Difference, not style, keeps the bear at bay

It seems outperforming in a market of uncertainty and pessimism is not so much about style as it is about being different, according to two managers with completely contrasting investment styles who are managing to outperform their peers and indexes.

Fund manager Anne Gudefin, senior vice-president at London-based Franklin Mutual Advisors, was in Toronto for Franklin Templeton’s Investment Outlook and Opportunities Forum. She says for her style of investing there’s nothing better than a bear market because it means the bargains are out there.

Gudefin manages Franklin Templeton’s Mutual Discovery Fund, a five-star-rated fund by Morningstar Canada that’s been able to outperform its MCSI World Index benchmark over the last five-, three- and one-year periods. However, that margin of difference has been sliced very thin over the past few months, as the majority of world indexes enter bear market territory. In absolute terms, the fund returns are negative this year.

What distinguishes Gudefin from her peers is that’s she’s been able to accomplish this with the out-of-favour deep value investment style. As other value-oriented global equity value funds sink to unprecedented levels, the Mutual Discovery Fund is sitting on considerable cash from stocks it sold in 2007, which Gudefin, who looks to buy stocks at a discount of 60% to what she assesses they are worth, is eager to deploy as equity prices sink lower.

“There are good buying opportunities in a market like this because some people have to sell because they don’t have the cash, and they are facing redemptions. We are the opposite. We have a good cash level,” she says. “We buy stocks when it is the contrarian thing to do. We try to buy when the level of pessimism is at the highest. People are scared — we really love that.”

Gudefin says she’s been able to make value investing work for her fund because she doesn’t deploy the standard value style of buying everything that has a cheap book price. Instead, she has set up three strict parameters that her stock picks must adhere to: good management, a good price and a catalyst to unlock value.

“You want a good price at 60 cents on the dollar. That can be measured by price to earnings ratio (P/E), price to book value or a free cash readout,” she says. “With good businesses, we want companies where you have barriers to entry, meaning the companies in the market have pricing power. We want management at the helm that has a good track record and has also an interest in the share price because they personally own options and stock.”

Gudefin explains that a catalyst would be factors such as market conditions or a new management team’s plan to turn a company around. If, for whatever reason, a company’s direction isn’t corresponding to what Gudefin hoped, she says, her fund will take an activist role to force change in the boardroom.

“If these catalysts don’t work — this is a worst-case scenario — then we’ll have to be our own catalysts. We are activists and we have a good history in that regard, and we continue to get involved in a few companies each year where we don’t think the management is doing the right thing. [Our involvement] may include trying to insert new board members, not necessarily ourselves but people we know are shareholder friendly and will think along the same lines as us,” she says.

This approach has led to Gudefin taking positions in some interesting sectors such as her fund’s significant allocation to non–North American tobacco companies. The tobacco industry in North America has been hammered by anti-smoking lobbyists and litigation, but Gudefin says tobacco companies based in other parts of the world have great prospects.

“Outside of North America, litigation is almost non-existent. That is one attraction. Tobacco companies have also been able to increase their pricing by about 7% per annum. That’s fantastic pricing power. You don’t have many companies that are able to increase the price of their products by that much a year,” she says.

She expects tobacco pricing power to increase as the industry consolidates and some of the companies that were competing with lower prices get swallowed up by larger competitors. Gudefin also notes that some of the older tobacco plants are sitting on very valuable real estate, which adds a lot of value to the stock.

Growth manager Mark Schmehl, the portfolio manager for the Fidelity Special Situations fund, would rather be anywhere but in a bear market. His fund, which derives its name from the fact that it will invest in equities in any sector or country, uses earnings growth projections as its primary stock selection criteria. In a market of poor earnings reports, he notes it’s not a fun style to employ.

“It’s not a good market for me. I invest in companies that are good and getting better. It’s really hard to find those right now. Give me a bull market, and I’ll do much better,” he says.

Yet Schmehl, a Canadian citizen who manages money out of Boston, has managed to yield an impressive one-year return of 36.52% as of July 2008. The fund’s primary benchmark, the S&P/TSX Completion Index, is at -3.94% during the same period.

However, Schmehl says he doesn’t really pay attention to the index because he buys wherever he finds the stocks he likes. He says he has been able to have success using a growth approach by working with a team of 15 analysts who look for well-capitalized stocks with good earnings growth and even better earnings projection. As those types of stocks become scarce, he says, he has tended to look at smaller companies and in overlooked markets.

For example, one of his favourite holdings of the fund is SLC Agricola SA, a Brazilian farming company that grows all sorts of agricultural products from soybeans to wheat. He says there wasn’t even a ticker symbol on an exchange for the stock when he first started buying it. As agricultural goods go up in price, the company’s earnings have increased, and it continues to buy more land to grow more.

“Essentially, they are buying more land as the price of food goes up. The yields are rising and they can produce more. In addition, this is a really well-managed company,” he says.

Schmehl finds it interesting that two different styles can work in a similar global market. He notes it may just have something to do with what type of investing style the manager is comfortable with. For him it’s earnings growth.

“I’ve never made money buying stocks just because they are cheap,” he says. “Value investing is wrong for me. I think the longer you do this job, you develop a style [stock-picking] that works for you. I always tend to make money when the business is good and making money.”

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com

(07/24/08)

Mark Noble