February 10, 2014

CONSUELO MACK: This week on WealthTrack, the two time winner of Morningstar’s International Stock Fund Manager of the Year Award explains how he and his colleagues built the Artisan International Value and Global Value Funds to prosper in all market conditions. Artisan’s Daniel O’Keefe is next on Consuelo Mack WealthTrack.


Hello and welcome to this edition of WealthTrack, I’m Consuelo Mack. This week on WealthTrack we are thinking global for two reasons. One, we have an opportunity to do a rare in-depth interview with Morningstar’s recently announced International Stock Fund Manager of the Year and second, because the economic and financial dynamics of the world are changing significantly and U.S. investors are not positioned to take advantage of it.

They say a picture is worth a thousand words. In this case we have two images that illustrate the shift occurring in global financial power. The first comes courtesy of independent research firm Strategas, which calls it “a key international inflection point.” It shows that the share of global GDP from emerging economies now surpasses the share of advanced economies. Emerging market nations now contribute 51.1% of the world’s economic output versus the 48.9% provided by developed economies. The second chart comes from T. Rowe Price. It illustrates that the value of the world’s stock markets do not reflect the new reality, although they are starting to do so. The U.S. stock market accounts for a little under half of the world’s stock market capitalization. At the beginning of the last decade it was over 50%. Whereas the rest of the world, including the emerging markets, accounts for a little over 50% and the emerging markets are a mere 10%. Meanwhile U.S. stock mutual fund investors are woefully underexposed to overseas markets. T. Rowe Price estimates less than 30% of stock mutual fund assets are invested abroad.


This week’s guest is a dedicated global investor. He is Daniel O’Keefe, founding partner of the Artisan Global Value team and portfolio manager with his longtime colleague David Samra of the Artisan International Value and Artisan Global Value Funds. Both were named Morningstar International- Stock Fund Manager of the Year for 2013 and for 2008, a rare feat. One major reason is their superb performance. Artisan International Value has delivered 15.9% annualized returns since its 2002 launch beating all of its competitors. The younger Artisan Global Value is ranked number three in its world stock category with 8.6% annualized returns. As Morningstar put it, “both funds have been less volatile than their benchmarks and average category rivals, leading to chart topping Morningstar risk-adjusted performance.” Well, how do these managers do it in both bull and bear markets? Daniel O’Keefe says it starts with their value approach.

DANIEL O’KEEFE: For us and for our clients, value investing is about trying to find businesses that meet four different characteristics. So we want something that is cheap relative to its long-term intrinsic value. We want a high-quality business, so a business that has some competitive advantage, that has the potential to grow, that’s defensible. We want a strong balance sheet, and we want a strong balance sheet not only because it’s a repository of value in difficult times, but it’s also a repository of value in good times as well, and we can talk a little bit more about that, and then finally we want a management team who is working in our interest, actively engaged and building the value of the company on a per share basis. So if you think about all of the risk/reward elements of those four characteristics, how do they play out in difficult environments, and how do they play out in strong environments like what we saw in 2013?


CONSUELO MACK: So the risk/reward, is you’re constantly balancing those, and these four characteristics you think protect you in down markets and enable you to participate in up markets. Is that kind of what this recipe does for you?


DANIEL O’KEEFE: It makes sense intuitively that they would protect you in a down market, a strong balance sheet, a discounted valuation, a high-quality business. All of those are intuitively defensive characteristics, but we manage our portfolio in a way that hopefully we can participate in strong markets as well, and the way to understand that is to think about what’s going on with the discount to intrinsic value. So in 2008, we protected capital because we had great businesses. We had strong balance sheets. We didn’t own banks. We didn’t own commodities and emerging markets, areas that were very hard hit. So we held up well in 2008.


CONSUELO MACK: And let me stop you there, because a lot of value investors did own banks especially. So why did you stay away from banks.


DANIEL O’KEEFE: So banks were at a low price to earnings multiple. So were they cheap? They were statistically cheap, but were they truly cheap? Well, when we looked at banks, because we didn’t own any for years leading up to the financial crisis, we acknowledge the low P/E, but we looked at the risk. Okay? Because this business is as much about risk as it is about reward. We looked at the risk, and we said, well, the leverage is 20 times. The businesses have been growing their loan books without interruption. They haven’t taken any reserves against potential credit risks. There’s a lot of risk in there. Ok, so a low price to earnings multiple doesn’t necessarily indicate true value because those earnings are arguably peak, and because they’re so levered, if something bad happens, then you stand to get wiped out. So you look at it and you say, well, is it truly an attractive risk/reward scenario where if you’re right you can make a little bit of money or a decent return, but if you lose, you can lose a ton of money. We focused on the ability to lose a ton of money, and that’s why we stayed away. So that’s different from focusing on something where you see not only or you see significant long-term undervaluation, and that undervaluation is underpinned by the tailwinds of a strong balance sheet or the tailwinds of a defensible business model, the tailwind of a management team working in your interest. That would be where we would get very excited and we would say, okay, it’s not only undervalued, but you have all of these other characteristics working in your favor as well.


CONSUELO MACK: So what you were describing to me as you said, these are defensive characteristics, so you can understand why they would reward you, protect you in a down market. But then in the up market and certainly since the bottom of 2009, for instance, in many cases it’s been the lower quality stocks and the high-risk stocks and small cap that have done better than the quality companies. So how come you did well in 2013 as well and had such a good …


DANIEL O’KEEFE: Well, what we did was after we held up well in 2008, we looked at our portfolio as we always do. We looked at our portfolio, and we looked at where are the discounts to intrinsic value? What is the discount in the intrinsic value of the overall portfolio? That’s something that we track, because it will tell us something about the future prospective return, and since we own things like Wal-Mart and Johnson & Johnson, for example, that didn’t decline as much, the discounts that we saw in the portfolio after 2008 were not as attractive as the discounts of many other businesses that were trading out in the market that got really murdered. And so what we did was we reallocated capital from stocks where the discount was not so great into stocks where the discount was huge, okay, and so that lever, accessing that lever, widening that price to intrinsic value creates the opportunity for significant future returns. So…


CONSUELO MACK: So a for instance.


DANIEL O’KEEFE: For example, we bought Google in 2008, and Google’s a great example of what we do, because it gets to the heart of the distinction between something that is merely statistically cheap and something that is fundamentally undervalued. So Google at around 12 times our estimate of earnings when we purchased it was not necessarily the cheapest company in the universe. You could buy plenty of stocks at nine or ten times earnings.


CONSUELO MACK: Much less. Right.


DANIEL O’KEEFE: But Google is a better value over a long period of time at 12 times earnings than an average or mediocre company at nine times earnings even though it’s a higher multiple. Why is that? Because it has huge operating margins. It operates in a long-term secular growth market. It has significant competitive advantages, and it’s worth 20 plus times earnings whereas an average company at nine times earnings, yes, the multiple is lower, but what is it worth? Twelve or thirteen? Would you rather buy something at 12 that’s worth 20 and growing or something at nine that’s worth 12 that may or may not grow?


CONSUELO MACK: And what about the management piece of Google, for instance? I mean, how investor-friendly is the management of Google?


DANIEL O’KEEFE: As always, we’re dealing with judgments and shades of grey, and I would say that in the case of Google, you have phenomenal technologists and very talented people who are very able to see years ahead in terms of where the market is going and how to manage the business in that direction. So for example, they got into Android. When they got into Android, investors said, “Why are you investing in a mobile operating system? Your core business is search,” and they invested a lot of money in Android, and it was controversial, but what they saw was they saw that the search business was going to not go through the door of the desktop. It was going to go through the door of the mobile device, and if they wanted to protect their search business, they needed to be the one opening and closing that door, and as search has migrated away from the desktop and onto mobile, the Android investment, which arguably doesn’t make any money because they give it away for free, has been a phenomenal wealth creator for the shareholders of Google. So in those respects I give a lot of credit to the management of Google.


Now, I would criticize them for some corporate governance issues, and I would, I’m not convinced that some of their capital allocation is necessarily so great. So the Motorola acquisition has been very difficult and they have not really articulated how that business is going to generate attractive returns to shareholders. Whether it’s Android in five years, I don’t know, and they just recently announced this acquisition of Nest which cost them about $3 billion, and the articulation of how that’s going to create value for shareholders is not well flushed out.


CONSUELO MACK: So when do you decide basically you know to pull the plug, or do you tend to reduce your holdings?


DANIEL O’KEEFE: So Google’s a good example. We have made it a larger position when it was at a very wide discount, and as that discount has narrowed, as you’ll see where the stock price is today, we would be trimming the position and trying to take that capital away from a Google into something where the discount is larger and where we would expect to be able to generate greater returns. In this environment, frankly, that’s very difficult.


CONSUELO MACK: Yeah, so talk about this environment, because when you and I talked before the interview, you had said that it’s really tough to find good values out there now. So give me your assessment of the companies that you’re looking at and how they’re valued right now.


DANIEL O’KEEFE: Well, a very wise man once told me now is always the most difficult time to invest, and I think that is certainly true today. What we see is we’ve seen markets that have gone up a lot, and certainly in 2013 earnings grew in high single digits, and in many cases stocks were up 20, 30, 40, 50%. So there’s been a huge re-rating of securities, and that re-rating has generally extinguished the undervaluation that we saw years ago. I mean, we were buying great companies at low multiples of depressed earnings five years ago, and now we have multiples that are high in historic terms or average to high in historic terms on earnings that have rebounded and are at a normal or strong level. So just intuitively the bargains have been wrung out of the market.


CONSUELO MACK: You’re running a global fund which can invest in the U.S., and you’re running an international fund which is non U.S., obviously overseas. So looking at the U.S. market which has done extremely well and, for instance, the international fund you’ve got the emerging markets which actually emerging market people are saying are pretty cheap right now. So do you find yourself migrating, looking more to emerging markets, for instance?


DANIEL O’KEEFE: Well, we are looking, and you’re right. Emerging markets right now are at a generally low multiple, and record you know, at least over the last seven or eight years a record discount on a P/E basis to the developed world, something like four points on the multiple. And so that gets our attention, so we look, and the comments that I made about the average valuation in the developed markets are very different from the emerging markets. In the emerging markets, you have an average P/E of, let’s say, 11, and that is comprised, at least our research tells us that’s comprised of some really, really good companies trading at high multiples and some really kind of low-quality leveraged businesses trading at low multiples, and so we haven’t found anything that’s cheap and high quality.


CONSUELO MACK: Oh, interesting.


DANIEL O’KEEFE: We can find cheap and low quality at a low multiple, or we can find expensive and high quality at a high multiple, but we can’t get an attractive combination of price and value which, as we said before, is an important component of what we do.


CONSUELO MACK: So let’s talk about some of the things where you are in the market, and we had talked about financials, avoiding them before, but lo and behold, some of them started to look attractive. So you’ve got Bank of New York Mellon is one of your holdings, for instance. I know at one point it’s a different kind of financial, but at one point American Express was an important holding of yours as well.


DANIEL O’KEEFE: Yeah, we own today across both funds we own American Express. We own BNY Mellon. We own ING bank. We own Lloyds Bank. We own RBS. Those would be some of our more meaningful financials. We also own property and casualty insurance companies. We picked up some of the financials during the financial crisis.


CONSUELO MACK: Right, and so, again, looking at what was going on with their balance sheet and the leverage, so have the companies, I mean the banks specifically that we’re talking about, the leverage levels are okay now? I mean, you feel like you know what’s in their portfolios, what their loan portfolios look like?


DANIEL O’KEEFE: You never really know.


CONSUELO MACK: You don’t, do you?


DANIEL O’KEEFE: Right, you never really know, and so let’s use Lloyds.


CONSUELO MACK: Just the banks, for instance.


DANIEL O’KEEFE: Let’s use Lloyds as an example. Lloyds is the largest retail and commercial bank in the United Kingdom, and it’s a phenomenal franchise and, at the end of the day, it’s a pretty simple business. They primarily make mortgage loans, retail, unsecured loans and loans to business. They got into trouble in the financial crisis because they were effectively forced to buy another bank in the United Kingdom called HBOS, and HBOS had a completely separate underwriting culture, a very different underwriting culture from Lloyds which has always had a very good underwriting.


CONSUELO MACK: Conservative.


DANIEL O’KEEFE: Right, very conservative underwriting, so when you put those two together, HBOS basically made Lloyds go bust. So they had to raise capital a few times. The government participated in that and took a large holding in the company, and they began to write off bad loans. So we got involved after the final rights issue or capital raising when the company was losing money, was writing off loans at a very high level, had been writing off loans at a high level but had really replenished its capital reserves and now was well-capitalized. So in the years before the crisis, they had skinny capital bases and loan books which were of unknowable quality. Now, when we bought Lloyds, we had a replenished capital base, and we had an asset portfolio that was going bad, and you could see it. Right? And you were in the middle of it, and you could make a reasonable estimate based upon historical loan loss levels, where that would peak and what the stressing of those levels would do to the capital base, and you could say, well, okay, we’re probably midway through it or more than halfway through it. We have the capital now to continue to absorb it, and we’re closer to the end than the beginning.


And most importantly, if you’re able to buy that at a discount to book value, then once things get better and once you get over the other side and the bank starts to earn a double-digit return on equity, then that entry price of book value or less will look very good in hindsight, but your point is right. You never really know. You never, so you have to have confidence in the people and you have to have confidence in the capital base, and you have to …


CONSUELO MACK: And the price you’re paying.


DANIEL O’KEEFE: Most importantly the price.


CONSUELO MACK: Yeah, that you’re not going to get …


DANIEL O’KEEFE: I mean, these banks were all selling for one and a half, two times book before the crisis, and then once the bad news came out and it was very messy, they traded below book value and, of course, by the time the mess is cleaned up, they will be back at one and a half to two times book.


CONSUELO MACK: Right now if I were only to choose one of your funds, you know, pick your favorite kid, are there opportunities do you think in the Global Value because it included the U.S. more than there are in the International Value Fund?


DANIEL O’KEEFE: I can never pick between my two kids, and I have about as much money evenly spread across the two funds as does my partner and co-manager, David. We like them both, and we allocate a lot of our personal assets.


CONSUELO MACK: Is there a lot of overlap between the two funds?


DANIEL O’KEEFE: There is around half.


CONSUELO MACK: There is around half. Yeah, yeah.


DANIEL O’KEEFE: I would say maybe a couple years ago the bias might have been towards Global because of the opportunity in the U.S.




DANIEL O’KEEFE: So before the interview we were talking a little bit about how large cap, especially large cap U.S. companies were very cheap, and we really noticed that, and we’re able to put a lot of great large cap U.S. companies in the portfolio. We talked about Google, MasterCard, and I could go on down the list. I think that after a couple years of very strong performance in the U.S. stock market, that obvious undervaluation opportunity has largely played itself out. So I think the opportunities now are maybe even slightly biased to the international side and away from the U.S.


CONSUELO MACK: I was going to say, like Europe or I don’t know where.


DANIEL O’KEEFE: If I had to pick one with a gun to my head, I would say there’s a little bit more opportunity in Europe today than in the U.S.


CONSUELO MACK: So we always ask near the end of an interview if there’s One Investment that we should all own some of in a long-term diversified portfolio, what would you have us own some of, and obviously you can’t recommend your own funds.


DANIEL O’KEEFE: Well, one stock that we’ve recently added where we do see a lot of value is another U.K. bank, Royal Bank of Scotland, and it’s a very similar story to the one that I laid out earlier about Lloyds. They were actually worse than Lloyds.


CONSUELO MACK: No. Is that possible?


DANIEL O’KEEFE: They were truly … it is. They were truly the poster child for bad behavior pre financial crisis. They did leveraged acquisitions. They expanded the balance sheet into all kinds of junk assets. Their capital levels were terrible. There was no underwriting discipline within the bank, and they effectively went bust, and the U.K. government took an even larger stake in RBS than they did in Lloyds which they still own today, and they still have the dominant controlling share of that company. But over the last five years, RBS has been going through a very painful revolution in terms of selling off the toxic assets, de-leveraging the balance sheet, getting the capital ratios better, narrowing the focus on the organization, and today we’re probably 80 to 90% through that process. There’s still a little bit more to go, but on the other side of this process, we think a very, very valuable franchise will become apparent through very strong earnings and very high return on equities.


CONSUELO MACK: And what kind of a franchise does it have that you think is valuable? I do worry about government ownership, and I also worry about it’s a very different regulatory environment. Banks can’t do what they used to do which is good in some respects but in other respects they’re going to be much more constrained in their ability to profit.


DANIEL O’KEEFE: Sure. All of those things are true. What I would say is that we like the U.K. banking market for a few reasons. Primarily we like it because it’s a highly consolidated market. There’s basically four main players, and in banking consolidation equals profitability, and that’s a structural characteristic of the U.K. banking industry, and RBS, despite all of the upheaval, has maintained a very strong market position and franchise because it’s so consolidated, and that hasn’t been lost, and they have a new CEO who’s running the company now, Ross McEwen, who has a fantastic retail banking franchise and we think is focused on the right things, and I think he will see the company through to the other side. I think he will manage the exit of the U.K. government. And again, once we get through managing the assets, the bad assets out, once we get through managing the U.K. government out of the shareholder registry, you’re going to have a very profitable bank with very attractive return on equity versus a bank today that’s trading at a discount to tangible book value and whose earnings are obscured by the abnormally high write-offs of the historic bad lending. So this is one for the next three to five years. We think over that timeframe on the other side, you will do very well with it.


CONSUELO MACK: So we’ll leave it there, and your investors have certainly done very well with you, Daniel O’Keefe, in the Artisan International Value Fund and also the Artisan Global Value Fund, so thanks so much for joining us on WealthTrack.


DANIEL O’KEEFE: Thank you for having me.


CONSUELO MACK: At the close of every WealthTrack we try to give you one suggestion to help you build and protect your wealth over the long term. This week’s Action Point is:

Pay attention to the Morningstar Manager of the Year Awards. We do so for a reason. They identify managers who are skilled investors over multi-year periods in both good markets and bad. Since creating the awards in 1998 Morningstar has periodically tracked how their honorees have done. Morningstar’s vice president of research and columnist John Rekenthaler analyzed them recently and found that despite the occasional outlier most of the awardees perform well, according to both Morningstar’s risk adjusted return criteria and traditional total return. By a three to one margin, funds landing in the top two performance quintiles outnumber funds in the bottom two performance quintiles over the next five and ten year periods. There is a reason many of them show up in our Great Investor category.


Well, next week we are going to explore a global laggard. Emerging markets have hit a rough patch. Our two portfolio manager guests, Matthews Asia’s Teresa Kong and Loomis Sayles’ Peter Marber, discuss the opportunities to be found there. In the meantime to see past shows and additional interviews done exclusively for our website’s extra feature please go to WealthTrack.com. And for those of you on Facebook and Twitter stay connected! Have a great weekend and make the week ahead a profitable and a productive one.



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