HARTCH & PRIEST Transcript 5/24/2013 #948

May 24, 2013

CONSUELO MACK: This week on WealthTrack, two global investors who chart different courses to achieve award winning track records. Tim Hartch of Brown Brothers Harriman takes a tightly focused approach with his BBH Select Funds. Epoch Investment Partners’ Bill Priest makes a much wider sweep. Where they are finding opportunities is next on Consuelo Mack WealthTrack.

Hello and welcome to this edition of WealthTrack, I’m Consuelo Mack. We try to take a long-term view on WealthTrack and occasionally we stretch that definition far beyond normal boundaries, especially when we find a chart that tells a compelling story. This one comes from famed Yale economist Robert Shiller. It shows the “real” total return, that’s with the effects of inflation removed and interest and dividends reinvested, of U.S. Government bonds compared to stocks from 1871 to 2013. All you can say is wow! Stocks have won hands down over the last century.

A large part of the outperformance, of course, is the reinvestment of dividends. As we have talked about with recent guests, dividend streams have been growing again as companies increase their payouts, while bond payments have been decreasing. And that makes a big difference in total returns for shareholders over time.


Much more recently, there’s also the capital appreciation piece. How much has the Federal Reserve had to do with the now five year rally in the stock market? Here comes another telling chart. Since the market bottom in 2008, the Federal Reserve has initiated four major stimulus programs. As you can see, after each one, the market rallied significantly: quantitative easing one, known as QE1 in 2008, Quantitative Easing 2 in 2010 when it started buying long-term treasury bonds in earnest, Operation Twist in 2011, again targeting long-term treasuries and interest rates, and the most recent QE 3, initiated last year, where its buying a combination of mortgage backed securities and long-dated treasuries to the tune of $85 billion a month.


These are the conditions this week’s WealthTrack guests are investing in. They are two global money managers with impressive track records. Timothy Hartch is a partner in Brown Brothers Harriman, a nearly 200 year old privately held investment firm serving institutions and high net worth individuals. Hartch is co-manager of the firm’s large cap Core Select equity portfolios including the BBH Core Select Mutual Fund which he has run since 2005 and for which he was nominated for Morningstar’s Domestic-Stock Fund Manager of the Year Award in 2012. He also co-manages the new BBH Global Core Select fund.


Bill Priest is Chief Executive Officer, Co-Chief Investment Officer, and portfolio manager of Epoch Investment Partners which was named Institutional Investor’s 2012 Global Equity Manager of the Year in 2012. He is portfolio manager for its Global Equity Investment Strategies. One of his funds, the MainStay Epoch Global Equity Yield fund, ranks in the top 10% of its fund category for its 3 and 5 year performance. MainStay is a sponsor of WealthTrack but as you can tell, Bill is here on his own merit. I began the interview by asking each of them for their assessment of the state of the markets.


TIM HARTCH: Well, we focus on buying and owning high quality businesses, and it really is a bottom up process. So I think it’s actually becoming more challenging as an investor to find new opportunities because valuations have definitely moved meaningfully higher, particularly for some of the consumer staples and healthcare businesses that people understand as being really high quality, high return equity businesses. So from an investment perspective, I think it’s becoming more challenging today than it was certainly… you know, today is not 2002 or 2008, it’s a very different environment.  So in terms of the overall macro economic perspective, I think it’s mixed. You’re getting different signals right now from the businesses that we invest in.


CONSUELO MACK: Bill, what’s your take?


BILL PRIEST: Well, I think from our perspective, people didn’t appreciate the potential calamity that befell us in 2008.  This was the mother of all liquidity crises. What came out of that was a monetary policy that was massive, and you had to solve this liquidity problem, and they have solved it. There is no liquidity problem anywhere in the world.  Liquidity risk is off the table. So whether you look at Bernanke, the ECB, the Fed, UK, there is no liquidity problem. But they have created a different kind of problem. In the last 12 months PE ratios have expanded probably 30%. I think that’s largely driven by QE. And this QE policy is having less and less of an effect in the real world having…


CONSUELO MACK: This is quantitative easing by the Fed, right?


BILL PRIEST: Correct. And that Quantitative Easing is having a huge effect in asset prices.  They’ve been very successful in getting asset prices up. But it hasn’t rolled over to the real economy, and real economic growth has been incredibly slow. It’s probably been the worst recovery in terms of growth in the past 100 years coming out of a recession.  But it’s the nature of this problem. The debt to GDP is huge among the G7, and you have to be able to bring debt down relative to GDP, but you can’t bring it down so fast that you put yourself into another recession.


CONSUELO MACK: So Tim, when he talks about this multiple expansion, this is what you were referring to as a bottom up investor, right? That you’ve seen this multiple expansion in the universe of companies that you look at?


TIM HARTCH: Correct. A lot of the businesses actually are facing a mature market in the US and Europe, and in some cases actually a recessionary environment in Europe, and when you have that kind of slow growth but a higher multiple, it suggests that returns going into the future are going to be lower than they’ve been in the past.


CONSUELO MACK: You’re new to WealthTrack, as I said, so we’re not familiar with Brown Brothers Harriman and the Core Select approach. So talk to me about the two goals that you have in your investment strategy.


TIM HARTCH: Well, the first is a pretty basic goal, and that’s to protect the capital that’s been given to us. I think most investors, whether institutional, or high net worth, their first objective is to protect the capital, and then it is to grow it over time. And for us that’s on an absolute basis. We’re trying to generate attractive absolute returns over a multi-year period.  And we believe, still, that the best way to do that is by owning high quality businesses, but you have to be very selective in what kinds of businesses you want to invest in. We have specific criteria that we look for, you know, loyal customer base, we look for companies that have an essential product or service, strong competitive position, and we look for companies that have very attractive financial characteristics, high returns on capital and free cash flow. The challenge is, as I said, is can you buy them still today at an attractive price where you get a margin safety not only in the business, but in the price you pay?


CONSUELO MACK: And you’ve chosen, the name is very good, the Core Select funds that you run, so there are core portfolios, and you know, at 30 stocks, for instance, in the flagship Core Select fund.  So why have you limited yourself to that extent?


TIM HARTCH: We like concentration, you know, reasonable diversification, but also concentration. We don’t want to be over-diversified. One thing that’s important to recognize is there actually aren’t that many new opportunities every year. Last year we just purchased five new investments for our domestic fund, and we’ve only bought one so far this year, which we’re still accumulating.


CONSUELO MACK: So, Bill, talk to us about your investment approach, basically what your primary goals are when you’re investing.


BILL PRIEST: Well, the first thing you need to do is to understand the business, and the best way to understand the business is to look through to the prism of a free cash flow metric. And there are only five things that management can do with a dollar-free cash flow. They can pay a dividend, they can buy back stock, they can pay down debt, they can make an acquisition, or they can reinvest in the business. Every conceivable strategy falls into one of those five buckets. So in talking to management, and when we talk to the CFO about capital allocation, they actually get our approach because our approach is really what’s called a capital budgeting model. It’s the same thing that guy’s doing internally, we do it publicly and investing in public equities.


So what happens is we focus, we scour the world for those companies that have certain characteristics. First of all, they generally are large, mature firms that return capital to the shareholder in one of three forms.  They pay cash, have cash dividends, they buy back stock, or they pay down debt.  All three of those are a form of dividend.  We call them “shareholder yield”. Now, it turns out what you want to do in this kind of a strategy, our goal is to identify a portfolio that offers a 9% return. That consists of 4.5% from cash, 4.5% cash dividend.  Another 150 basis points from share buybacks and debt paid out …




BILL PRIEST: … which will give you a 6% shareholder yield, but that has to have a growth rate, otherwise you have what’s called a “liquidating dividend problem”.


CONSUELO MACK: So is that share buybacks and paying down debt, that other 1.5% in return?


BILL PRIEST: Correct. That’s correct. And you need a growth rate of at least 3%. So the way to think about it, it’s 4.5 in cash, 1.5 from these other two components of shareholder yield, and a 3% growth rate. Now, it turns out in putting this portfolio together, you want to buy as many names as possible, because the more names you have, you’re shrinking what’s called “dispersion”, or uncertainty around expected return. And it turns out we have something around 100 to 110 names in that portfolio.


CONSUELO MACK: Okay.  I’m going to stop you there because, Tim, I’m listening, and I can see some similarities, and I can see some big differences, too. So where do you differ in what you look for in a company that you go to from what Bill’s doing?


TIM HARTCH: Okay. Well, the similarities, I agree with the focus on cash flow, the focus on cap allocation, and the overall approach in terms of focusing on the business first, because that’s your protection. For us, we’d like, though, to have a more concentrated portfolio where we have the 40 to 50% of our capital invested in the top ten positions, and we want those businesses really to be a great fit with all of our criteria, and we think that helps to drive our portfolio, and make sure it behaves the way we want it to in terms of downside protection. And, you know, if you have too many names, 500 names then the market’s overvalued.  You’re guaranteed, if the market goes down, to participate fully in that decline. We try to identity at any one time 30 businesses that have these resilient characteristics, but are attractively valued and do have a discount to our intrinsic value estimate.

CONSUELO MACK: So talk to me about the 30 companies, because earlier you had said that because of the values in the market now that you’re having a harder time, you know, finding new companies to buy. So how wide is the universe in which you are looking, number one, and what do you do if the market keeps going up? I mean are we going to cash or what?


TIM HARTCH: Our cash position has increased, so that’s a little bit over 10% currently.  But we have a wish list of 150 businesses that fit all of our qualitative criteria, and currently we own 30 companies from that list. And they’re not, you know, when I say we’re value investors, we’re not just buying companies at low book multiples and ten times earnings. It would be very hard to do that in today’s environment. For example, we have an investment currently in Praxair, which is an industrial gas business. It may not be that well known to all the viewers, but in its industry it’s extremely well respected, it has a really loyal customer base, take-or-pay contracts are exclusive supply agreements for much of their customer base, very strong competitive position. These truly are essential products. If you are just looking at it from a deep value play, you might say, you know, it’s trading at a high teens earnings multiple, but when we look at it and see the high returns that the company has been able to generate, 28% return equity in the current quarter, we look at the future of the business, discount the cash flows back, and actually think we do have a discount. So in today’s market, those are the kinds of very high quality businesses that can continue to invest and generate high returns that we’re focused on.


CONSUELO MACK: The emphasis on dividends. Why is that so important for you, Bill?


BILL PRIEST: Well, let’s step back a minute and see. You can take any investment strategy and it will fall into one of two camps. You can maximize return per unit of risk, which is what most people offer.  We offer some of those strategies, and I think that’s really what Tim’s talking about. Or you can minimize risk per unit of return sought.  So if you seek a number, if you gave me a number, you said, “Bill, give me the most efficient portfolio possible that could generate 9%  I’d like it to be an equity portfolio”, that would be Global Equity Shareholder Yield. And in fact, I would say that our approach is actually quite similar. He’s maximizing return per unit of risk in a 30 stock portfolio, we’re minimizing risk per unit of return sought. We’re turning it inside out, and by doing that …




BILL PRIEST: S-o-u-g-h-t. In other words, this is what people are trying to seek.


CONSUELO MACK: Oh. But you’re seeking, okay. In our business “SOT” means something different. Sound bite.


BILL PRIEST: Right. No, so what it means is that portfolio of 100 to 105 names has a beta, a sensitivity to market of 0.75, and it lives in a world of markets going up and down.  We’ve never failed to deliver the 9%, but it’s always better than nine if the market is going up, or it’s a little less going down.  It turns out that over the life of this product, it has a very significant premium over any benchmark. But frankly, that is more of a coincidence. In the world that I described, the benchmark moves around us  We’re going to get that 9%. It will be a plus or minus number. In his world …


CONSUELO MACK: Over time you will. Not every year, right.


BILL PRIEST: In the product that I think that he’s describing, he moves around the benchmark, and it’s fundamentally a different perspective. It’s consistent because we offer products similar to his, and I think given some of what their clients seek, he’s going to want to look for portfolios that also preserve capital, provide after-tax income, and have capital growth.


CONSUELO MACK: So, you know, from your own point of view, what about this, the first goal is basically to protect capital and not lose money. So why does this focus portfolio do that?


TIM HARTCH: Well, I think we’ve been able to, yeah.


CONSUELO MACK: And I think you certainly have succeeded, your track record shows that but why does it work?


TIM HARTCH: Well, I think valuation matters, and so in 2006 and 2007 one of the companies we were asked the most about was Wal-Mart, and it kept going down year after year. And it was a large position. People say, “Why do we own Wal-Mart?” And it was because it was a very good business, and the valuation kept becoming more and more attractive, and then …


CONSUELO MACK: As the price went down…


TIM HARTCH: As the price went down. And then in 2008 it was one of the few stocks that actually went up when the market was down 37, 38%.  And I think that highlights how, well, you can’t time it if you’re very focused on owning businesses that objectively are trading at a large discount to their intrinsic value, you can protect capital in a down market. Now, certainly we had stocks that did go down meaningfully in 2008, but …


CONSUELO MACK: Everyone did. Right.


TIM HARTCH: … it’s important to have businesses that are attractively valued relative to how you value them.


CONSUELO MACK: So do you still own Wal-Mart?


TIM HARTCH: We do still own Wal-Mart. It’s a much smaller position than it was in 2007.


CONSUELO MACK: Right. Because as the price went up you were trimming your positions, right?  So I’m looking at your top, at least the top five holdings that I know that are publicly acknowledged. And Berkshire Hathaway, Comcast, U.S. Bancorp, Nestle, Novartis.  So are these, you know, I mean, what do they have in common? Why would I say, “Okay, that’s clearly a Brown Brothers Harriman Core Select selection. “


TIM HARTCH: Well, they’re all businesses with great competitive position, and they’re all businesses that in their area have a loyal customer base. If you look at the individual companies within Berkshire, for example, they provide essential product and services. And they’re industries with good industry structure, and they’re leaders in those industries. And then going back to a point Bill made, they also have leaders and managers who know how to allocate capital. And Warren Buffett actually, probably the best example of an investor who has really been able to allocate capital very effectively to create value for shareholders.


CONSUELO MACK: Except the dividend piece is missing with Warren Buffett if Berkshire Hathaway… I don’t know the particulars of the… well, Nestle is a very good yield, I know that, but I mean, you’re not looking for what… when he’s looking at, you know, the capital allocation, dividends are not at the top of your list?


TIM HARTCH: We’re agnostic about dividends… or not dividends… but we own a number of companies like a Novartis or a Nestle that pay very significant dividends.




TIM HARTCH: And if it’s excess capital and they don’t have investment opportunities, we want them to either distribute it as dividend or buy back stock if the stock is particularly cheap.


CONSUELO MACK: And Bill, I’m looking at the top five, again, that you can talk about publicly, the BCE, Swisscom, PPL, Vodafone, Kimberly-Clark. They’re not all household names, they’re global. So how would you describe the characteristics that they all represent in your portfolio?


BILL PRIEST: Well, they’re all very large companies.




BILL PRIEST: Management has a history of good capital allocation. They dominate the market shares. Some of these companies are so large they couldn’t spend all the money internally if they wanted to. They have to give it back to the shareholders.


CONSUELO MACK: Which is a good thing as far as you’re concerned, right?


BILL PRIEST: Well, it’s a good thing for total value creation. Many of these companies like Nestle, which happens to be a big position, we own Novartis, we own Praxair, we actually own some of the same names that he mentioned. What you want to make sure that you get with these companies is when you look at where Nestle spends its money, almost half of it goes back in dividends and share buybacks. But when they reinvest in their business, it’s all in emerging markets, because that’s where relative growth is in the world. Virtually all their capex, if you will, is spent overseas in that way.


CONSUELO MACK: And that’s important for you in the Global Equity Yield fund, and…



TIM HARTCH: That’s where the world’s growing.


CONSUELO MACK: That’s where the world’s growing.




CONSUELO MACK: And of course, you’ve just started a Global Select fund, Core Select fund.  I mean, would you say the same thing when you look at these big, high quality businesses that where they’re investing is overseas, and that’s a plus, that’s something you look for?


TIM HARTCH: It’s critically important. Nestle actually now derives 45% of their revenues from emerging markets. So some companies, many companies, you know, it’s a fraction of that number. So if you’re a consumer products company in mature categories, and you’re landlocked in the US and Europe, or Japan, you’re not nearly as well positioned as somebody like in Nestle, which has almost half their business in the rapidly growing parts of  the world.


CONSUELO MACK: What’s the most undervalued company in your portfolio, in your Core Select portfolios?


TIM HARTCH: Well, some of our energy names are trading at large discounts to intrinsic value, the largest in our portfolio. They, by definition …




TIM HARTCH: Well, the ones we currently own are Occidental and EOG, and Southwestern, but I was going to highlight that those intrinsic value estimates, those companies almost by definition have a wider range of outcomes than a company like a Nestle. And so we would actually look for a higher discount…


CONSUELO MACK: Because of… right, they’re oil and gas, and how that’s valued…


TIM HARTCH: They have commodity prices that are not in their own control, and we actually have a positive outlook on energy prices in the long-term, but certainly, you know, one thing you know about energy is the prices are going to be higher than they are today, as well as lower at some point in the future. So I think it’s appropriate to buy them when they’re trading at a large discount.


CONSUELO MACK: And so, Bill, in the MainStay Global Equity Yield portfolio, is there a position that is the least understood, or is most misunderstood by the markets?


BILL PRIEST: No. The key to this strategy is the diversification process. No single name is more than 2.3%.  And by doing that you aren’t dependent on any name.  Even more important, the dividend yield for the entire portfolio, the most that can come from any one name is 3%. The key to producing this portfolio is make sure it’s the maximum diversification you can have in the entire world, and still collect the 4.5, the 1.5, and the 3. If you can do that, and the world offers you a six to 8% return in the stock market, we can collect 9, half in cash, a beta 0.75, the world will find a path to our door.


CONSUELO MACK: One Investment for a long-term diversified portfolio. What should we all own some of in a well diversified portfolio? But maybe it should be a very selective core portfolio. Tim, what would it be?


TIM HARTCH: Well, one of the areas that we haven’t spoken about too much that I want to highlight is the importance of industry structure, and investing in attractive industry. So I was going to highlight one industry that we think is particularly interesting for investors interesting for investors, and that’s the dental industry. And it’s arguably the most attractive part of healthcare today. And I say that for a couple of reasons. First, there are demographics working in their favor. As people get older, they need more dental work, and also there is a rising standard of care outside in emerging markets. So that’s first, demographics. The second is pricing. Most healthcare you’re facing cut backs from the government, a reimbursement is challenged in the US and Europe and Japan, and unlike most parts of healthcare, the dental industry actually has private pay. Most people pay out of pocket, or they have private insurance.  And they’re sheltered then from that reimbursement pressure, and historically they’ve been able to pass through inflationary pricing onto their customer, so a second big benefit.


And then a third specific to our criteria is we look for businesses that have a loyal customer base. And dentists tend to be solo practitioners, or small group practice, and small businesses tend to be very loyal to their key suppliers, and so they trust their distributors and their key suppliers of their key brands and products that they use. So it’s a very stable, attractive industry, and we think it’s a… you know, you have to be careful in terms of valuation, but we think it’s a very long-term growth opportunity in the dental market.


CONSUELO MACK: So what’s a big dental company that would meet your criteria of high quality and customer loyalty? Is it Dentsply?


TIM HARTCH: Yeah. We currently own Dentsply and Henry Schein. Dentsply is the largest manufacturer of dental equipment on a global basis, and Henry Schein is one of the two largest distributors serving the dental market.


CONSUELO MACK: And this is the first on WealthTrack, not only are you a first on WealthTrack, you’re the first dental basically, someone who has mentioned dental companies. So thank you for that new idea. Bill Priest, what would yours be, the One Investment for a long-term diversified portfolio?


BILL PRIEST: I would probably highlight CVS Caremark. It’s the largest firm of its type. It’s got about a 21% market share. They really get capital allocation. They pay out 100% of their free cash flow every year. We think they’ll generate something in the area of $5.50 of free cash flow in a couple of years, and if you take the same multiple times that, you’d produce a stock around $80.  It’s about $57 today.


CONSUELO MACK: All right. Terrific. Thank you both so much, and thank you for giving us a One Investment, Bill, because I know you want a very diversified portfolio, which we all do. But Tim Hartch, it’s really great to have you first time on WealthTrack. Thanks so much for being with us. And Bill Priest, lovely to have you back again.


BILL PRIEST: Thank you very much.


TIM HARTCH: Thank you.


CONSUELO MACK: At the conclusion of every WealthTrack, we give you one suggestion to help you build and protect your wealth over the long term. This week’s Action Point is: consider the total return benefits of stocks.


Take another look at the chart we showed you earlier of how well stocks performed over time, with their dividends re-invested, versus bonds with their interest payments re-invested. Dividends can grow while you are holding stocks. Bond coupons are fixed over the life of the bond. That fact alone gives stocks a big advantage to provide purchasing power protection for at least part of your long term portfolio. .


And that concludes this edition of WealthTrack.  To see any of our past Great Investor or Financial Thought Leader guests go to our newly re-vamped website. You will find them there along with additional interviews and information in our WealthTrack Extra Feature. In the meantime, thank you so much for watching.  Have a lovely   Memorial Day weekend. I hope you can attend a ceremony in honor of our fallen soldiers. Make the week ahead a profitable and a productive one.


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