Episode #339: George Davis, Hotchkis & Wiley, “We’re In Unchartered Territory Right Now”
Guest: George Davis serves as CEO and is responsible for setting the firm’s strategic direction. Mr. Davis also serves as a portfolio manager on the Large Cap Fundamental Value and Large Cap Diversified Value portfolios.
Date Recorded: 7/21/2021 | Run-Time: 49:27
Summary: In today’s episode, we’re talking long term value investing. We start with George’s investment philosophy and then walk through how he views the market today, seeing value in both financials and energy stocks. We talk about what it’s been like to invest for over 33 years, the lessons he’s learned along the way, and what attributes make a great investor.
As we wind down, George talks a little about the business side of asset management and what it’s been like leading a firm that’s been around for over four decades.
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Links from the Episode:
- 0:39 – Sponsor: Masterworks
- 1:28 – Intro
- 2:20 – Welcome to our guest, George Davis
- 3:50 – George’s framework for the markets and valuations
- 7:49 – Overview of George’s strategies, allocations, the universe and targeting
- 9:09 – Average hold times, turnovers and the nature of value investing
- 11:40 – What the world looks like today through George’s eyes
- 13:29 – Some sectors and opportunities they feel are attractive lately
- 15:08 – George’s thoughts on growth vs. value
- 20:23 – “The Coffee Can Portfolio” (Kirby)
- 23:53 – Owning General Electric
- 25:56 – Embracing mean reversion
- 28:49 – What he’s learned after investing through a series of major bubbles
- 36:15 – High yield fixed income positions
- 37:44 – Thoughts about the years ahead as he looks out to the horizon
- 38:59 – The art and science of building a company in a world of disruption
- 41:59 – What George looks for in an ideal employee
- 43:22 – George’s most memorable investment
- 46:33 – Learn more about George; hwcm.com
Transcript of Episode 339:
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Disclaimer: Meb Faber is the co-founder and chief investment officer at Cambria Investment Management. Due to industry regulations, he will not discuss any of Cambria’s funds on this podcast. All opinions expressed by podcast participants are solely their own opinions and do not reflect the opinion of Cambria Investment Management or its affiliates. For more information, visit cambriainvestments.com.
Meb: What’s up everybody? Great show today. Our guest is the CEO and Portfolio Manager for Hotchkis & Wiley, global investment manager serving institutional and individual investors. In today’s episode, we’re talking long-term value investing. We’ll start with the guest philosophy and then walk through how he views the market today, seeing value in both financials and energy stocks. We’ll talk about what it’s been like to invest for over 33 years, the lessons he’s learned along the way, and what attributes make a great investor. As we wind down, we talk a little bit about the business side of asset management and what it’s like been leading a firm that’s been around for decades. Please enjoy this episode with Hotchkis & Wiley’s, George Davis. George, welcome to the show.
George: Good to be here. Meb, thank you.
Meb: Tell the listeners where you are, fly fishing country.
George: I really am. I’m in the beautiful state of Montana. Although at the moment, it’s a bit hot and smoky. I feel great. Lots to do. You’re right. The trout seem reasonably happy. I catch them, say hello, release them. There’s a lot to do up here and nice to be with some family around as well.
Meb: I was once travelling with a Buddhist friend of mine in Asia and was talking to him about fly fishing, was talking about how I like to fish. And he’s like, “I don’t really understand it.” You know, I was like, “No, no, we catch one of these, you know, send it back.” He’s like, “Yeah, but that’s like me walking up to you, my friend, slapping you and then walking away.” And I said, “You know, that’s kind of a good argument. I have a hard time coming up with a comeback to that.”
George: Well, you know, with my career dealing with erratic stock markets, it’s a great getaway. You tend to be very focused when you’re fly fishing. And then when you suddenly look up and assess where you are, it’s always at a beautiful place.
Meb: I didn’t get much fishing in because I was with a big crew last summer in Montana but we did float down a river and have the absolute best time with my three-year-old. My wife is a little bit concerned that he should be floating down a river with a cooler and everything else but our local Montana folks, it is fine, you know, he’s fine. Just slap a lifejacket on, what’s the worst that going to happen? So we had a blast. I love it there. All right, let’s talk about investing. Y’all has been doing this for a while. Hotchkis & Wiley has been around, what, five decades?
George: Well, 41 years, two great gentlemen started the firm back in 1980, John Hotchkis and George Wiley. And I just joined 33 years ago. I have been around for a lot of it.
Meb: Tell us a little bit about the framework for how you guys think about the world as a prelude to how you think about the world in 2021. But what’s the lens with which you guys view markets?
George: Well, again, it started with the founders, definitely classic-value investors. I mean, John Hotchkis used to say that portfolio managers whose egos are too large and they’re probably been to too many schools, too articulate and they’re like a kid in a candy store, they can justify picking a little of this, picking a little of that. You really need discipline in this business and you need to think long-term about what companies are worth. George Wiley would say, “It’s like ploughing your way through a turbulent sea, the madness of the market, keep focused on what businesses are worth.” So, we really think long-term about just that, what companies are worth, trying to focus on the fundamentals and the price that we’re paying. So, I think our assessment, our value investing is really we care about price or maybe said better, what do you get for the price that you pay in terms of earnings, cash flow, dividends?
Meb: Those are all noble comments. Easier said than done, though, you know, when it comes to some of these things, particularly when markets start to go a little bit batty or individual securities, of course. What is the sort of process look like, the valuation process? I know you going to talk a lot about mean reversion but how do you think about this universe of securities and slapping a price on something? Do you guys do the traditional DCF or are you using boots on the ground sort of analyst? What’s it look like?
George: Absolutely. We have first off just a great team, 24 investment professionals plus 6 research Associates. So 30 of us working on investing, 64 people in the firm overall. And we’re looking at what businesses, as mentioned, can earn over the long-term and what are sustainable levels of profits. So, what we believe is that Wall Street tends to be a little too short-term and its nature, you’re looking at how businesses are performing today and extrapolating those too far into the future. So you have companies that are earning high rates of return, growing really nicely, and the market tends to think that’s going to carry on for a long period of time. Whereas the laws of economics, which just meant high earnings and high rates of return are going to invite competition. They’re very difficult to sustain. Then on the other side of the equation, you have businesses that are under-earning. They may be struggling at the moment, going through bad product cycles. Expectations are that those businesses are going to be dogs forever and they’re priced with very low expectations. And what we’ve found is that, over time, if you have the right assets, managements can improve those rates of return of low levels and, ultimately, you’ll have better earnings and then a better multiple on those earnings. And that’s really the value proposition. So when we’re trying to find in our thinking is really what our long-term sustainable, what we call normal earnings. And in our financial models for each of the businesses we’re investing in, we incorporate normal earnings in year five. So, to your point, what we’re doing is we’re putting our best estimates in years one through four of how the business will perform and then anchoring on normal earnings in year five, and that effectively does create a series of cash flows that you can discount to the present value. There’s obviously beyond a year five. There are differentiated growth rates and a terminal value that gets incorporated into much similar to a dividend discount model. Discounted cash flow is really the way to figure out what investments are worth at the end of the day. But normal earnings are something that we anchor on.
Meb: What’s the process actually look like, the universe you’re targeting and how active these names in, names out tend to be?
George: So we have a number of different strategies. I’m most involved with our large-cap value strategies. We also have mid-cap, small-cap, all-cap, international, global, high-yield fixed income at the firm. We’re just thinking about the process works with large-cap. We have industry analysts. I mentioned there are 24 of us. What’s beautiful about our firm and when I think our real strength is, is the experience of that team. We have on average a tenure of 16 years of those 24 people. So they’re working hard to get to know their industries. What’s the backdrop? What’s the industry landscape? What are the companies…? How are they faring versus each other? Which ones have competitive advantages or disadvantages? And they’re meeting with company managements. They’re screening a universe of companies for value metrics that are important to us. Some differ by the sectors that we’re investing in. Those analysts will bring their research to one of six global sector teams for what we call peer review, and we’ll talk about the businesses and we’ll go through the financial models. We’ll look at the risk assessment and try and determine intrinsic value and build portfolios from there.
Meb: What does that end up looking like as far as holding times, turnover? Is it something, you know…most traditional value investors, I assume, it’s a little slower, long-holding periods? What does that end up looking like?
George: With that mindset of thinking about what businesses are worth for a long period of times, the mean reversion that you refer to does take a bit of time are in large-cap. Other strategies may have a little bit higher turnover. But in large-cap, our turnover rates have been right between 30% and 35%, which is indicative of a three-year holding period on average. Now, clearly, some businesses will open for much longer than that, and sometimes you might get lucky or you might make a mistake and it’s shorter than that. We’re constantly, sort of, trimming or adding depending on price movement and our fresh assessment of what the businesses are doing and how the thesis is effectively playing out.
Meb: And then, of course, markets can help as well by going kind of bat crazy as they are known to do every few years, which sloshes things around a bit?
George: Yeah. Reminds me of John Hotchkis, who retired, I believe it was 1999. It was a really difficult period of time for our firm and for value managers, in general. That was right towards the end of the tech bubble, ultimate momentum market and someone asked him, “How do you think Ben Graham…?” John claims he was the last active portfolio manager to actually have Benjamin Graham as a professor. After his years at Columbia, he came out and taught at UCLA. And John was a student of his. And they said, “How would Ben Graham be doing in this market?” And John Hotchkis said, “Well, Ben Graham will be doing fine because he doesn’t have to go to client meetings and talk about last quarter’s performance all the time.” So, you’re right. It’s a durable process. There have been bat crazy markets, the last sort of 15 months since the pandemic broke out and turned the world upside down. And spring of 2020 is a great example of how markets can be really upended over a short period of time. And again, as I mentioned earlier, that short period of focus that the investment community takes. Clearly, there were huge impacts from the pandemic and all the efforts to mitigate the shutdown, the economy, etc. And businesses were dramatically impacted. But the price reactions were so extreme in our view that it really was a bit of a wacky market and it created some opportunities. The comeback has been tremendous for the markets in general and then more recently for value stocks, too.
Meb: We’d like to hear how you think about the world today in the summer of 2021. So a recent survey, I’m going to take this that said investors are expecting 17% returns in the U.S., which I don’t know seems a little bit aggressive. A lot going on with SPAC and IPO supply, you know, a lot of retail trading things like options and meme stocks. You guys have been through a few different cycles and so you know that they’re all different. Sometimes they rhyme. What does the world look like today through y’all’s perch?
George: Well, I’d say the backdrop is pretty positive when you look at the health of earnings and the rebound of economies, particularly the U.S. economy. But globally, it’s happening for sure. Clearly, there’s continued worry about a resurgence of the virus and the Delta variant and others for sure, that could derail some of that rebound. But the interest rate environment and the earnings profile would normally be incredibly supportive to equities. And the problem is, as I mentioned earlier, we care about price and prices are just really high for most assets. So that creates a bit of a dangerous zone. So I think there’s the wind at the back of this market, but you have to be careful. There are some extremes. For sure, the trading environment is probably like nothing I’ve ever seen. You mentioned the meme stocks. I would say just the amount of computer algorithmic trading that looks at factors and creates momentum over very short periods of time is probably stronger than I’ve ever seen. So price moves are really dramatic in many cases. And again, those are short-term variations and volatility that can create opportunity but it’s not easy to really work your way through the madness of some of these markets.
Meb: I imagine for particularly most equity funds that you guys tend to say fully invest or close to it. So, what’s looking good to you? Like, what are some of the sectors or opportunities that are starting to show you guys a little bit of interest or value?
George: So we’re constantly looking at valuation and at risk. And I would say most of the attractive value that we say is in more cyclical businesses. And two most dislocated sectors where we do have pretty healthy weights in the portfolio would be financials. And ironically, energy, which clearly has been tested through the pandemic. And many of these businesses were able to, fortunately, survive through a period of great uncertainty and a huge downturn. But now those two sectors really represent a lot of great opportunity. And other than that, you know, there are some sectors that are really difficult to own. And I’d say, classic areas where you might find value, like dodgy old utilities, consumer staples. They’re really bid up to very high multiples. And because their growth rates are relatively low, they’re hard to justify. So, we end up finding more value and more … economy. You know, that killed us when the pandemic broke out in the spring of 2020. It’s worked better since then, although there’s now a bit of a reversion against that. And then there are pockets of the market that are just very difficult for us as a value manager to justify and that would be, you know, the real leadership of the market through growth companies, many of which are great businesses, but just in our view, are hard to pencil out.
Meb: You guys wrote a piece recently based on this dramatic growth versus value, opportunity set. Do you mind kind of walking through the thesis on what your thoughts were there?
George: Well, again, I think we’re looking at valuations and spreads.
And when you think about historically the premium that higher-quality, higher-growth businesses deserve, we’re sort of in unchartered territory right now.
And it’s been built over the last 10 or 11 years where growth stock leadership has been dramatic and tough time to be a value manager for sure. And so, when you look at either prices relative to medium valuation, cross markets or even within the sectors, spreads are really high. They started to converge a little bit since last November on the positive news of the vaccines from Pfizer and Moderna, to begin with, and J&J later, but now they’ve widened back out again quite a bit. So, I think you need to be a bit selective in this market. The momentum and sediment can drive prices over short periods of time and they can be extended. But over long periods of time, what really you want to own as a value manager is earnings. And the returns that you’re going to have on that stream of earnings depend on the price that you pay. If you pay a high price, your returns may not be so great, but if you pay a reasonable price or a low price for that stream of earnings and cash flows, your returns can be really high. I was just looking at a booklet for one of our client meetings coming up here at the end of the second quarter. And I said at the outset, 41 years of history and our average compound and annual rate of return over 40 years, not to be cocky about it, but it’s 13.2%. That when you think about 41 years compounding at that level of the growth of the dollar, it’s pretty warning to stay the course. And, you know, that compares really favorably to the large-cap value benchmark, which is about 11.8%, and the S&P, which is 12.1%. And that’s in the aftermath of having a pretty tough decade. So about 41 years, we’ve done a good job and I’m really proud of our team that we’re going to stay together and keep it going.
Meb: We talked to investors, particularly young ones, about that concept. Forty years seem so far in the future for the young people listening to the show. If you’re 20 years old, that may be retirement, it may not. At that point, maybe live in 2050, by then, but the ability to compound for that long, we often tell people, can you envision 100 times your assets on a portfolio but it also applies to spending. I mean, Buffett used to talk about this and say, you know, this purchase $20,000 isn’t $20,000. It’s costing me $2 million, 50 years from now because of the compounding. And so we talked about it to a young group of students about to go on spring break. And I said, “You know, look, it’s probably worth it for the memories and maybe you’ll meet your future spouse, but thinking in the terms of this framework, I’m going to spend €2,000 on this trip or $2,000. Can I have some sort of future empathy with myself at 70?” That’s $200,000 anyway. That long-term compounding really has effect, if you can do it.
George: It’s one of the marvels of the world. You don’t really fill a stadium full of people to watch compounding. It’s pretty incredible how it does work. I really met John Hotchkis from two angles. And one of them… I was fortunate to be at Stanford Business School, in my second year, I was taking an investment management class, taught by a legendary Professor Jack McDonald, who I believe taught for 50 years, the late Jack McDonald. And one of his frequent guest lecturers was Bob Kirby from Capital Group. And Kirby used to race cars with John Hotchkis, but he wrote a piece way back then called the “Coffee Can Portfolio” and the idea was find good quality companies that you can buy and foresee owning for a long period of time. Metaphorically, put them in the coffee can, bury them in your backyard and don’t touch it for 10, 15, 20 years, and you’ll be amazed at what happens. I before business school was fortunate to have another great mentor in Claude Rosenberg, who was a true growth stock investor but with a healthy degree of skepticism. He created when I was there and working personally for him after my undergrad years, a tool called Straw Hat. And the idea there was that the time to buy a straw hat is not in the hot summer. It’s in the winter when they’re on sale and people want to get rid of their inventory. He created a tool that measured the popularity of various stocks based on analysts, strong by recommendations, by hole, etc. And he had a great degree of skepticism about those businesses. They were over-owned. And we see a lot of that today in the market. There are some crowded trades in our view. It really isn’t reasonable to sometimes just put these things away and continue to monitor but make sure that the compounding is working for you.
Meb: You know, you mentioned a couple of topics. I was laughing as you were talking about the straw hat because I’m like the analogy I actually literally was having this conversation this morning with my co-worker, we went out surfing and I said, “Man, you need a new wetsuit.” I thought it’s the perfect time. It’s summertime. Nobody’s buying wetsuits. It’s probably… All the sales are coming to clean out inventory. You want to go buy a wetsuit now, as opposed to next fall. But, you know, you mentioned Kirby, and we actually had linked to his old article on the “Coffee Can Portfolio” from the 1980s on a recent blog post we did. And I’d love to hear your perspective because as someone who appreciates the long-term holding period and the beauties of holding some of these stocks for a really long time, contrasted with the hyperactive trading mentality, I am often critical of sort of Robin Hood’s methods about investors who are checking the app eight times a day. I’m trying to think of behavioral suggestions or nudges that will keep people from lighting all their money on fire by overtrading and have a long-term perspective. And it’s not easy. Education is certainly one way but trying to think of hacks or structures that keep people from mucking around with it over time, I almost feel like there needs to be like a coffee can app. And they’re like, “Look, here’s the deal, you buy this stock, it’s in a lockbox. Like, you can’t touch it for 1, 3, 5, 10 years, whatever it may be, or else you have to pay some penalties or something. Anyway, the point of the article is actually talking about illiquidity being a feature not a bug through private investments. But I’m trying to think of a way to do it through the public market. I’m stumped. So if you ever come up with an idea…
George: I wish that we were good enough to come up with an app like that. I love the notion. I do think, you know, it’s difficult to be a value manager in some respects because, you know, if you’re at a cocktail party and people are talking about the market, the things or the companies that we own aren’t going to be particularly well-received as exciting, necessarily, but they do generate returns because the prices are compelling. And they’re throwing off cash flow and dividends and growing them over time. So, I agree, I think the temptation to own what’s hot is so strong out there. And it can work for a while but it’s a bit of a dangerous game over time.
Meb: Listeners are probably sick of hearing about this idea because I haven’t done anything with it. But I said, my idea for the hack, as far as a public fund would be, you have an investment fund, invest in stocks, whatever and you get penalized on a sliding scale over the course of 10 years. So you buy and sell on, like, first month or year 1, you’re paying like 5% or 10% load fee all the way down to 10 years, in which, case it’s not. The kicker was that all of that revenue didn’t go to the fund company, went to the other shareholders. So you get penalized for being bad behavior, you get rewarded for being good behavior. Anyway, I’m not prepared to launch it just yet. So, anyone listening, feel free to steal it because I would love to see the experiment run over a full cycle.
George: I think so much of it is really knowing and understanding what you own. And many of these businesses are complex. And product cycles can be short and difficult to extend. I think, you know, one of the things that a firm like ours with the analytical power that we have, as I mentioned, 24 investment professionals who’ve been there on average, 16 years, if you think about each individual’s knowledge base, it grows over time because they’re working hard. They get to know the companies. They’re passionate about what they do. And then collectively, the research platform at a firm like ours, the knowledge base just grows. And I’ll mention one company that we’ve owned in recent years, that’s been hugely controversial and obviously impacted by the pandemic. And that’s GE. You know, if you’re one or two people trying to analyze General Electric, I think it would be near impossible because you have so many different business divisions, which are extremely complex. You’ve got, obviously, the aviation jet engine manufacturing business. You’ve got oil and gas through their Baker Hughes investment. You have the power business, which is the huge gas turbines that generate electric utility, power, etc. You’ve got enormous healthcare business, which is a gem of a business, then you’ve got run off financial assets, you know, insurance liabilities for long-term care, potentially, the very, very complex issues to kind of get your arms around. And a firm like ours, we can put a lot of people to work and kind of compartmentalize the business divisions and build up the analysis with people that really are experts at understanding the reserve adequacy for the insurance liabilities or an analyst who’s been following the aviation market for 20 years or healthcare experts, etc., and build that up or our generation analysts who’ve been following utility and power generation markets for years and years and years and sort of collectively be able to put the puzzle together and really understand what’s there, let alone look at balance sheet issues, cycles that you’re in, in terms of production with cash flow to the parent or using cash flow from the parent. It’s management changes, putting all that together and having our peers really embrace a view on it about what’s the upside potential? What are the risks towards getting there? It’s a real advantage. So again, for people that are owning stocks for minutes or hours or days, it’s a just very different approach. And I know it sounds quaint and old-fashioned, but over time, it really does work.
Meb: Geez. Interesting, because it touches on a few topics that we’ve danced around. One is sort of distinguishing between a company with potentially temporary problems or permanent structural stranded problems and assets. You know, my mom who’s probably one of the best investors ever, I’m sure she’s a far better track record than I do. You know, it was a big talk about buy and hold. You know, you buy some stocks, you put them away, like total Kirby right there. But for me, and look, I’m a client. So, I struggle with the emotional side on some of these ideas where, to me, it’s hard, like you said, like, endlessly complex. I mean, GE being this company that has gone through various cycles, I mean, where did it bottom out? Like, five or something? And I think it’s up mid-teens now. And then you look at the top market cap companies every 10 years and the list is often pretty different than 20 years ago or 30 years ago. So I always struggle with this sort of without having a full-analyst team capacity of investors to figure it out. Like, when is this time different? When is this a mean reversion value? And when is it… The company’s just a goner? You’re getting any simple, really easy answers for us?
George: Of course not. If it was simple, then I wouldn’t have to work so hard and nor would our team. And I’d say, it’s great having a team and I’m grateful for the stability that we’ve had in keeping our group together and gotten a lot of talent there. And I think, you know, we’re not alone. There are a lot of great firms in our business that you see. And there are different ways of making money for sure. But our way is what we all believe in, which is why we hang in there and stay together even through tough times. Like, last year, you know, when I think about the resiliency of attitude when things aren’t going well. There have been probably three major periods of time in my 33 years of Hotchkis where we’ve had difficulty in terms of performance. And that would have been the late ’90s that I mentioned earlier, the financial crisis. And then last year with the pandemic, where again, the world kind of got turned upside down. And I was just so pleased that our team, through the course of last year, it’s no fun to underperform. And as I said earlier, it’s certainly no fun to lose money for your clients. It’s emotionally difficult, but to stay the course and not capitulate to the great pressures that are out there over a short period of time for the business, etc., is something that I really value that our firm and our team. We didn’t get off compus or lose our way. And, fortunately, when value started to make a recovery, really in November last year, we were there in spades and it’s really helped. And our clients understand what we’re doing. You can’t sit on your hands. You have to communicate in this day and age and make sure that they understand you’re still the same athlete, you still have the talent and your processes are intact, having also a knowledge that you really have a need for continuous improvement and to learn from some of those difficult periods of time. And I think we’ve done that over the years.
Meb: The ability of a firm who’s been around and has the scars, as we all do, older traders and investors in a good way, all the obviously bear markets and struggles are different each time. They all have a different personality but gives you, at least it feels like the fortitude to be able to withstand what’s coming again because you know that it’s inevitable. It’s going to be different and maybe worse, maybe in a totally different way. Like last year, I mean, last year was a different personality than anyone we’ve ever seen before as far as speed from all-time highs to bear market and back. Talk to us a little bit about lessons learned through that three crises. Again, they’ve all had their own differences. Late ’90s, for me, feels like it has more similarities with now on some of the sentiment things we’re saying. But as we know, with Japan, things can certainly get weirder and longer and stretch than even where they are now.
George: I mean, I think about the attributes that make a good investor, I think you’d probably have to start with humility. And the combination of having humility and resiliency is huge. You’re not always going to get it right and the markets aren’t going to cooperate with you over short periods of time. So, you need to approach things with a bit of humility and not fall in love with your winners and not necessarily shirk away from your losers, even though they’re not as fun to talk about. That’s for sure. But what I think makes a successful investor over time is to have great balance in terms of high conviction. And if you do in-depth research like we do, I think you can have that high conviction. But also this thought that you need to continually improve and learn from mistakes that you might have made. So, in the late ’90s and similar to last year, as you mentioned, those environments aren’t perfectly akin, but there are some similarities. It’s really about staying the course and not losing your focus and enhancing your measurement of risk over both short periods of time. And we really defined risk through quality of the business, balance sheet issues, and then governance issues, and we measure risk. And over the last couple of years, learning from the environment we’re in, we really enhanced our measurement techniques for risk. In the financial crisis, we have a little bit of a smaller firm. I mentioned we’re 30 people on the investment team now. We were probably maybe 16, 17 in the late ’09 period of time, and we were structured differently. We had analysts brain the research into the entire group. And I think that created some issues. Number one, you know, obviously, the biggest area of stress was in the banks and financials. And we would sit around a very large research table in a conference room and talk hours and hours and hours about very complex issues. And I remember, our worst-performing stock of the time was Wachovia Bank, which Wells Fargo ended up picking up at a very attractive price later on.
Meb: I lived in Winston-Salem, North Carolina. So Wachovia has a very familiar memory.
George: The panic was so severe that even those long-time customers of Wachovia were pulling their deposits out of the bank out of fear that they weren’t good and even with FDIC insurance, etc. The regulators were panicking, the investors were panicking, etc. It was a sad story and a really difficult period of time. But learning through that, one, I think there’s a group dynamic, when you have more than, say, six or seven people, maybe eight people in a room max. You have 14 or 15 people, even though dissenting points of view may be valid, they seem to kind of get brushed under the table, kind of by the power of the crowd. You have an analyst that’s been working super hard and knows more about the business than anybody else. And people tend to kind of rally around that person as opposed to being more objective. The decision-making is not optimal in size like that. So, what we’ve done is created these six-sector teams where analysts bring their research into people who are very familiar with the business models, who have an understanding of the competitive dynamics and the landscape of the industry and you can give valuable feedback on the assumptions that are going into the financial modeling, to the thesis for the risk profiles of the business that we measure, etc. And I think it does two things, one, it enhances the efficiency. If you just think about the man-hours of sitting through all of the research over long periods of time. If you’re any one person and you’re a primary analyst on one sector, and then you’re a peer reviewer and another, you know what your responsibilities are, you’re very focused, you’re very efficient with your time. So collectively, it improves the efficiency of the platform. And then secondly, you have better decision-making coming out of that process. So, what we have in six-sector teams, I think of them as silos, and we have a great sense of sort of the relative attractiveness of all the stocks that we’re looking at in those silos.
But you may have less context of what’s happening in other silos or other sector teams. So to coordinate that, in our large-cap strategies, we have three of us that are large-cap portfolio managers. We’re all embedded in those sector teams so we can take the output. Again, we don’t have a louder voice than anybody else. But what we’re reflecting is the research work that gets discussed in the sector teams and have the context across sectors to build a portfolio that really reflects the best thinking of the entire team. And that going on now since really the beginning of 2009. Again, a lesson learned from that tumultuous time in 2008. It’s been really gratifying to see it work out so much better. I think we’re stronger and better than we’ve ever been as a firm today.
Meb: You mentioned GE. Are there any other names that stand out here in the summer of 2021? You can pick either side, an area to really avoid or something that you think is really attractive?
George: I have issues with being very compliant with our compliance department and talking about individual securities, but I already mentioned Wells Fargo having bought Wachovia Bank back in 2008. I would say that that is a franchise that still has strong, strong value. It’s very much out of favor, partly because of the mistakes that they may not their own, going back to 2016, the sales practice scandal. But the franchise is under-earning right now its potential for a couple of reasons, the macro environment with low-interest rates, but also very elevated cost structure. You have completely new management who’s in there, trying to address those situations and also regain the confidence of regulators who have put an asset cap on the growth of Wells Fargo. So I think it’s a stock that is misunderstood in the short period of time that can regain earnings that will match its longer-term return on assets and return on equity. And that can be super rewarding for long-term shareholders that are willing to have the patience to put it away as we talked about earlier.
Meb: There are always constant surprises with markets. One of the ones over the past cycle that’s been particularly odd is interest rates heading low and negative kind of around the world with sovereigns. You mentioned you guys do a bit in the bond world. Is that mostly corporates? And that’s pretty interesting too because if you go out to the junk spectrum, you have some of the lowest yields ever. What’s the fixed-income world look like for you guys?
George: It is all high-yield fixed income actually or, as often labeled, junk. But for sure, that is an area of the market that does have a premium yield, even though spreads have come in more recently, particularly with some of the out-of-favor sectors, like energy, railing, somewhat. Absolute yields are reasonable in that space, you know, certainly compared to what you find in treasuries or higher-grade, fixed income, for sure. And spreads are somewhat normalized right now, relative to history. And we have a very experienced group of people that are managing our high-yield fixed income for us and utilizing our research platform for the data to understand in a lot of cases, smaller and mid-sized issuers that aren’t that well-followed by maybe some of the bigger players. I would say it’s a middle-of-the-road time of attractiveness right now. It’s not a glaring buy. But on the other hand, it’s actually a time where you can compound some yield. It’s a decent period of time. I would say, probably, in the middle of the spectrum.
Meb: As you look to the horizon, so 2020, is anything that’s got you scratching your head, worried about, excited about, as we look out to the world, hopefully, reopening?
George: As we sit here on July 21st, I have to say, I have been stunned that our 10-year treasury, which rallied higher, the yield rally… The bonds obviously sold off making the yield elevated towards, say, 1.7%, just a month or 5 weeks ago, now down to 1.25%. I didn’t see that coming because, from our vantage point, the economy really is gathering some footing. The amount of stimulus from the Federal Reserve, from fiscal spending, is unprecedented. And I would have thought that the inflation that we’re starting to see in many areas of the economy right now, really would be more long-lasting as opposed to transitory and interest rates would be going higher rather than lower. So that’s been a real surprise for me over the past few weeks, something that I find a little bit difficult to explain. But again, I think some of it is technical factors and trading that has created some of that move and it could revert back in fairly short order, mostly.
Meb: One of the things I’d like to spend a little time with, while we have you, is someone who’s been at the helm, not just on the investment side but, you know, when I talk to a lot of young investors, they only see the investment side of the world, the sexy part, picking stocks, dealing with management, flying around the world and doing research, all that fun stuff, like out of the show “Billions,” but the reality is like the business of money management is totally different and a skill set too. I’d love to hear any thoughts you guys have on the art, science of building a sustainable company that’s lasted, you know, going on its fifth decade in a world of kind of constant disruption of the Vanguard Death Star trying to absorb everyone in its wake. Any general thoughts? I would love to hear them?
George: In any career, my recommendation to any younger people out there is find what you love and, obviously, follow your passions. It’s age-old advice, but it’s so, so true. And I think what we’ve built as a firm are people that really do love research. I love digging in and getting to the deep degree of understanding of companies, breaking them apart, really understanding how to build back the profile of a business. And we find that people not only like to dig in and do the research, but we want to find people that love to compete. And I personally grew up playing a lot of sports. I still do. I love to compete. I like to win. And it’s really fun to be able to analyze a business, sometimes very complex ones, like GE, we mentioned, and then have it work out. It’s rewarding beyond financial aids. It’s gratifying just sort of emotionally. And so, what you want to have with a firm are people that love doing it, that like working with the team, so that they have mutual respect for others that they’re working with and ultimately, they believe they’re going to win over time. And the business pressures are real. There’s decompression. There’s passive versus active. And the trend is certainly further on the pendulum towards passive than I think I’ve ever seen it. It may be coming back here just a little bit with recent performance from active managers. And I think it ultimately will… There are some huge, large, very, very talented firms at our business that are strong and have distribution that’s unbelievable. So, for sure, from the business side, there are pressures, but I just believe there’s always going to be a place for performance. And if you can really have clients understand your process and look at your history and believe that over time it will work, I think that they’ll hire you and pay for it. So it’s a difficult business, but one that can be rewarding if you stay the course. And you’re differentiated from the market and from others. So we clearly do believe in high-conviction, active investing.
Meb: So, if a young person is listening, they want to come get a job at your shop, what do you guys look for? What’s the ideal sort of candidate besides a passion for stocks? What’s the process like and how do you guys go about it?
George: We certainly spend a lot of time recruiting. In fact, our entire team meets research associates. We have research associates that start sometimes unusual, but sometimes straight-out of undergrad programs. Others might have had experience for a couple of years in investment banking or accounting or what have you. But again, we want to find people that are capable of doing the job and enjoy doing the job and have, what we would believe, is an ability to be a good teammate, someone that will listen to constructive criticism and will offer it as well. So ultimately, just finding people that we think can thrive over a long period of time, that believe in value approach as we do and they would fit well in a culture that really stresses investing for the long-term.
Meb: It helps if you’re a Stanford Cardinal. Isn’t that where are you from, right? Right down the road?
George: You know, there are a couple of us, but it’s certainly not just Stanford. And I think more representative than Stanford is probably Columbia Business School, which is really a beacon of value investment education.
Meb: They do a great job, for sure. Have for a long time. You look back over the past couple of decades, this is going to be a tough one, I imagine across hundreds, if not thousands securities. You get the most memorable investment, good, bad, in-between, anything that’s seared into your head?
George: By using that word seared, it actually reminds me of maybe one of the most unusual investments that I could pick over that time. And that’s Sears, Sears, Roebuck and Company. So, in the early 2000s, we owned that business. Our analyst Patty McKenna had done a great job on profiling it. It was certainly a challenged business. Their sales per square foot were woefully lagging those of competitors. But we thought that there was an ability to perform better and improve returns. And then they had an underlying value of real estate properties that were much more than the franchise value or the enterprise value of what the market was asking for. And we had to explain why this was a dog that we continue to own to our clients for a year or two. And it was difficult because it just wasn’t very popular, to say the least. Eddie Lampard came along and also with the same attributes that we did. He bought the business. He started talking about improving returns or he bought a majority part of the business and the stock did extraordinarily well for several quarters. And we sold it. But that round trip is something I’ll always remember, being willing to be a contrarian, to dig in and understand what a business’s worth, even if it’s a lower-quality business in that case, but also having a cushion of knowing that you had the backdrop of financial strength and assets on the books that could be liquidated to save your investment and make sure that you didn’t have liquidity issues. That was a great example of something that was seared into my memory.
Meb: With word association, it’s funny, we had a guest on, I’m blanking on who it was, but we got into this topic of the Sears catalogue. And I got on the podcast afterwards and was on eBay. So I was like, “People under 40 probably don’t even understand what it was like.” I was like, “This is how you, like, find out about toys and things.” You get this catalogue in the mail and you flip through it. It’s like 500 pages. You can find them on eBay, you can go back, and it’s kind of fun just to look at the products and offerings from 10, 20, 30 years ago. But our very first ETF we launched in 2013 has a ticker symbol that is near-identical to the Sears symbol back then missing one letter. And it was not too infrequent, where someone would send us a really angry email talking about how they lost all their money or their stores were dirty or something about, you know, I should have saved them all into a folder because I get equally as many crazy emails because of my first name. Looks like it’s a surname, too. I get a whole bunch. But the Sears one used to be particularly fun because people would just be irate about whatever Eddie was doing and would send it to us.
George: I appreciate that. Even though there’s a little age differential between me and you, there are a lot of shared experiences. And I really do applaud the way you go about looking that far back at the dynamics of how the world was and what’s similar and what’s changed, and always keeping an eye towards value. Very much appreciate that.
Meb: Well, I’m excited to come, head up your way and spend some time on a river together, slapping some fish around as my Buddhist friend would say, “There’s so much to do up in your part of the world.” George, if people want to check out y’all’s writings, you guys put out a lot of great content, if they want to go check it out y’all spawns, what’s the best place?
George: Hwcm.com. It stands for Hotchkis and Wiley Capital Management. Appreciate that, man. It’s been a real pleasure speaking with you.
Meb: It’s been a blast. Thanks for joining us.
George: All the best and come see us in Montana.
Meb: Podcast listeners, we’ll post show notes to today’s conversation at mebfaber.com/podcast. If you love the show, if you hate it, shoot us feedback at the mebfabershow.com. We love to read the reviews. Please review us on iTunes and subscribe to the show anywhere good podcasts are found. Thanks for listening, friends and good investing.
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