Finding 60-Cent Dollars In A Pessimistic Market


Ty Nutt, Portfolio Manager and Team Leader, Delaware Value Fund

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Nutt: We are a traditional value manager. By that I mean that in the tradition of Ben Graham, we believe that markets are not efficient. At least on a short and intermediate basis, they can be affected by human emotion and crowd psychology. We are trying, at all times, to be rational in our approach. It’s a disciplined approach, and we develop a pretty concentrated portfolio – 33 stocks currently.

Forbes: That is pretty concentrated.

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Nutt: Yes, it is a little bit more concentrated than some value investors. We don’t want to be an index or benchmark. We want to concentrate on the best ideas only.

Forbes: Even a value manager is not necessarily successful on a short-term basis. We have had many months of volatility, which can make sticking with value investing a little trying at times.

Nutt: It does. It can be extremely trying. I think discipline and patience are keys. But really, if I were to give an overview of the things that we believe are really key to the whole process and success in the investment world, I would say that we think you have to have great people who work well together as a team, follow a highly-disciplined process, and stay consistent over the years. Teamwork, discipline, and consistency.

I feel that we’re blessed to have a really great team. My teammates are talented, hard-working people with a lot of experience. We have a collegial, collaborative approach and actually make our decisions on a democratic basis – the majority rules.

Forbes: What is leading you to the choices you’re making at this point?

Nutt: We still think we’re in a rather slow-growing economy. That’s certainly true in the U.S., and it may be true, of course, much more broadly than just in the U.S. We believe we still have high valuations for U.S. stocks overall, so we’re staying with quality and defensiveness. We continue to insist on cheapness, as always.

The main point to make about that backdrop is that we have a very high indebtedness in the U.S. Total credit market debt is roughly 350% of G.D.P. in the U.S. The S&P 500 P/E, on a five-year normalized basis, is around 18.5. Down from 34 at the top, but still above the long-run P/E median, which is about 16.5.

The market has been flat since the beginning of this bear market. Since April 1st of 2000 through the end of 2011, the S&P 500 total return was 0.37% annualized. So you’re right that we’re in a volatile period, but we’re also in a period of low returns. You have to work that much harder to build in value, to get stocks below their intrinsic value. We’re like other traditional value people in the sense that we want to find a dollar bill for 50 cents.

We’re happy, frankly, to find dollar bills for 60 cents or less. You find those when there’s pessimism in the market. And you build in what Ben Graham called the central concept, which is the margin of safety concept – when you can buy at a steep discount from intrinsic value. Let me get into some of those ideas. I’ll give you, in each case, just a couple of headline thoughts and then dig into some details.

Cisco, for one, is a market leader with a rock-solid balance sheet. It’s positioned to benefit from some major secular themes, we believe. It’s trading now near historic lows in valuation, with a single-digit forward P/E.

When we did our in-depth analysis, this was a company that certainly faced a whole list of challenges, including competition in its major businesses in switches and routers. We also considered that there were probably going to be reduced levels of public sector spending, which is an important driver for Cisco. And there were even questions about management credibility.

Growth rates had come down, margins were compressed and Cisco was facing these issues. Management had started to acknowledge the issues and had a restructuring plan in place. But the stock was down about 35% over the prior year. It was down 80% from its all-time highs back in the early part of the decade, around 2000.

The valuation was really compelling to us – it was near 20-year lows. And this stock was in the second cheapest decile in our screen, so it was quite attractive. It was also attractive on a contrarian basis because only about 40% of Wall Street analysts gave it a buy rating, down from about 85% just a year before.

Now this is a strong company – $44 billion in cash and marketable securities. Its cash generation was really strong. It had a forward, free cash flow yield of about 12% at the time we made our decision. The company had just announced a dividend too — a first-ever dividend in March. At the time that we made our purchase, it was about a 1.6% yield.

Forbes: How big is the price differential from when you initially made your investment?

Nutt: We bought the stock in the neighborhood of $15, and the stock is now above $18 per share. We think the company is really well-positioned with respect to some very major, long-term themes. Things like productivity, internet growth, mobility, band-width demand, virtualization, and also Cloud-based computing.

The most recent quarterly report showed good execution versus the company’s restructuring plan, and you now have a stock trading at about 9.8 times FY2 earnings, and a 1.3% dividend yield.

Forbes: Well, you make a good case.

Nutt: Another one is Raytheon. Raytheon is the most diversified of the major defense companies. It has about 25% of revenue coming from overseas. It’s got a strong balance sheet with interest coverage of 23 times, a P/E of only 9.2 and a dividend yield of 3.6%.

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