Another Interview With Donald Yacktman, President and Portfolio Manager, The Yac
by Maria Crawford Scott
The investment landscape last year was stained with the red ink of many a stock fund last year. Even value-oriented funds, on average, lost ground—despite their comeback during the prior two years.
But there remain bright spots in fund performance.
One fund that fared well last year, as well as over a very tough three-year period, is the Yacktman Fund. The fund follows an approach that combines growth and value, investing in growth companies at what it considers to be low prices.
In 2002, the fund returned a handsome 11.4% at a time when the S&P 500 was down a hefty 22%. The fund is among the top 25% of its category for the last one-year and three-year periods through year-end 2002.
Currently, the Yacktman fund has about $293 million in total assets.
In late December 2002, Donald Yacktman, president and portfolio manager of the fund, discussed his approach with Maria Crawford Scott.
What is the investment objective of the fund?
Our goal is to get returns above the S&P 500 while taking on less risk. However, we do invest in all areas of the market—were basically a multi-cap value fund.
Our strategy is like our logo, a triangle, with three basic attributes: We like good businesses, ones we can buy at a low purchase price, and that have good, shareholder-oriented management.
First, we like to find good businesses. We define a good business as a business that has one or more of these characteristics: It earns a high return on assets, it has a high market share, it has relatively low capital requirements, and it has unique franchise characteristics.
Another way to look at it is to look at what we dont own. We dont own businesses that have a lot of fixed assets, or that have a lot of economic sensitivity or volatile earnings—for instance, airlines, automobile manufacturers, and technological capital goods firms like Cisco. We like to go the other way. We particularly gravitate toward businesses that are more predictable and have lower asset intensities. For example, the biggest holding we have is Lancaster Colony, primarily a specialty foods company. It has a down year in earnings maybe once in a decade, plus it has a high return on assets, lots of insider ownership and 39 years of rising dividends.
The second part of the triangle is a low purchase price. We like to buy companies cheap, and we have a lot of low P/E (price-earnings ratio) stocks on our list. That doesnt mean that we buy a stock because it has a low P/E, but our holdings do tend to have low P/Es most of the time.
The third part of the triangle is that we like to see a management thats objective and works to build the company. In other words, the managers are good capital allocaters. We feel managers have five basic decisions with their cash. First, they can put it back into the existing business to try to improve and grow the crown jewels. Second, they can make synergistic acquisitions—acquisitions where they dont overpay and it fits in with the overall business. Lancaster Colony has basically built up their specialty food business gradually by doing just that. Third, a company can use its cash to buy back shares. Lancaster has done some of that, and a number of our other companies are cash generators to the point that they buy back shares.
Were less enamored with the fourth and fifth ways to use cash. Fourth would be to pay down a debt. The only time you really want to do that is if youre overleveraged and you need to reduce the debt to get your credit position enhanced. Fifth would be to pay a dividend. Since dividends are currently double-taxed, were less enamored with that—wed rather see managers putting the money in the first three categories.
Yes. Think of it conceptually. A common stock is really very similar to a bond except that you dont know what the coupons going to be. If youre a long-term investor, the person who is reallocating those bond coupons to make returns on them becomes pretty important over a period of years. If youre only owning them for the short term, it doesnt matter much. Thats the idea. Lancaster fits the ideal pretty well when you look at all three parts. Not all of our holdings do.
When you value a business, what you really ought to do is value normalized operating income. Then you need to, in effect, unleverage the balance sheet and look at the debt and the equity together, to see what the total is that you would be paying for it. As an example, suppose you have a company with $100 million in pretax operating income, and it has a market cap of $800 million in equity and another $200 million in net debt—together, thats $1 billion, so in effect you would be paying 10 times the net operating income for that company. This method allows you to look at everything across the board, and be more objective about how you value a company.
On the other hand, there is a high correlation with our portfolio and low price-earnings ratios. Every month we update our portfolio, put it on the Web site, and show a weighted average P/E. What we end up with is a portfolio of above-average companies for which weve paid below-average prices.
We obviously favor businesses that have certain characteristics—most of them are low capital-intensive businesses. Sometimes well have some that are more capital-intensive but are relatively predictable. One of our major investments is in Qwest, but not the common stock—were in the bonds. We think of the bond as really being an equity and the common as being more like an option. Qwest went from $60 to $1 or $2. But if you look at Qwest as a business, its very much like the old U.S. West, but youre paying about half of what youd pay for SBC, or a Verizon, or a Bell South. We just happen to like the one that has less risk in it—which is these bonds. They still have about a 20% return to maturity—they are 7.9% coupons until 2010 selling at about 50 cents on the dollar.
The company bought U.S. West and theyre also in some other businesses, some of which have turned out to be poor. But they are getting back closer to what the original U.S. West was.
Yes. Every company has a ledger that contains positives and negatives. When stocks are going up and the media write about them, they write about all the positives and usually dont tell you about the negatives. When the stocks are going down and they dont like them any more, they tell you about all the negatives, but they dont tell you about the positives.
Theres no substitute for knowledge and nobody has all the answers. In this business youre wrong every day because you never buy at the bottom, and you never sell at the top—its just a matter of degree. Anytime that we buy a stock, were buying it with the idea that we can own it as far out as the eye can see—as long as it doesnt get overvalued. Were not trying to buy something that we can be cute about and sell two weeks from now. We just try to be objective.
The Yacktman fund can have up to 25% of the portfolio in positions over 5%. I also manage a Focused fund that can have up to 50% in positions over 5%.
Right now, weve got over 25% in the top four holdings, but that is due to price appreciation, and you can only do that if it comes from appreciation. We also have over 45% of the fund in the top 10 holdings. We may have a lot of stocks, but you should look at where most of the money really is.
Our theory is that if you have a good business, why dont you want to own a lot more of it? And if its a real bargain—the juicy ones, the fat pitches across the middle of the plate—those are the ones you want to have the most money in. The four big ones in the fund right now are Tyco, Liberty Media, the Qwest bonds and Lancaster Colony.
The more diversified you get, the closer youll end up with returns close to the S&P 500. Were clearly not indexers. If an investor wants to do that, they might as well buy an index fund.
I think risk is how much youre going to lose in permanent capital. What I feel most comfortable with in our funds is the fact that, at the end of August, our investors were virtually at their all-time highs. I dont think there are too many other funds that can say that. And, in the past three years, all three years weve been up: 2000, 2001 and 2002.
Yes, thats typical. A good example of that would be Tyco. We bought a thimbleful in the teens, and then when it got down to $10 or below, we just backed up the truck. We felt that at that price, were ready.
Well when we feel a stocks no longer a good value. Part of it is a function of what its value is relative to other things out there. Sometimes you have to make calls between two stocks that you like. If the spread gets to be big enough where you feel that this one is a much better deal than that one, then well make the decision to go sell one in order to buy the other.
Usually what happens is that you get new information and you need to adjust the values accordingly. If youre wrong and the companys not worth $50, its worth $45, then you ought to adjust the value down and be objective.
When we make a decision on a company, part of its relative to other companies, part of its relative to cash—but its not mechanical. For instance, some investors say they wont buy a stock until it gets to two-thirds or 75% of what they think its worth. Well, that sounds good, but what if you paid 80% of what its worth and you beat Treasuries in the process. Wouldnt you be better off? Its really capital allocation. You might be better off doing that and then waiting and keeping that particular position until something else comes up and you can say, all right, at this point Id rather sell it and buy this other because this is at 50% of what its worth. Its a matter of relative value.
I can give you a few examples. Fruit of the Loom and Reebok were pretty disastrous situations. In the case of Reebok, we were able to make a lot of it back with some other shoe companies—K-Swiss being one of the investments.
But with Fruit of the Loom, who would have thought that a company with a 40% market share would have had the manufacturing problems they did when they took it overseas? They made terrible management decisions, and they basically blew the company. Those situations are rare. Usually if you have a good business with attractive managers, then usually the businesses will stay good. That was one we should have analyzed differently in hindsight, no question about it. But our record is not a function of each individual decision, its the overall decisions. And if you look at the overall record over the last three years in our category, I think were right at the top right now.
No. Its just a function of whats out there and how excited we are. If we think well beat Treasuries by enough of a margin and we feel comfortable with the quality level, well buy a stock. Our cash position does vary. Right now weve got 14% in cash in the Yacktman Fund.
I dont really have any. The best thing I can tell you is that if you take the S&P normalized earnings for 2003, which we think will be around the 48 level, and if interest rates stay where theyre at, that gives you a price-earnings ratio of about 20, which gets the S&P to roughly 960—not too far from where we are now. So the market right now is around what you would think of as equilibrium. But you can also see that over the last few years the S&P stayed way above what the normal equilibrium would have been. And you can have periods where it will go way below and stay there. Thats why I think that to try to predict where the market is going is folly.
Were not buying the S&P, so why worry about it other than to try to have some sort of backdrop? But I dont care what it does day to day. Volatility is our friend. Volatility creates value and it also creates selling opportunities. Thats fine with us.