Robert
G. Kahl, CFA, MBA, CPA is the founder of Sabino Investment Management, L.L.C.
A question and answer session follows:
Q:
How would you describe your investment style?
RGK:
I am an all-cap value manager. I
consider stocks across the capitalization spectrum from small cap to large
cap, with an emphasis on U.S. equities. Foreign
stocks that I look at tend to be the larger cap companies that have ADRs and
financial information that is available to U.S. investors.
Q: What is your investment
philosophy?
RGK:
I look for companies that are projected to generate a large amount of
free cash flow relative to the amount of money invested.
I prefer to see assets on the balance sheet that support the price of
the stock. There are also
qualitative issues involved such as earnings predictability, financial
strength, and management ability.
Q: What is your background?
RGK:
I earned my Bachelor’s degree in accounting at the University of
Arizona. Then, I worked as an
auditor for the Arizona Auditor General’s Office for two years and became a
CPA. I decided to go to graduate
school at UC Berkeley to round out my business education with a MBA in finance
and marketing. After earning my
MBA, I worked as a financial analyst and accountant for Mattel, Tosco, and
Xerox. It was good experience for
a securities analyst because I had a chance to work on detailed financial
projections and had a first-hand look at how companies were managed. While I was at Xerox, I decided to make a career shift
to investment management.
Q:
Why did you decide to work in investment management?
RGK:
When I was 9 or 10 years old, I started looking at the stock quotes in
the Los Angeles Times and started asking my mother lots of questions. She came home with a book published by Merrill Lynch, How
to Buy Stocks. I read it and
developed a basic understanding of the different types of securities and how
to place orders. I maintained an
interest in investments but didn’t really have an idea of what to look for
until I read Benjamin Graham’s book, The
Intelligent Investor, which I read when I was 29 – better late than
never. When I read his book, I
began to see the financial markets in a very different light and I knew that
investment management was the career that I wanted to pursue.
Q: How did Benjamin Graham change
your perspective on the financial markets?
RGK:
After I received my MBA, I believed in efficient market theory.
At UC Berkeley, efficient market theory was the guiding principle in
the finance classes. People like
Benjamin Graham and Warren Buffett were not even mentioned.
If an investment manager outperformed the market, it must have been
luck. Based upon my personal
experience at that time, it made sense to me.
After reading Benjamin Graham’s books,
I could no longer accept efficient market theory.
In Benjamin Graham’s books, he gives examples of companies that
represent a buying opportunity and others that were clearly overvalued. Since then I have identified other companies that were
undervalued and I’ve been able to take advantage of those situations.
I now think of the financial markets as a bell curve.
On one side of the curve, you have stocks that are overvalued.
At the other extreme, you have stocks that are undervalued.
In the middle of the bell curve, you have many stocks that are close to
a reasonable price. At times, the distribution curve may be skewed so there are
many undervalued or overvalued stocks. I
attempt to concentrate my clients’ capital among those stocks that I believe
are undervalued.
Q: Do undervalued stocks entail
more risk?
RGK:
To the contrary, I believe that they often involve less risk.
Benjamin Graham wrote that the secret of sound investment was “margin
of safety.” Value investors
attempt to find companies that are selling for less than their intrinsic
value. Intrinsic value is
determined by the analyst based upon facts and reasonable assumptions about
the future. The difference
between the price and the intrinsic value of the stock provides the margin of
safety. The potential for
appreciation results from the tendency of the stock’s price to move towards
its intrinsic value over time. We
cannot eliminate risk but when a stock is undervalued, the potential negative
factors tend to be fully reflected in the price.
Q: Value investing has been a
popular style in recent years. Is
it a style for all seasons or should investors consider growth stocks now?
RGK:
In my article, “Value vs. Growth – The Importance of Investment
Philosophy” (click
here) I summarized the results of ten different studies on the
subject. The studies involved different time periods and some included
foreign countries. The results
were consistent - if you buy stocks at low ratios of price/earnings or
price/book value, you should be able to beat the market by 3-4%. The vast majority of investors and money managers have
ignored the results of the empirical studies to their detriment. It should be noted that many value stocks have earnings
growth but investors may not be excited about the company, so the prospects
for earnings growth may not be reflected in the price.
Q: How do you identify stocks to
research?
RGK:
There are a number of sources. Value
Line is my primary source. I look
through the weekly statistical screens and many of the reports on individual
companies. I sometimes do my own
statistical screens on databases that are available on the internet.
I look at some companies that are favored by investment managers that I
respect. Sometimes an industry
contact or publication will mention a company and I will request information
on it. I try to keep an open mind
about where to find a good stock.
Q:
How do you research a stock?
RGK:
I request information from the company.
I review the annual report, 10-K, quarterly statements, and press
releases. I call the investor
relations department to ask some follow-up questions.
If it’s a smaller company, I usually talk with the chief financial
officer. I also look at some of
their competitors because I want to find the best value within the industry.
If I buy a company, I monitor it by reviewing press releases, changes
in earnings estimates, listening to conference calls and calling the company.
Q: You mentioned free cash flow
as a primary consideration in stock selection.
Why?
RGK:
Investors pay their bills with cash.
If a business generates lots of cash relative to its price, eventually
other people will notice and start bidding up the price.
Q: How do you define free cash
flow?
RGK:
Free cash flow represents the cash generated by the business after
capital expenditures and working capital requirements.
This cash flow may benefit the shareholders either in the form of
dividends, stock buybacks, or expanding the business further.
I also subtract free cash flow that will be used to reduce debt when
the company’s debt level is high and must be reduced.
Q: How do you project cash flow?
RGK:
I don’t have a crystal ball, not one that works anyway.
But, I do have a quantitative model that I use to make my assumptions
about a particular stock explicit. I
believe that it’s important to use reasonable assumptions, know what they
are, and review them on a regular basis.
I crunch the numbers using my quantitative models to find out what kind
of return I can expect to receive if a company achieves the operating results
reflected in my assumptions. Generally,
consensus earnings estimates are a starting point for the forecast but I will
modify them when I think the consensus is missing something. I make assumptions about free cash flow for ten years based
upon the industry outlook, the company’s competitive position, ability to
maintain profit margins, capital expenditure requirements and debt service
requirements.
Q:
Don’t most investors make reasonable assumptions about their
companies?
RGK:
When I look at some companies that are selling at very high price to
earnings ratios, it is obvious to me that people are making implicit
assumptions that are not reasonable. If
they stopped to do the math, they would find that their odds are better in Las
Vegas.
Q: What are your criteria for
buying a stock?
RGK:
When I compute a projected return for a company, I compare it to the 10
year U.S. Treasury bond, which I use as a benchmark security.
I look for companies that have a projected return that is at least
three times greater than the 10 year U.S. Treasury bond. I may raise or lower the bar somewhat for the degree of
earnings predictability or financial strength.
There are not many stocks that meet the criteria and I feel that my
investors are adequately compensated for the risk that they are taking.
Q: When do you sell a stock?
RGK:
When the projected return declines to a point where I would prefer to
look elsewhere. The projected
return will change due to changes in the stock’s price, earnings estimates,
and interest rates. The model is
not very sensitive to changes in interest rates unless it is a big move. It can be very sensitive, however, to changes in price and
earnings estimates.
Q:
Why do you use closed-end funds?
RGK:
I use some closed-end funds for some portfolios that have a fixed
income component. I look for
closed-end funds that have the type of bonds that I want and are selling at
significant discounts to net asset value.
There are some operating expenses at the fund level but if I can buy
the fund at a large enough discount to net asset value, the yield will exceed
the yield on the bonds within the fund. The
article that I wrote on closed-end funds has a more detailed discussion (click
here).
Q: You’ve had a pretty good
performance record since you started Sabino Investment Management.
Will you be able to do that in the future?
RGK:
I can’t tell you what I’ll do in the future.
I can only tell you what I’ve done in the past.
In my opinion, good investment performance is the result of a
disciplined process. I intend to
apply the same principles and process that I have in the past because
they’ve worked well. When I buy
a stock that I believe is undervalued, I can’t tell you when it will go up. Some stocks move right away and others don’t move much for
quite awhile. Sometimes I make a
mistake and the stock goes down. Like
everybody in this business, I make mistakes too.
But, I have a pretty good batting average. Investors should certainly consider the performance record
but they should also feel comfortable with a manager’s investment philosophy
and decision process.
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Sabino
Investment Management, L.L.C.
