Aristotle Capital letter for the third quarter ended September 30, 2016 titled “The Lion Dancer.”
Aristotle Capital – The Lion Dancer
“O.K., everyone … line up again. This will be our last rehearsal before the event tomorrow morning.”
“Remember, the first movements are lunge right … then lunge left … then dip. If we can begin in perfect unison, we’ll make a great first impression and it will be ‘smooth sailing’ from thereon!”
“Excuse me,” said one of the Lion Dancers, still in her costume. “Some of us have exams tomorrow and it would be helpful to have a couple of hours to study tonight. When may we expect to be finished?”
[drizzle]“Well,” said the leader, “as college students you may, of course, leave at any time. But perfection requires practice. You do want to dance to impress, don’t you?” The leader smiled as he saw a line of lions’ heads nodding up and down. So the Lion Dancer shrugged off studies for another practice of the Lion Dance. Unfortunately for her grades, she actually preferred it that way.
As depicted in the picture here, a Lion Dancer is one of two people who, combined with a costume, form a colorful and exaggerated “lion.” A “Lion Dance” is a form of traditional dance in Chinese and other Asian cultures in which Lion Dancers mimic a lion’s movements in their costume. Differing from a “Dragon Dance” whereby the “performers” hold one long dragon costume overhead, the Lion Dance is usually performed during the Chinese New Year and other Asian cultural and religious festivals. It may also be performed at important occasions, such as business opening events, special
celebrations or wedding ceremonies, or it may be used to honor special guests. During Chinese New Year, the “lions” eat lettuce and dance so as to give luck to businesses. [The Chinese word for “lettuce” sounds almost identical to the construction “to get rich,” with the exception of a tone change on one of the characters.]
The Lion Dancer loved participating in lion dance festivals, finding it excellent exercise as its fundamental movements can be found in most Chinese martial arts. She also developed a camaraderie with her fellow performers. It was a great social pastime for her throughout her college years. But this great social event had a “cost” to the Lion Dancer, one that would not be evident for some years.
The Lion Dancer graduated from the university with respectable, though not the highest, grades. As she was not preparing to continue with her studies past a bachelor’s degree, the tradeoff between grades and lion dancing seemed worthwhile. Instead, after graduation, to immerse herself even further in Asian culture, the Lion Dancer went to China and taught auxiliary high school classes to students preparing for overseas study. To better communicate with her students, she became fluent in Mandarin. She also volunteered at local hospitals serving the underprivileged. In short, she flourished. In time, she also matured.
Several years later the Lion Dancer decided it was time to resume her studies and returned home to the United States. “Medical school is what I want,” she announced to her family. Her father immediately reached to hide his wallet. Her mother jumped for joy, while her sister and uncles nodded approvingly. So back to school she went, at first to a one-year post-baccalaureate program geared for the college graduate who wants to apply to medical/dental/vet schools. No Lion Dancing this time and she excelled. She received straight A grades and a Medical College Admission Test (MCAT®) score placing her in the top one-percent of her peers.
“Great,” she boasted. “Now I can go to any medical school I choose!”
But, alas, it did not turn out that way. Medical schools are very competitive, with some admitting fewer than three percent of those who apply. How do they winnow the candidate field? Many employ quantitative screening tools, insisting on minimum grades for each level of education. Her most recent results and life experiences would lead most to conclude she had a unique background, well suited
to becoming an outstanding physician. But this was not enough, as the Lion Dancer was “screened out.”
The story of the Lion Dancer is, we believe, a good analogy as to why we, at Aristotle Capital, typically do not employ a screening process.
It is always easier to explain by example. The following two companies were chosen for illustrative purposes only, not necessarily as “recommendations.” As of the time of this writing, the first is a company that has been owned in Aristotle Capital portfolios, while the second has not. First, consider homebuilder Lennar.
The top graph above shows the price-to-earnings (P/E) ratio of the company’s stock from January 2000 to the present. Note that during the U.S. housing boom of the mid-2000s, Lennar’s P/E ratio declined to nearly 5x. The bottom graph above shows Lennar’s absolute stock price. Note that in early 2007, the company’s low P/E ratio was not due to a low stock price. In fact, it was the opposite, as the stock was near its all-time high at over $60 per share back then. The low valuation was relative to extraordinarily high profitability when U.S. housing starts exceeded two million annually.
Many value-oriented managers employ screens looking for just this type of anomaly, whereby earnings are high while stock prices have not kept up. But the Aristotle Capital investment philosophy would not have resulted in purchasing Lennar at that time. The company was deemed to be over earning due to an unsustainable industry environment. No, the philosophy also would not necessarily have predicted the precipitous decline that followed.
A non-screening process could have, however, resulted in an investment in Lennar in early 2011. The company had built a unique low-cost land position, maintained a sustainable balance sheet and was one of the few homebuilders (of any size) still viable. But note, from the graph above, that the company’s P/E was not meaningful at that time as earnings were negligible during the depths of the housing downturn. For opposite reasons as in 2007, the same P/E screen may not have resulted in Lennar’s identifi cation as a potential investment. An extraordinary opportunity to purchase (at a very low price) what many believe to be the best homebuilder in America would have been foregone due to a meaningless P/E screen. Only a fundamental understanding of the company’s businesses could have yielded a positive viewpoint.
A second example is biopharmaceutical company Gilead Sciences. The stock has been “screening” well of late as the approval and marketing of its Hepatitis-C medications have caused earnings to spike (and thereby its P/E ratio to drop). But how sustainable are those results?
We have long followed Gilead, as its HIV medications have proven to be a stable and durable franchise. From the above graph, one can see that the company’s fundamental strengths were well reflected in its valuation with P/E ratios exceeding 40x. The recent dip in the company’s valuation to less than ten times earnings could be, to some, a unique opportunity to