value” with the likelihood that their share prices will return to their intrinsic values, if not rise above them, over time.

Intrinsic value is a term you see batted around in the financial media, but the exact definition can be elusive.  Contrary to some thinking, intrinsic value isn’t just another name for “book value.”  Warren Buffett, for example, has defined intrinsic value as “…the discounted value of the cash that can be taken out of a business during its remaining life.”  Thus, intrinsic value relates to the true value of the business underlying the stock without regard to short-term market fluctuations. 

The value-style strategy can be very successful if implemented properly.  Warren Buffett and many others are examples of that.  The problem is that most investors do not possess the knowledge and ability to analyze complicated business financials and detect industry trends that are necessary to determine what the true intrinsic value of any given company really is.

Few investors have an army of analysts to produce all this information as Mr. Buffett does.  So if they want a value-style exposure in their portfolios, their only option in most cases is to buy a mutual fund that specializes in value investing.  Even then, there are hundreds of so-called value funds to choose from.

Today I will introduce you to a professional money manager that thrives on value investing, one who literally grew up under the roof of one of the most successful value investors of our time.

Value Investing Seizes on Market Inefficiencies

There are some who maintain that the US stock markets are too “efficient” for value-style investing to work.  These folks believe that everything there is to know about a company is “already priced into the market.”  Successful value investors like Warren Buffett know that’s not true – there always seem to be market inefficiencies one can exploit, IF you know where to find them.

Buffett once said: “I'd be a bum on the street with a tin cup if the markets were efficient.”

These inefficiencies in individual stock prices can be taken advantage of if you have the knowledge to find them. Value-style investing originated with Benjamin Graham, the “Father of Value Investing.” Warren Buffett learned this strategy from Graham while he was a college student and has used it ever since.

Graham argued that because of speculation in the markets, the prices of individual stocks are often driven above or below their intrinsic values.  If an investor has the knowledge to correctly determine the true intrinsic value of a company, then buying healthy companies that are trading below that value should be very profitable. Successful value investors have proven that to be true in spades.

Best of all, there are stocks that trade below their intrinsic value in all types of markets – bull markets, bear markets and even sideways markets – thanks to speculators.  The trick is how to know what the true intrinsic value is, and that’s why you need a professional on your team.

Introducing Yacktman Capital Group, LLC

So far, we have discussed how Benjamin Graham taught that it’s important to differentiate between speculators and investors and that quality businesses can be purchased at a discount.  Warren Buffett improved upon this concept by focusing on businesses that have good prospects for the future, essentially using the same analysis to buy a stock as you would if you were acquiring the entire business operation.

Brian Yacktman, founder and portfolio manager of Yacktman Capital Group (Yacktman) offers a further improvement upon Graham’s and Buffett’s principles by devising a way to set up a portfolio of individual stocks so that it has the potential to protect capital during times of severe market declines while still attempting to produce above-market returns over a full business cycle.

That’s an important point, so let’s say it another way:  Yacktman seeks to maximize your risk-adjusted return on capital by employing a strategy that grows your purchasing power over time no matter what economic scenario the unknown future holds.   

If the Yacktman name sounds familiar to you, it’s because Brian’s father, Don, founded the Yacktman family of mutual funds in 1992 and built it into a value-style investment powerhouse.  While there are lots of eager emerging money managers out there, few have the stock selection pedigree that Brian Yacktman does.  Because Yacktman Capital Group was formed in 2007, its official track record is relatively short; however, Brian has over a decade of time spent honing his money management skills in personal and family accounts.

For the millions of investors on the sidelines taking a “wait and see” approach, Yacktman’s value strategy offers a way to re-enter the market with the knowledge that their portfolio will consist of only businesses with stock prices that Yacktman has purchased at a discount to their intrinsic values. 

By focusing on capital preservation and superior stock selection, as opposed to matching some market index, Yacktman seeks to produce “absolute returns.”  While the details of Yacktman’s methodology are proprietary, we can make some general observations about its management style based on information gathered in our due diligence process.

Yacktman’s Seven Key Insights

We noted above how Yacktman seeks out stocks that are trading at a discount to their intrinsic values, which is far easier said than done.  Yacktman knows that the evaluation of a company’s intrinsic value is only as good as the analysis performed on its internal condition.  As a result, it has developed an evaluation process that is based on the following seven key insights Brian has gained over his decade-plus experience in managing money:

Insight #1 – High-Quality vs. Low-Quality Businesses:  Yacktman has determined that high quality businesses outperform low-quality businesses over the long haul.  For Yacktman’s purposes, a high-quality business is one with high profitability, low profit volatility and minimal use of leverage (borrowing).  Not only that, but high-quality stocks also tend to outperform lower quality stocks during down markets.  The following graph shows the multiple needed to regain stocks’ original values based on the quality of the underlying business during the Great Depression:

Quality in the Great Depression

Brian notes that the combination of higher returns and better downside protection can potentially preserve principal, even in a bear market scenario.  This is why high-quality businesses will always be the vast majority of client holdings in the Concentrated Composite Strategy.

Insight #2 – Treat Stocks Like Bonds:  If you study most value strategy approaches, you will find that they seek to determine a stock’s value by predicting all of its future cash flows and then applying an arbitrary discount rate.  Instead of using this methodology, Yacktman treats stocks like bonds, in that they calculate the implied return expected from buying the stock at the current price and then determine the predictability of that return.

While going into the calculations used is a bit involved for this article, the gist is that Yacktman seeks to calculate the stock’s forward rate of return, which then allows it to evaluate the yield spread as compared to stocks of varying quality levels.  Brian says that this approach is beneficial in that it forces him and his staff to be long-term thinkers rather than being a hostage to short-term market actions.

Insight #3 – Most Investors Intend to Act Rationally, but Rarely Do:  Yacktman has observed that even many professional investors approach the market with the intent to act rationally, but often find that they cannot do so.  Why?  Yacktman ventures that even professionals sometimes become victims of the old saying that “genius is a bull market.”  In up markets, they seek out stocks that may be of lesser quality but appear to have a greater potential return.  Benjamin Graham observed that this is when they stop being investors and start becoming speculators.

Yacktman, on the other hand, has structured its clients’ portfolios such that they not only have the potential to withstand market shocks, but actually benefit from these scary periods.  In addition, Yacktman may actually buy more quality stocks when this irrational fear drives down the stock price of good businesses.

Insight #4 – Maintain the Proper Level of Concentration:  Yacktman’s Concentrated Composite Strategy carries that name for a reason.  Yacktman generally limits the number of stocks held under this strategy to anywhere from 15 to 30 holdings.  By doing this, Yacktman seeks to maximize returns while minimizing volatility as measured by standard deviation. 

Having too few holdings can subject a portfolio to too much risk from a single stock, but too many holdings can dilute the value added by Yacktman’s fundamental analysis.  Brian calls the process of holding too many stock positions “de-worsification.”

Insight #5 – Taxes Matter:  Unlike many other money managers, Yacktman is committed to earning the best after-tax returns possible.  Historically, turnover has been low and holding periods usually extend beyond one year, so capital gains tend to be long-term in nature.  Many of the holdings in Yacktman portfolios also pay dividends, which are also currently subject to special tax treatment.

Insight #6 – Fees Matter:  Absolute return strategies such as Yacktman’s are often found in so-called hedge funds, which typically charge a base fee of 2% plus an incentive fee of 20% of any profits.  Yacktman’s management fee starts at 2% and can be even less for larger accounts, and there is no incentive fee on profits.  [Also note that Halbert Wealth Management shares a part of the 2% fee, so our involvement does not result in any additional cost.]

Insight #7 – Incentives Matter:  Last but not least, Yacktman has observed that many investment managers are more interested in selling products and receiving a commission than in providing solutions.  The asset-based fee structure discussed above provides an incentive for Yacktman to grow accounts over time.  Plus, Brian notes that he and his staff have virtually all of their own money invested alongside his clients in the various programs he manages. 

Brian notes that he has an additional special incentive in that his family (including his father, Don) and friends are also investors in his strategies.  Plus, I have my own money invested with Yacktman, just as I do with every money manager that we recommend to our clients.

Yacktman’s Risk Management Techniques

Yacktman defines risk as a permanent loss of capital and seeks to minimize risk of loss in a variety of ways.  As noted above, buying stocks at a sufficient discount provides a margin of safety during market declines.  The quality of the companies purchased is also an important risk management feature.  As a general rule, the better the quality of the company, the quicker it can recover from market declines.

The use of individual stocks rather than mutual funds is another way Yacktman controls risks.  The level of fundamental analysis performed by Yacktman does not work if applied to a stock mutual fund, since such funds consist of a constantly changing collection of stocks.  Plus, using Brian’s term, a “de-worsified” mutual fund is more likely to follow the major indexes during market downturns, while a portfolio of carefully selected individual stocks may actually rise during down markets, depending upon the types of businesses held and market conditions.

A final risk management feature is that Yacktman invests in stocks without regard to their market capitalization.  Yacktman is not “pigeon holed” into any particular size of business, freeing the firm to select only the best opportunities across a wide spectrum of market caps.

It is important to note that Yacktman does not move to cash in bear markets or downward corrections.  In fact, they may buy more stocks if the downtrend makes them more attractive from a pricing perspective.

Performance Evaluation

From its inception in November of 2008 through April of 2012, the Yacktman Concentrated Strategy has produced an average annualized gain of 18.4% compared to 13.5% for the S&P 500 Index, with dividends.  Yacktman’s worst drawdown was -15.83%, significantly lower than the S&P 500 Index’s drop of 23.24% over the same period of time.

Brian cautions that future drawdowns could potentially be considerably larger than the -15.83% losing period noted above, especially should we have another blowout like the 2007 – 2009 bear market when the S&P 500 Index lost over 50% of its value.  However, since Yacktman’s strategy seeks to purchase stocks below their intrinsic value and does not go to cash in down markets, Brian expects that any short-term drops in value would be made up in subsequent rallies, much as was the case in 2009.  There are no guarantees, of course.

See the performance information below for more comparisons and detailed monthly returns. All performance information is provided net of all fees and expenses:

Be sure to read Important Notes following my signature.

The minimum account size for the Concentrated Composite Strategy is $100,000.  Additional information, including administrative details, fee schedule and Advisor background can be found in the Yacktman Advisor Profile by clicking on the following link:

Click here to view the Yacktman Advisor Profile.

Conclusions

Value investing has been and will continue to be an important strategy for those of us who believe that the market can sometimes be irrational, setting up a potential gain for the knowledgeable investor.  With investing legends such as Benjamin Graham and Warren Buffett going before, Yacktman has some big shoes to fill, but we believe this firm is more than up to the challenge.

We feel that one of the most important features of Yacktman’s Concentrated Composite Strategy is that it seeks to preserve capital and make money in any kind of market or economic environment.  That being the case, it may be the perfect vehicle for those investors who are still on the sidelines and nervous about getting back into the market. 

In the words of Benjamin Graham, “It is far from certain that the typical investor should regularly hold off buying until low market levels appear, because this may involve a long wait, very likely the loss of income, and the possible missing of investment opportunities.” (The Intelligent Investor)

More importantly, if you have money in stocks that you manage yourself, or if you own equity index mutual funds, I would seriously considering moving all or part of that money to Yacktman.  While I can’t make any guarantees, I believe Yacktman will do a better job for you than doing it on your own or in equity mutual funds. 

All of us have observed that there always seem to be some stocks that do well even in down markets.  The problem was that we didn’t know how to find them.  With Brian Yacktman and his staff, we now have a guide to lead us to the opportunities that lie undiscovered by most investors. 

It is rare to be able to take advantage of an emerging money manager early in his career.  It is even more rare to have an “emerging” manager with over a decade of hands-on money management experience.  Rarer still is an emerging manager who learned his craft at the feet of an industry legend, his dad.  We have all of these things in Brian Yacktman.

To learn more about this promising emerging manager and its value-style approach, contact us in any of the following ways: 

I also invite you to sit in on a webinar featuring Brian Yacktman and Yacktman’s CEO, Will Kruger, to be held on May 24, 2012 at 1:00 PM Eastern Time (10:00 AM Pacific).  The webinar will last approximately 30 minutes and will allow you to hear about this innovative value-style all-cap approach directly from the money manager.  Seating is limited, so click on the following link to register today: 

Click here to register for the Yacktman online webinar.

Very best regards,

Gary D. Halbert

IMPORTANT NOTES:  Halbert Wealth Management, Inc. (HWM) and Yacktman Capital Group, LLC. (YCG) are Investment Advisors registered with the SEC and/or their respective states.  Information in this report is from sources believed reliable but its accuracy cannot be guaranteed. Any opinions stated are intended as general observations, not specific or personal investment advice.  Please consult a competent professional and the appropriate disclosure documents before making any investment decisions. HWM receives compensation from YCG in exchange for introducing client accounts.  For more information on HWM or YCG, please consult the respective Form ADV Part 2, available at no charge upon request. Officers, employees, and affiliates of HWM may have investments managed by the Advisors discussed herein or others.

The returns shown are based on a composite of accounts, subject to the composite qualifiers set up by Yacktman, which are available upon request.  Performance reflects all income, gains and losses and the reinvestment of interest, dividends and other income.  Returns are net of fees.  Returns provided by YCG have been adjusted since inception by HWM to reflect the new annual management fee of 2% (previous fee was 1%).  

These performance numbers have not been verified by HWM, and therefore HWM is not responsible for their accuracy. Since all accounts in the program are managed similarly, the results shown are representative of the majority of participants in the Yacktman Concentrated Composite Strategy.  Statistics for “Worst Drawdown” are calculated as of month-end.  Drawdowns within a month may have been greater. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

When reviewing past performance records, it is important to note that different accounts, even though they are traded pursuant to the same strategy, can have varying results.  The reasons for this include: i) the period of time in which the accounts are active; ii) the timing of contributions and withdrawals; iii) the account size; iv) the minimum investment requirements and/or withdrawal restrictions; v) accounts may hold different securities depending on when the client invested and any restrictions placed on the account; and vi) the rate of brokerage commissions and transaction fees charged to an account. There can be no assurance that an account opened by any person will achieve performance returns similar to those provided herein for accounts traded pursuant to the Yacktman Concentrated Composite Strategy.

In addition, you should be aware that (i) in the Yacktman Concentrated Composite Strategy, your principal is not guaranteed and there are risks involved; (ii) the Yacktman Concentrated Composite Strategy’s performance may be volatile; (iii) an investor could lose all or a substantial amount of his or her investment in the program; (iv) Yacktman Capital will have trading authority over an investor’s account and the use of a single advisor could mean lack of diversification and consequently higher risk; and (v) the Yacktman Concentrated Composite Strategy’s fees and expenses (if any) will reduce an investor’s trading profits, or increase any trading losses.

As benchmarks for comparison, the Standard & Poor’s 500 Stock Index (which includes dividends), and the NASDAQ Composite Index represent unmanaged, passive buy-and-hold approaches.  The volatility and investment characteristics of these benchmarks may differ materially (more or less) from that of the Yacktman Concentrated Composite Strategy, since they are unmanaged Indexes which cannot be invested in directly. The performance of the S & P 500 Stock Index and the NASDAQ Composite Index is not meant to imply that investors should consider an investment in the Yacktman Concentrated trading program as comparable to an investment in the “blue chip” stocks that comprise the S&P 500 Stock Index or the stocks listed on The NASDAQ Stock Market that comprise the NASDAQ Composite Index.

Management fees are deducted quarterly, and are not accrued on a month-by-month basis.  Returns do not include the effect of annual IRA fees, if applicable. No adjustment has been made for income tax liability.  Consult your tax advisor.  “Annualized” returns take into account compounding of earnings over the course of an investment’s actual track record. Money market funds and other low risk asset classes are not bank accounts, do not carry deposit insurance, and do involve risk of loss.  The results shown are for a limited time period and may not be representative of the results that would be achieved over a full market cycle or in different economic and market environments.

 


Read Gary’s blog and join the conversation at garydhalbert.com.


Forecasts & Trends E-Letter is published by ProFutures, Inc. Gary D. Halbert is the president and CEO of ProFutures, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, ProFutures, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.

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