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An Interview with Scott Barbee founder and Portfolio Manager of Aegis Value Fund(AVALX) and Aegis High Yield Fund(AHYFX)

An Interview with Scott Barbee founder and Portfolio Manager of Aegis Value Fund(AVALX) and Aegis High Yield Fund(AHYFX)

Scott Barbee’s bio

Scott founded the Aegis Value Fund (AVALX) and has served as Portfolio Manager since its inception in 1998.  He is also the owner of Aegis Financial Corporation and the Portfolio Manager for the Aegis High Yield Fund (AHYFX). Prior to Aegis, Scott worked as an analyst with Simmons & Company, and later Donald Smith & Company.  He received his M.B.A. from The Wharton School at the University of Pennsylvania in 1997 and holds undergraduate degrees in Mechanical Engineering and Economics from Rice University.

Aegis High Yield Fund has beat the Barclays Capital High Yield Index since its inception in January 2004. The fund recently won the Lipper Award for having the highest risk adjusted return for the 5-year period ending December 31, 2009, ranking best out of the 337 funds in the high current yield category as measured by Lipper over the period.

The Aegis Value Fund was started in 1998 as a small cap value fund. It has crushed its index, producing a 10.5% return per annum versus 6.4% for the Russell 2000 value index.

Mr. Barbee was king enough to answer several questions I had for him below is our interview:

I like starting off an interview with the following question. Value investing is contrary to human nature, how did you get started in value investing?

 

I first became seriously interested in value investing while working at Simmons & Company, an oil-service investment banking boutique that was my first employer out of school.   I had first started working in the Securities Group in 1993 and was supporting the sell-side analysts after graduating from Rice University with degrees in Mechanical Engineering and Economics.  At the time, I remember Simmons was still ordering 10-Ks and 10-Qs from an overnight delivery service.  One of my jobs was to aggregate the news, accounting and valuation statistics for the oil-service universe for a monthly oil service overview we were publishing.  That’s the first time I remember becoming interested in investing in stocks that were statistically cheap on historical metrics.  Looking for cheap stocks based on historically-based attributes particularly appealed to my contrarian, engineering-focused mindset.  I ordered a public company statistical database and began running screens for cheaply valued stocks in the broader market, and remember buying Advanced Marketing Services, a book distributor that was a Benjamin Graham net-net.  As my investment in Advanced Marketing started to make money, I began reading everything about value investing I could get my hands on.  In 1995, I went to Wharton, where I was able to take a class from John Neff, who successfully managed the Vanguard Windsor fund for many years.  During this time, I also met Donald Smith, Rich Greenberg and Alan Kahn, three talented deep-value investors who helped me get into the business.

 

On a similar note how did you get started specifically in small cap value investing and high yield investing?

While at Wharton, I became interested in the academic research of Eugene Fama and Kenneth French, which seemed to demonstrate that very small companies trading at big discounts to book-value were delivering impressive historical returns.  The research dove-tailed well with my own findings that deeply undervalued companies with the most interesting stories tended to be smaller market-caps.  Small-caps were also easier to study, as they typically had only one or two business lines, and regulatory disclosures seemed more granular and comprehensive.  So when I started the Aegis Value Fund in 1998, I focused on small-cap, deep value stocks.  Later, we realized that the companies that we were looking at, which were typically going through periods of fundamental stress, also often had high-yield debt issues outstanding that traded at attractively discounted levels.  We started the Aegis High Yield Fund at the beginning of 2004 in order to take advantage of these kinds of situations.

 

There are many different schools of value investing, which school would you say you adhere to the most? Who has had the greatest influence on your investment philosophy?

We consider ourselves to be deep-value investors, and typically focus on buying companies at prices under tangible book value.  In this respect we are probably closer to the old-school, deep-value investment style that Benjamin Graham himself applied in his own work, as opposed to the new-school, Bill Miller-type approach.  We have a contrarian nature, so deep value seems to work better for us.  In terms of who has had the greatest influence on my own investment philosophy, it’s difficult to pick just one.  Certainly books by Benjamin Graham, Seth Klarman, Joel Greenblatt, and Louis Lowenstein have all made deep impressions on my thinking, as did my class with John Neff.  I’ve also picked-up significant experience vicariously over the years in conversations with Rich Greenberg, Donald Smith, Alan Kahn, Walter & Edwin Schloss, Bill Berno, and many others.

 

How do you manage risk?

First, I describe risk as falling in two general categories.  The first is the risk of permanent capital loss, which occurs when the fundamentals underlying a company’s intrinsic value are initially too optimistically assessed or deteriorate post investment.  We focus the vast amount of our own effort on this first category of risk, looking very carefully at the fundamentals of the companies in which we invest.  By doing substantive due diligence work and monitoring our investment carefully, we hope to mitigate the potential for a breakdown in investment thesis or an erroneous assessment of intrinsic value.  The second general category is the risk of temporary capital loss due to a quotational decline stock price that is not materially indicative of a deterioration of company fundamentals.  This kind of investment illiquidity or quotational risk can be very difficult to guard against as a deep value investor, as it has more to do with the financial condition of other shareholders than with the subject company itself.  Perhaps the only way this illiquidity risk can be addressed is by holding additional liquidity when the Mr. Market gets too keyed-up and putting the liquidity to work when Mr. Market is sober and depressed.

Do you ever meet with management?

Sure.  We spend a lot of time talking with management, either in person or over the phone, typically after fleshing out the fundamental issues over several hours of deskwork.  We think interaction with management is an important part of the investment process and one that can lead to a better understanding of the various businesses in which we invest.

How do you go about finding stocks? Do you look at the 52 week low list? Do you use a screener for stocks with high dividends and low payout ratios?  Do you favor stocks with higher dividend yields? What percentage of your returns comes from dividends as opposed to increases in the price of the stock?

Our process begins with a quantitative overlay, screening for companies trading at discounts to tangible book value.  We also tend to look for less levered situations, as a levered discount to book can easily evaporate with a small erosion in asset value, which can certainly happen during times of distress.  Additionally, we look for either current cash flow, or evidence of better future cash flow.  Corporate share repurchases, insider share repurchases, restructurings, and other potentially impactful corporate events also factor into our selection process.  As we dig deeper into a particular situation, we typically will recast the balance sheet, giving credit for hidden , or undervalued assets.  Similarly, we make deductions for hidden or understated liabilities or overstated assets.  Dividend policy and payout ratios don’t have much of an impact on our process, except in cases where a recent dividend elimination is driving temporary selling pressure on a stock, and dividend returns are only a very minor portion of our overall returns.

I see the average stock in your portfolio has a P/E of 8.4, average P/B .7, average P/S .3, These numbers are all much lower than the average stock in the Russell 2000 value index. Are these metrics that are important to you when you make your investment choices?

As a result of our focus on screening for companies that are very cheap on a price-to-book value basis, the Aegis Value Fund generally holds positions that tend to be significantly cheaper than the Russell 2000 Value Index averages from an overall statistical viewpoint.  We also tend to stress cash flows over earnings, but also recognize that cash flows may be temporarily depressed at a company that is restructuring or facing a cyclical downturn.

 

Your top 10 ten holdings make up about 35% of your portfolio. I would consider this neither diversified nor concentrated. In general do you favor a more diversified or more concentrated portfolio?

Our top ten holdings typically consist of 35 to 45 percent of portfolio value, depending upon the levels of conviction we have in our top investments.  We generally hold about 80 names in the portfolio overall, so we have a large number of smaller position portfolio companies.  We are in the process of working some of these smaller holdings into or out of the portfolio.  Other smaller holdings might fall into the higher-risk category where the likelihood of significant stock appreciation outweighs the risk of capital loss.  Generally, we don’t add to a position once it has reached 5 percent of fund assets.  With regard to my concentration preferences, my ideal portfolio would probably consist of 20 high-conviction holdings with 5 percent of capital allocated to each.

I normally do not look at 1 yr performance but your numbers are spectacular. Your fund returned 154% over the past year through March 31, 2010. How were you able to accomplish this, did you change your portfolio a lot when the market hit bottom in March 2009 or did you continue holding onto the same stocks as before?

Given that the market bottomed on March 9th, our trailing one-year performance has captured a tremendous rebound in quotational values as the financial crisis subsided.  Many of the deep value small-cap stocks that we owned were heavily owned by hedge funds and other proprietary trading desks that funded positions with borrowed money and capital susceptible to shareholder redemption.  As the credit markets began to freeze-up in late 2008, these institutions were forced sellers, which disproportionately impacted deep value small-cap liquidity.  Pricing was driven to a steep discount to the intrinsic value of the underlying companies.  When the financial pressures and forced selling began to lift in March 2009, the prices of small-cap deep value stocks experienced a dramatic rebound.  We remained very fully invested through the downturn, and with the exception of some minor adding and trimming around the edges, including our selling off a few positions to meet redemptions, the portfolio remained basically invested in the same names.

How does a typical day look like? (For instance: Two hours checking news, two hours search strategy, two hours doing research on the best picks of the search strategy, two hours talking to clients, one hour checking the positions of the portfolio.)

I spend about 80 to 90 percent of my day in research.  Generally, I tend to absorb material fastest when I am reading, and so I spend a tremendous amount of my time reading pieces:  10-Ks, 10-Qs, conference call transcripts, analyst reports, articles, etc.  I spend a lot of time, 10-15 hours a week, on the phone with various management teams and other investors going through the fundamentals of our various investment prospects.  I also spend a significant amount of time talking and working through ideas with our analyst team.  I would say the balance of time is generally spent on various client interactions, press communications, and other regulatory and business management issues.

What was it like starting a small cap value fund near the peak of the bubble when large growth companies were roaring and producing spectacular returns?

We started the Aegis Value Fund in April of 1998, just prior to the demise of Long-Term Capital Management.  As the Fed lowered rates to bolster the banking system in the wake of this crisis, tech stocks just melted-up.  It was a particularly frustrating time to be a value investor in all these “old economy” names, many of which were actually declining in price, primarily because investors were selling off these investments in order to speculate in overvalued tech stocks.  So from a customer retention standpoint, it was a very difficult time.  However, from the standpoint of investment opportunity and conviction, it wasn’t so bad.  Many value stocks had traded down to mid single digit P/E ratios and were at deep discounts to book value.  It seemed fairly straightforward that the tech stocks were too highly valued and that this was likely to correct, and at some point these small-cap value stocks would have their day.  The only uncertainty was how bad the overall economy would become when the tech bubble popped.

I see your second largest holding is Alliance One International, Inc. (AOI), legendary investor Seth Klarman owns about 9% of the company. What do you find attractive about this stock and did you originally find this idea by looking at Seth Klarman’s portfolio? Being that he is one of the largest shareholders of the stock have you ever had any interaction with him regarding the AOI?

We first became interested in the tobacco leaf dealing industry after AOI’s predecessor company Dimon bought out Intabex in 1997 and there was significant financial stress being caused by excess leaf inventory in the system.  We had been shareholders of Standard Commercial and Dimon prior to their merger to form Alliance One, and have successfully bought and sold these stocks over the last 10 years.  Currently, we are attracted to Alliance One International because of its low valuation, as the company trades at a very modest premium to book value and at a ratio of price to our estimate of normalized earnings in the mid single digits.  The leaf-dealing market has consolidated into two dominant, global players, and the company has reduced leverage and cut costs significantly over the last several years.  Furthermore, the company recently refinanced its debt, pushing out maturities and taking maturity default risk off the table.  Tobacco is a business with generally stable demand attributes.  We like Pete Harrison, Alliance One’s CEO, who did a fine job cleaning-up Standard Commercial, which had been a big winner for our fund in the past.  So we can certainly appreciate why Seth Klarman might like the company.  Of course, it’s always nice to see a deep thinker with a solid record involved in a name we hold, and you could certainly do much worse in life than buying into names that Baupost owns in its portfolio.

Do you ever find small cap companies in bad fiscal shape that might be a good buy and the bonds a good buy or the stocks a short and the bonds a long which might make it a good arbitrage play?

We often run across companies where we are doing our equity work and realize they have a bond trading at an interesting price level.  In fact, it was a series of events such as this that convinced us that managing a fund focusing on high yield corporates would make some sense for us.  While we do not short stocks in any of our funds, we do run across situations from time-to-time where we are comfortable owning the bonds, but would pass on the equity.  The Aegis High Yield Fund gives us an opportunity to capture the value of the work we do in those cases by owning the bonds.

Third Avenue Management just opened a credit fund citing opportunities in the distressed debt, high yield etc market not seen since the early 90s do you see large future gains in these asset classes?

Where we sit today, the high yield corporate markets have experienced a significant amount of spread tightening in the last year.  Interest rates generally, upon which those spreads are based, are also near generational lows.  So I think the market had a very unusual period of incredible performance as high yield liquidity returned.  From this point forward, returns in high yield are almost certain to moderate.  That said, we believe that there is the opportunity for investors to dig up situations, even in today’s more competitive environment, where investors can be well compensated.  Fortunately for us, our asset size allows us to be particularly flexible and opportunistic.

Are you making changes to your portfolio based on the changing economic atmosphere?  How important is the macro environment when it comes to high yield investing?

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