Benevolent Princes, Cannibals and Zombies

Why stock picking is more relevant now than ever before

Originally published in the December 2010 issue

“Do not accustom yourself to consider debt only as an inconvenience,” said Samuel Johnson. “You will find it a calamity.” How – and, crucially, when – to deal with the ‘inconvenience’ of vast sums of government and consumer debt is the big question currently facing the world’s developed economies. Some, such as the UK, have decided to act sooner rather than later, while many others, most notably the US, have chosen to delay debt reduction – and even extend quantitative easing – in fear of causing a double-dip recession. However, irrespective of the particular paths chosen by individual countries, one thing is certain: at some point, every country that is carrying a huge amount of debt will have to take measures to substantially reduce it – meaning reduced spending, falling asset prices, higher unemployment and sluggish growth for many years to come.

In such a weak economic environment, demand for the skills of talented asset managers with strong long-term track records will be high. Gifford Combs is a managing director and portfolio manager at Los Angeles-based Dalton Investments. Over the 12 years from its launch on 30 September 1998 to 31 October this year, Combs’ global equity composite in USD registered a compound annual growth of 18.1% [1] – compared to the MSCI World index’s annualised return of 4.3% over the same period. The composite’s Sharpe Ratio was 0.84 and its maximum drawdown was -23.9% (compared with the index’s 0.07 and -53.7% respectively).

In November last year, Combs began managing a UCITS fund for GAM, called GAM Star Global Selector [2]. The fund follows the same investment approach and process as Combs’ global equity strategy and typically consists of 20-40 positions on the long side and up to 20 positions on the short side. The average holding period on the long side is 3-4 years and 6-18 months on the short side. Positions typically start at 3% of the portfolio and build, according to conviction, up to a maximum of 10% on the long side and 5% on the short side. When attractive stocks cannot be found, Combs is comfortable holding cash. From its inception on 19 November last year to 30 November this year, the USD class of GAM Star Global Selector returned 8.1% [1].

Combs began his investment career in 1984 working for a former protégé of Warren Buffett and he traces his investment philosophy directly to that of the famous Berkshire Hathaway founder. “I start with the notion that your money is always at risk,” he says. “The most important thing is to protect your assets. This has been forgotten by many people in the ‘performance derby’ that is the money management business. There are no guarantees in investing and it is fallacious to think that you can always achieve a satisfactory return every single time. A lot of people found that out the hard way in 2008.”

Combs summarises his investment approach succinctly: to buy good quality companies at a discount to fair value and sell them when they get close to fair value. “When we talk about a ‘great business’ we like to think of the image that Warren Buffett uses, which is that of a castle filled with gold, sitting on a hill surrounded by a big moat, run by a benevolent prince,” says Combs. “What this means is a fantastic business that has substantial defensive characteristics that keep competitors at bay. Then what you need is the benevolent prince running the castle. The benevolent prince consists of a management that is able to allocate capital intelligently on behalf of shareholders and – very importantly – is not trying to steal the gold for itself, but is willing to share the gold with the minority shareholders.”

By way of example, Combs highlights the case of Inco Indonesia (now PT Inco), a publicly-listed company that was formerly a subsidiary of the International Nickel Company of Canada. Inco Indonesia owned a nickel mine in the Indonesian archipelago that was the cheapest source of nickel in the world. The problem was that although it was, in Combs’ words, “a wonderful business”, it was not run by a benevolent prince. “I followed the company for close to ten years and visited the management many times, but I just could not bring myself to buy it,” Combs says. “Finally, several years ago, International Nickel of Canada was taken over by Vale of Brazil and it became immediately obvious that the people who ran Vale of Brazil were benevolent princes. They were planning to pay out all of the earnings from the subsidiaries up to the parent company and that meant they had to pay out large dividends to the minority shareholders of the publicly-listed subsidiaries in Indonesia and elsewhere. That made it a great investment opportunity.”

Over the years, Combs and his team have built up a primary database of around 275 companies that they follow very closely, augmented by a secondary database of around 600 names that they follow slightly less closely. The prices of these companies are monitored on a regular basis in order to spot any potential undervaluations. Nevertheless, Combs and his cash are not easily parted. “We only move out of cash when we find an opportunity in which we believe most of the downside risk has been eliminated,” he says. “By concentrating on reducing risk as much as possible, we are able to construct a portfolio that, although including some concentrated positions, actually has less risk than the market as a whole.”

When constructing the portfolio, Combs observes upward allocation limits of 10% in any one name, 25% in any industry and 45% in any country apart from the US. He also advocates a strict sell discipline that allows no room for sentimentality or misplaced loyalty to any one stock. “Value investors are like wallflowers at a Christmas party – they start on their own in the corner while everybody is dancing and drinking, but eventually people come over to join them and they end up being the centre of attention. When this happens, the stocks that the value investor holds go up,” says Combs. “However, the danger in value investing is that you begin to fall in love with your ideas and find yourself with a portfolio of fairly-valued assets that suddenly fall in price. We are very quick to begin reducing positions that we find are selling at something in the order of 90% to fair value.”

Combs rejects the view – frequently expressed to him – that it is impossible to buy very high quality companies at a significant discount to fair value because efficient markets hypothesis holds and everybody knows about such companies already. He cites the example of Apple, which he first became interested in around seven years ago when his teenage daughter came home and said she wanted an iPod, which until that moment Combs had never heard of. That same week, he visited Sony, which he was interested in as a possible recovery story. “I met with Sony’s strategic planner and asked him the same two questions I always ask: who is your toughest competitor? And who would you most like to buy?”, Combs says. “His answer was the same to both questions: Apple. This was extraordinary because at the time Apple had very little following on Wall Street and was basically considered an also-ran to Microsoft. But the man at Sony told me that Apple had an amazing installed base of loyal customers who were willing to buy software from the company on a repeated basis. The company went from a market capitalisation of around US$7 billion then to one of around US$290 billion today.”

While such opportunities do come along every so often, they are not common. And in highly subdued macroeconomic environments such as the one the world currently faces, they are even harder to find than usual. According to Combs, the big problem for investors today is simply that they are not being paid well enough to take risks. “It would be one thing if the whole world was priced at 7x earnings and some companies were even cheaper than that. If that were the case, you might be willing to overlook things like high taxes, trade barriers and government meddling – none of these things are insurmountable provided you are getting paid well,” he says. “However, I do not think investors are currently getting paid well. At best, equity markets are currently about fairly valued. But I don’t want fair! Fair is good for the other guy.
What I want is cheap – but that is not easy to find today.”

In the absence of many cheap stocks, Combs recommends that investors who are serious about generating attractive returns over the next few years fill their portfolios with two kinds of company, which he calls ‘cannibals’ and ‘zombies’ – the former being a long investment and the latter a short sale. Cannibals are companies that “eat their own” – i.e. buy back their own stock, Combs explains. “We look for companies that actively manage their balance sheets and use their capital base in an intelligent way to generate returns for their shareholders,” he says. “If you live in a world of low growth and no pricing power, the only way to generate returns is to take advantage of the volatility of the equity market pricing of your company – and by capturing that value for shareholders, you can do very well over time.”

It is still important to be discriminating when choosing cannibals, Combs warns. “You don’t want management that will buy back stock with one hand only to give it to itself with the other, which was a popular thing to do during the late 1990s tech boom. That’s good for management, but not good for you.”

Rather, he says, you should actively seek managers who are intent on providing value for shareholders and are prepared to do it on a proactive basis. He cites the example of DirecTV, the California-based satellite TV company whose dominance of high profile sports events makes it the US’s equivalent of Sky Sports in the UK. “DirecTV is reasonably valued, lightly-regulated, operates in a competitive market but not an overly-competitive one, and – most importantly – it has embraced cannibalism with a vengeance by announcing plans to buy back around a third of its shares over the next two years,” Combs says. “DirecTV’s management clearly understands that the company is essentially an unregulated utility business that can bear a lot of debt, but also that it only makes sense to assume that debt if it can help to provide value for shareholders.”

In order to benefit from both sides of the book, zombies as well as cannibals are required. In voodoo, zombies are dead people who have been revived and are under the control of a sorcerer; their equivalents in the financial world are companies whose securities are effectively worthless but which are being kept alive and propped up by an outside power, usually a government. “It’s interesting to note that in a deleveraging world, governments seem to want to create more and more zombies all the time,” Combs says. “Examples include three-bedroom ranch houses in Las Vegas, various financial institutions on life support and perhaps Greek sovereign debt.”

The good news about zombies, Combs explains, is that they don’t stay alive forever – the sorcerer’s power is eventually exhausted and they go back to the land of the dead. Or, in economist-speak, price will out. The bad news is that sorcerers – i.e. governments – may want to keep them alive for a long time (or at least until the next election). Fannie Mae, by some measures the world’s largest financial institution, is, Combs argues, a classic example of a zombie. “Fannie Mae is only solvent if one uses Martian accounting and some day it will be put out of its misery, although it’s hard to say when,” he says. “There are plenty of other examples around and governments are seemingly creating new ones every week.”

Ultimately, Combs’ strategy for dealing with the slow growth environment ahead is to stick to what he and his team do best. “Our focus is on valuing businesses,” he says. “We want to value businesses better than the guy down the street. And if we can do that, and also stay rational and disciplined and buy things when they’re cheap, we’ll be fine.”

[1] Past performance is not indicative of future performance.

[2] This is not an invitation to subscribe for any product and is by way of information only. Products are not available for sale in any jurisdiction in which such sale wouldbe prohibited.

Reference to a security is not a recommendation to buy or sell that security.

Gifford Combs is the Managing Director and Portfolio Manager for Dalton Investments LLC, and was a founding member of Dalton which was established in 1999. Gifford has over 25 years of investment experience managing equity portfolios. Prior to joining Dalton, he managed equity portfolios for US and international institutions at Pacific Financial Research, a Beverly Hills-based money manager with assets in excess of US$5 billion. In 1994, Gifford retired as partner to concentrate on managing a US investment partnership and in 1998 he began managing the global equity strategy. He currently serves as a director of the Sir John Soane’s Museum Foundation and the Council of the Friends of The Bancroft Library at the University of California, Berkeley. Gifford holds a M.Phil. degree in Economics and Politics from Cambridge University and an AB degree from Harvard College.