Saxon manager vows to stick with value

(December 2005) Ever since the collapse of the technology bubble, value investing has enjoyed a renaissance, as investors rediscover the beauty of companies that have earnings and are trading at a discount.

Knowing the fickle nature of the investing public, some have suggested that value investing may once again fall out of favour, ushering in a new cycle of more speculative growth investing.

Certainly some investment managers may succumb to style drift, seeking to capitalize on the hottest markets — and there’s nothing wrong with that, so long as investors are aware of the manager’s intentions.

It’s just not Richard Howson’s style.

“We’re value investors. We believe having a value investing style is going to give us superior returns over the long term,” says Howson, executive vice-president and chief investment officer of Saxon Mutual Funds and manager of the Saxon Balanced Fund. “We think it’s very important that people understand what we are giving them, which is a value style. We don’t want to pretend that we’re giving them investment genius.”

A large part of his philosophy is to stay fully invested. Money parked on the sidelines may face the least risk, but accepting risk is the price of earning returns.

“Every investment style goes through periods when it’s outperforming the market and also periods when it’s underperforming the market,” he says. “What we’ve been able to do is consistently follow the same style even when it was underperforming, which means that from day one when it begins outperforming, we were fully invested in value stocks.

“You will never here from us say something like ‘We think the markets are overpriced, so we went to 30% cash.'”

Whether value investing is better suited to economic soft spots, or boom times, Howson says he honestly does not know, although he suspects that value would outperform in a higher inflation environment, when higher interest rates force contraction in price to earnings ratios.

Convincing investors to stick with a value fund during a market that favours growth, however, can be tricky. In these periods, absolute returns are sometimes not enough.

“If we go back to the tech boom, in spite of the fact that we had good nominal returns in 1998, 1999 and 2000, the relative performance was weak,” Howson says. “I remember total assets at that time went from something like $130 million down to about $100 million. I’m talking about the Saxon Funds, not just Saxon Balanced. I’d consider a 20% decline in assets to be pretty substantial.”

Howson’s investment process starts off in a rather typical way — screening the market for stocks which are undervalued, based on the usual ratios: price to earnings; price to book; price to cash-flow.

“As an objective, we want to put together a broadly diversified portfolio of statistically inexpensive stocks,” he says, pointing out that they ignore forward earnings estimates. Of more interest are the results for the most recent 12 month cycle.

“Our view is that investors, analysts and portfolio managers as a group tend to be optimistic people,” he says. “If we did this analysis based on somebody’s forecast of what was going to happen two years from now, its more likely that would turn out to be too optimistic of a forecast.

“That’s how you make the stock appear to be cheap — by looking at what you think is going to happen some time in the future.”

After the earnings statistics have been screened and scrutinized, the investment team applies a private market valuation. Essentially, they want to know what the company would be worth if it were not publicly traded, calling on experts who are familiar with the nuances of the industry. The metrics that are important in valuing a mining stock are not likely the same as those in the grocery sector, for example.

“It’s a very good measure because it tends to be reasonably stable over the long term, whereas many analysts in the investment community are focused on more short-term valuation measures,” he says. “We all know how volatile stock prices are and therefore how volatile multiples can be.”

The investment team sets a sell-point of 25% above that predetermined fair market value. While the firm is not unique in using this private enterprise valuation, Howson says there are many investment counseling firms or fund managers that do not focus on this.

“What we’d love to be able to do is put together a portfolio of companies that are trading in the public market, at a public market value lower than their private market value,” he says, admitting that filling the portfolio with such stocks is a somewhat unrealistic dream.

The problem with finding undervalued stocks, however, is that managers are not alone in this quest. While mutual funds must follow strict regulations limiting their ownership stake in a given company, private equity firms do not face such restrictions. Howson says the larger private equity firms can become quite a nuisance.

“In many cases, they are becoming competitors for the kind of companies we want to own,” he says. “A good example of that recently was Masonite. Kohlberg Kravis Roberts bought Masonite. We didn’t feel the valuation they were willing to pay was fair and we voted against the deal, but there were enough shareholders who voted for it, that we had no choice. That was a company we wanted to hold, but was taken away from us by private equity.”

But while there seems to be a never-ending parade of companies being taken private, he says the depth of the investing pool has been maintained by the influx of income trusts, which essentially have brought more privately held small cap operations into the public market.

“They have provided a wide range of potential investment opportunities,” he says. “I’m not so sure that we’re worse off than we were before.”

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com

(12/28/05)

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