- We will buy a cheap, depressed, well-known stock like Honeywell.
- We will buy a stock that is strong financially but is simply overlooked or depressed.
- We will buy if there is a third-party involvement that will exert some kind of influence to help turn around a situation.
- We will buy in situations where there is a good franchise but it has been undermanaged, and we are convinced management will change and improve.
An Interview With Vincent Sellecchia, Portfolio Manager, Delafield Fund
by Maria Crawford Scott
In the past few months, the stock market drop has seemed relentless, a continuation of the longer-term downward spiral from the highs of the late 1990s.
But the numbers arent all bleak. There have been a few stock fund managers that have been able to defy the averages and turn in quite hefty returns.
One such fund is the Delafield Fund, which is up 11.2% for the one-year period ending June 30. The fund returned an impressive 32.1% during 2001, compared to 11.8% for the S&P500 and 0.5% for the S&P MidCap 400, and it has been among the top 25% of all mid-cap funds for the last year, three years and five years (through June 30). Currently, it has about $220 million in total assets.
In early July, portfolio manager Vincent Sellecchia discussed the management of the fund with Maria Crawford Scott.
What is the investment objective of the fund?
We take a bottom-up approach to investing, with the goal of providing high returns with limited downside risk. We do in-depth, fundamental research, including visits to the company and management.
We tend to be classified as a value/special situations manager. We like to find companies that can do well regardless of what is going on in the overall economy or stock market because of some kind of fundamental change that is occurring—for instance, there is a change in a way the company is being managed, perhaps in the way it is deploying capital, or the company is making a small strategic acquisition. We also like companies to be inexpensively priced.
The other aspect of our approach is to limit risk in the portfolio. We do this in several ways.
First of all, we are very careful about the purchase price. Typically, the purchase price is closer to the lows than it is to the highs. Usually, we will step in and start buying a company as it is going down in price. And in fact oftentimes our first purchase may be the highest cost. We tend to average down.
Second, we limit the level of risk in the portfolio through our sell discipline. For instance, we tend to sell stock as it moves up in price beyond what we think is an acceptable risk level. But we will do this gradually—it is unusual for us to immediately sell an entire position.
We also try to be tax-efficient, generating primarily long-term capital gains, and trying to be cognizant of selling on a short-term basis.
We invest across all market capitalizations, including the smaller cap to mid-cap area. However, we will buy big companies when they are cheap. For example, one of our largest holdings right now is Honeywell. This was bought after GEs failed attempt to buy Honeywell. We were attracted because the stock price went way down, and in addition Larry Bossidy, the former CEO of AlliedSignal, was returning as the CEO of Honeywell. After September 11, the stock went down further because of the concern over aerospace companies in general. But we feel that, with the companys diversification and Bossidys aggressive moves to size the business to the present-day realities, it is still in a strong position.
Right now, our median market capitalization is about $1.2 billion, which puts us in the mid-cap sector. But we consider ourselves generalists rather than specialists. We also cut across most industry segments.
We have an eclectic portfolio, and we feel the more eclectic, the better.
We look at the enterprise value of a company, including off balance sheet value such as natural resources and timber properties, and the size of the companys debt. And we assess this value in relationship to its earnings. The lower the multiple, the better the valuation.
We also take a close look at cash flow, and a companys ability to generate cash beyond its everyday operating needs. A company generating free cash flow (which we define as earnings, depreciation and deferred income taxes in excess of needs for capital expenditures and dividends) is attractive to us because the excess funds can be used to pay down debt, retire shares, acquire other businesses, or increase the dividend.
But it is really more art than science. We have been in the business for a long time, so there are many firms that we are familiar with. We also have access to good research within the firm.
We spend a considerable amount of time assessing the businesses and the individuals who are running the companies by visiting plants and talking to the managers, as well as talking to the companys suppliers and competitors.
Basically, we are looking for companies in which something will change for the better—for instance, a change in management or managements attitude toward how they run the business, or a change in business opportunities. We want to find these companies earlier than other investors, so that when the situations improve and earnings increase, the companies will be valued at a higher price earnings multiple.
For example, last year we invested in FMC Corp., a diversified company that split into two companies—FMC, a chemical company with substantial earnings and cash flow, and FMC Technologies, predominantly an oil-service company. At the time, we felt that the complexity of FMC detracted from its valuation, but that future prospects for each of the new companies was bright. Basically, we buy stocks for several reasons:
We are extremely concerned with managements philosophy. In todays environment, management is more important than ever. We want to invest in companies that are managed for the benefit of their shareholders. And we want management that is capable—for instance, we look at how they deploy capital and other resources.
The first thing we do is to see how management has done historically. For example, if it has made a major acquisition, did it make sense, did management understand the risks and the payback? Did management understand the downside if it didnt work?
Then you need to examine what management is currently doing, and what they have planned. For this, we will visit the management team, sit down with them and discuss their plans. If change is in order, we will try to find out if they are serous about changing their stripes.
For example, one of our companies is Furniture Brands, a manufacturer of case goods and upholstered furniture. We purchased Furniture Brands because it had three leading brands, it had a strong cash flow that it was aggressively using to pay down debt, and it had a good management team.
When Furniture Brands announced an acquisition, we bought more. We evaluated what the acquisition would mean in terms of cash flow and how the company would handle the leverage. And we decided the deal made an enormous amount of sense, particularly given the fact that management had proven extremely capable. We also got lucky in terms of timing, because the stock had dropped on concerns that consumers would pull back on bigger ticket purchases.
We are willing to look at companies that are troubled, and with a lot of moving parts. The question we ask is: Can a mediocre performer become a better performer? We are very much willing to buy a less than stellar entity if we think that the business prospects and the management can turn it around.
Another example is Deluxe Corporation. They are a fairly mundane check printing operation. But they also had an electronic funds business called E-Funds. We figured that they would separate the businesses. They did that, and when they did, the check printing business began to have a more rational approach to the pricing. We bought that as a special situation.
One reason would be if the stock is not doing what we expected. When we see this occurring, we try to stay in touch with management, and I think we tend to give them more time than they deserve. But if the situation doesnt change, we sell.
Second, we would sell if management changes direction. For instance, if they have good cash flow and suddenly decide that they want to make an acquisition that doesnt make sense. Third, we sell if a stock reaches a particular price point where we feel that there is more risk in holding it than in selling and taking our gain.
Currently, we have 10% in cash, down from the end of the first quarter when it was 24%. Part of our cash position is due to inflows to the fund, and part of that is that we want to have some money to put to work when we feel prices are depressed. In 2001, we were up 32%, and we were up about 11% at the end of the first quarter. At the end of the first quarter of this year, value had done very well, and stock market valuations were not cheap, although the market has since begun to weaken.
However, it is not a market timing issue—we use cash offensively, not defensively. When markets get weak and prices unduly depressed, we want the ability to move in aggressively, because we believe that that is the long-term investors best hedge against volatility. We believe that stock selection is much more relevant to successful investment than total commitment to equities.
We are cautious on the economy, but we arent really focused on a market outlook. We try to be company-specific and not market-driven, and we continue to look for unloved or misunderstood companies with the potential for improvement and that are inexpensively priced.