This is part two of a four-part interview with Abhay Deshpande of Centerstone Investors. The interview is part of ValueWalk’s Value Fund Interview Series.
Throughout this series, we are publishing weekly interviews with value-oriented hedge funds, and asset managers. All the past interviews in the series can be found here.
Centerstone is a new firm established by Abhay Deshpande, former Portfolio Manager of the First Eagle Global and Overseas strategies. The firm is a New York based, privately owned SEC-registered investment advisor offering niche investment vehicles. The Centerstone strategies are very similar to what Abhay practiced in the early days at First Eagle.
The team describes itself as business analysts not “equity” analysts a more holistic approach which includes the entirety of the firm’s capital structure allowing the manager to more accurately gauge the prospects for impairment in business value.
The Abhay Deshpande interview has been divided into several parts and will be downloadable as a PDF at the end of the series. So stay tuned for the rest of the series as well as the downloadable PDF!
Interview With Abhay Deshpande [Pt. 2]
What kind of metrics do you use to try and establish if a particular investment is attractively priced? What sort of discount are you looking for?
We seek to invest in companies when their market price is below their intrinsic value. We assess a company’s long-term earnings power when calculating intrinsic value. We make adjustments to operating profit for non-recurring expenses, non-economic expenses and also for where we are in an economic cycle. These adjustments aim to help us better assess the long-term earnings power of a company in a normal economic environment. Further, we look for businesses that have generated stable results and returns on invested capital throughout an economic cycle.
The discount to intrinsic value that we require varies. For high quality, long-duration businesses we are willing to pay a smaller discount to intrinsic value than we would for more cyclical businesses.
Would you mind sharing some of your current holdings or perhaps your highest conviction idea?
One holding that does a good job of reflecting our approach and what we look for in an investment is Emerson Electric (EMR). As of August 31, 2016, Emerson Electric was a 1.11% position in the Centerstone Investors Fund. Emerson was founded in 1890 and is a conglomerate in the truest sense of the word, with market leading franchises that span everything from air conditioning compressors to garbage disposal units to control valves for the oil & gas and nuclear power industries. Emerson’s crown jewel is the Process Management segment, which accounts for a little less than half their profit and provides a broad range of automation solutions to customers across the oil & gas, power and chemical end markets. Here Emerson distinguishes itself from the competition by being one of only a handful of players globally with the product range and engineering know-how to integrate equipment as part of total solutions. By focusing on total solutions, the company has been able to add more value and earn higher margins than they would selling equipment on a standalone basis.
A very important dynamic in Process Management is that the solutions Emerson provides account for just a tiny fraction of the total project cost, but are often absolutely critical to the safety, reliability and efficiency of the customer’s operations. A good example is the nuclear power plant industry, where the consequences of a failed control valve can be absolutely catastrophic, ranging from millions of dollars in damages to the loss of human life. Given what’s at stake, any rational customer cares a lot more about getting a quality supplier than the small amount of money they could save by going with a supplier that’s slightly cheaper. This in turn makes Emerson’s strong brand reputation in the nuclear industry a huge competitive advantage, resulting in dominant market share. Emerson valves are installed in over 90% of the world’s nuclear facilities and at premium pricing.
Aside from strong brands, a number of factors keep the Process Management business inherently well insulated from competition. For one thing, much of the equipment Emerson sells can last anywhere from 20 to 40 years, so competitors typically won’t have an opportunity to come in until quite some time after the equipment has been installed. On top of that, the focus on offering total solutions means Emerson is likely to have a huge number of mission critical touch points at any given customer site. Switching out all that equipment for a competitor can be very tricky from an operational standpoint and there’s a huge risk of unplanned downtime if something goes wrong. The more equipment you’re trying to switch, the closer it gets to being the industrial version of an organ transplant and for that reason, most customers aren’t eager to switch their automation supplier anytime soon.