Sound Shore Management was founded back in 1978 on the premise of long-term value investing, and according to co-founder Harry Burn not much has really changed in the firm’s approach over the last 37 years. It’s all about taking the time to constantly sift through all the equity chaff to find undervalued stocks that aren’t yet recognized for the gold nuggets they really are.
In a recent interview with Value Investor Insight, current Sound Shore principals Harry Burn, John DeGulis, James Clark and David Bilik discuss their fundamental research, why maintaining equal position sizes is important, the key benefit of active management, and why they are looking for price appreciation from Aon, CIT Group, Keysight Technologies, Hospira, Oracle and Thermo Fisher Scientific.
The importance of independent research
Burn explains his basic approach: “When we started we had a basic view of the world that price mattered, independent research mattered and that there were always opportunities in the marketplace because share prices regularly changed more than company values did. If our knowledge of companies allowed us to take advantage of that volatility and we made high-conviction bets, we’d at least have the opportunity to outperform.”
He also notes that he starts his research by looking broadly at beaten up stocks. “There’s a bell-shaped valuation curve with the market’s current median in the middle and then left-hand and right-hand tails toward the extremes. We focus our research on the left-hand tail, trying to understand how the companies ended up there and what two or three fundamental things have to happen for that to change.”
James Clark elaborates on Sound Shore’s stock selection methodology. “We screen the largest 1,200 or so U.S.-listed stocks and ADRs – with market caps today of at least $3 billion – for both low absolute valuation and low relative valuation based on the company’s history. The relative valuation element has enabled us to own higher-quality companies with better balance sheets and higher growth rates.”
Interestingly, Sound Shore notes:
We’ll end up owning in the same portfolio companies like regional bank Citizens Financial [CFG], which trades at only 70% of book value, and Google [GOOG], which when we bought it was trading at a 12x P/E rather than the 20x at which it normally traded. We think of our screening as an unbiased, blunt instrument at the beginning of the process to identify stocks saying “look at me.”
Sound Shore often buys after a temporary setback
According to John DeGulis, a good example of finding value after a temporary setback is Hospira, a specialty pharmaceutical company that had problems with FDA inspections as far back as 2010, and had to completely revamp operations at an important plant in Rocky Mount, North Carolina. HE noted that this situation “cut the company’s earnings power and stock price in half, providing an opportunity if you believed the problems could be fixed and production capacity restored.” He notes it did take some time, but today “most of the issues have been resolved and the share price is now above where it was before the trouble started.”
DeGulis also highlights Oracle in the context of industry change. Oracle’s multiple was compressed over a long time as growth slowed significantly and concerns increased that a shift from on-premise enterprise software systems to cloud-based software-as-a-service models would hurt the firm’s earnings.
He says Oracle is really just now coming into its own. “Our view is that it has taken a while, but Oracle is well positioned to navigate the industry transition, and that, in fact, that transition will allow it to capitalize on its installed base, customer relationships and massive free cash flow to significantly expand its addressable market. If we’re right, our being able to buy the stock at 12x earnings and a 9% free-cash-flow yield should turn out to be a pretty good deal.”