Cash flow investing - Chetan Parikh

In a great book “The Market Masters”, there is an insightful interview of value investor Andy Pilara.

“Like most young boys, Andy Pilara once dreamed of becoming a profes­sional baseball player. In fact, his love of sports is what originally sparked his interest in stocks. As a youth, he'd devour the sports pages of his home­town newspaper, the San Francisco Chronicle. Back then, the stock tables were part of the sports section, and all those funny-looking numbers fasci­nated him. Before long, Pilara found himself taking an investment class and developing a friendship with the instructor that eventually would pave the way to his future in the business.

After almost two decades of running his own value-oriented one-man boutique, Pilara joined RS Investments in 1993. While the firm has long been known as a growth-oriented shop, Pilara has made a strong name for himself as head of the RS Investments value group. Pilara, 63, runs three funds, all of which have been top performers in their respective categories, including the RS Partners, Global Natural Resources, and Value (formerly known as Contrarian) funds.

In describing his strategy, Pilara says he's a low-expectation investor who focuses on bottom-up analysis and cash flows. He follows small- and mid-cap stocks and has found some of his biggest winners over the years in some rather unusual places.

Kazanjian: Is it true that a friend took you to an investment course when you were in junior high school?

Pilara: It is. When I was 12 or 13, the mother of the catcher of my baseball team brought me to an investment class taught by Claude Rosenberg, who was the head of research at the time for J. Barth and Company. I really en­joyed it. In the summer, I would go down and walk along Montgomery Street in San Francisco, sit inside the brokerage houses, and learn as much as I could about this fascinating thing called the stock market. I made an investment a year or two later in a company called Yuba Consolidated. The stock went from $4 to $16 and I got hooked. My dad was a printer for 40­some years and I watched him sweat and toil with his hands. As I made four times my money in Yuba, I saw that you could make money investing without using your hands. During the class, I told Rosenberg I'd like to work for him someday. We kept in contact, and when I graduated from St. Mary's College, I called him and said I'd like to work for him, but had other things I needed to learn. Instead, I took a job with the Federal Re­serve Bank of San Francisco.

Kazanjian: What did you do there?

Pilara: I was a bank examiner. That job lasted about 13 months. I then went back to Rosenberg and said I'd like to work for him. He hired me to be a runner in the research department. It was a great experience. It was my first exposure to my most important lesson: the value of grassroots re­search. Getting out there and seeing companies, walking through the stores and factories, talking to customers, vendors, and competitors. After work­ing in the research department at J. Barth and Company, I became the first candidate for the firm's registered rep program in training to become a re­ tail salesman. I spent three years doing the things salespeople do. I then moved into an institutional sales position. J. Barth and Company special­ized in West Coast research. As institutional salespeople, we sold this re­search to investment management firms throughout the country. Among my accounts at the time were Capital Research (managers of the American Funds) and several hedge funds in New York. That job was really my MBA. I probably spent more time asking these managers questions than I did ser­vicing the accounts. It was especially insightful to be exposed to the Capi­tal Research process. One of my New York accounts was Steinhart, Fine and Berkowitz. Michael Steinhart was the guru of trading, and I learned a lot just watching him at work. I also learned a great deal about research from Jerry Fine.

At that time I knew I wanted to manage money. I started to get in­volved in trading and research at J. Barth and Company. I would try to go on research visits with our analysts. Salespeople don't do that any more. I also would sit on the trading desk.

Kazanjian: When did you make the move from selling to managing money?

Pilara: In 1974 I created a value investment management boutique called Pilara Associates. It was a one-man shop. Part of my education was picking up accounting books that I knew some of the Harvard MBAs used when they were in school. I educated myself in accounting and read some of the popular investment books of that era, including Phil Fisher's Common Stocks and Uncommon Profits. I would make notes about how Fisher ap­proached analyzing a company and work that into my own template. When I went out to visit a company, I had one sheet for all my production questions, one sheet for all my marketing questions, and one for all my fi­nancial questions. It helped me to organize and pattern myself after a very successful investor.

Kazanjian: When you started your own shop, why did you decide to focus on the value style and study value managers? Was it deliberate?

Pilara: I kind of grew up in the business in the era of companies like Am­pex and Memorex. When times were good, you made a lot of money. When times were bad, you lost a lot. That didn't fit my personality well. I'm a poor loser. I found the pain of losing far outweighed the pleasure of the gain, and became a value investor very quickly after some losing expe­riences. I really became a value investor two or three years before starting my own operation. I was a security analyst in the mold of Ben Graham, doing deep book-value work. It worked well, and 1974 was a great time to be a value investor and small-cap stock picker.

Kazanjian: So you originally were led to the value style because of your desire to lower the risk of investing in stocks?

Pilara: Yes. Emotionally I was trying to remove that pain of loss. As I say to my analysts, tell me about your serious money ideas. Tell me where we can invest big money. Don't tell me the latest fancy stocks. That's not what we're about. I really invested in plain-vanilla companies.

Kazanjian: Have you always been value-oriented in life as well, like many of the other value managers I've interviewed over the years, including several of those in this book?

Pilara: I'd say so. I grew up in an Italian-Catholic household that was both economically and religiously conservative. Marrying that background with my growth stock investing experiences made the transition to value easy.

I also made a transition in my "value process" from deep value to a focus on returns. At a point, I looked at my portfolios and while they were doing well, I asked myself if there was a common denominator to my losers. The stocks were cheap for a reason: They were poor businesses. I then started to investigate how I could improve my process. I still spend a lot of time on process. I went to Northwestern University, which in those days had something called Merger Week at the business school. It focused on cash flow return and how to create shareholder value. This really turned my head. I realized I could look at and evaluate businesses with this tool, using a discounted cash flow methodology. I moved from a process driven by PE and book value to a cash flow return methodology designed to im­prove results by avoiding poor businesses.

Kazanjian: What made you leave your own firm to join RS Investments?

Pilara: I met Paul Stephens in the early 1970s. He was one of the princi­pals at Robertson Stephens, an investment banking firm that also had a money management arm. He was building a very successful money man­agement business and I really liked the people at the firm. I talked to Paul in 1993 about joining the firm, and ultimately did in September 1993.

Kazanjian: You must have been a bit like a fish out of water, because Robertson Stephens was very much a growth shop at that time.

Pilara: Yes, and it still is. What interested me is Paul ran what was called the Contrarian Fund. Paul has always been a growth stock investor, but he has valuation disciplines and I felt comfortable bringing him my ideas. In 1995, I started the Partners Fund, which is our small-cap value product. A year later I launched the Natural Resources Fund. And in 1999 I became portfolio manager of the Contrarian Fund.

Kazanjian: Why did you start a natural resources fund?

Pilara: I've always been drawn to the natural resources area because I like putting my hands on a product. Unlike a technology company or retailer, once you have your mine in the ground, all you have to worry about is be­ing a low-cost producer. This area of the market lends itself to financial analysis. You can easily run discounted cash flow models with different commodity price assumptions. The natural resources sector has become a good diversifier to technology. Natural resources stocks are negatively co­variant to technology stocks and this makes them a good addition to one's portfolio. Plus, I think we're in a new area for commodities. Natural re­sources look like an even more attractive asset class today than when we started the fund.

Kazanjian: Why?

Pilara: I think if I were to ask a company one question, it would be how much capacity have you built in the last three years and how much do you plan to build in the next three years? Had investors asked that question in technology a few years ago, they would have saved themselves a lot of pain. There's been very little capacity added in most major commodities in the last three years. Commodity prices are primarily driven by supply, not by demand. We have major structural events going on, in which the two largest populations in the world-China and India-are moving toward a more middle-class society. When you move toward middle class, your con­sumption of basic materials increases dramatically. Commodities are the basic building blocks of a middle-class economy. I've not seen resource companies generating as much free cash flow as they are today. When I vis­ited all the paper companies in Canada four or five years ago, I started hearing talk about return on investment rather than the next big paper machine they were going to build. All of a sudden the energy companies are starting to talk about return on investment and so are the mining com­panies. The mindset and fundamentals of the resource business have changed. These companies are now terrific cash flow generators. Some of them realize they can get good stock performance if they can get their rates of return above their cost of capital.

Kazanjian: The natural resources group has done well in recent years. Is the sector still fertile ground for value investors?

Pilara: Yes, assuming you pick and choose your spots. We think that the re­sources sector has favorable supply/demand fundamentals for the next three to five years. China will certainly be a major factor on the demand side. Keep in mind that commodity stocks will always be more cyclical than the general stock market.

Kazanjian: Because of your affinity for this sector, do you keep large weightings in natural resources in all of the funds you manage?

Pilara: No, we are generalists. We do not have an affinity for any particular sector. We don't make big sector bets in the Partners and Contrarian funds. We try to have a diversified portfolio where we can get appropriate nega­tive covariance. That negative covariance is sometimes presented by the natural resources investments. But it's strictly a bottom-up process with an affinity for good business models available at a cheap price.

Kazanjian: You look for stocks with market capitalizations from $100 million to around $16 billion. That's a pretty wide universe to choose from. How do you find your investment ideas?

Pilara: We try to work with a focused list of 150 to 200 companies. This includes the 50 to 70 stocks in our typical portfolio. Our ideas come from various sources. Grassroots research generates ideas. We like to turn over as many rocks as possible. These company meetings also generate candidates for our portfolio.

Over the last 30 years I've had contact with a number of good compa­nies and executives that I want us to always follow. I call this our farm team. It wasn't created from a screen, but from my experiences observing these executives allocate capital.

In addition, because the market today is so short-term oriented, when companies miss earnings in one quarter it creates opportunities for us. I look for companies with good business models experiencing short-term problems. We take a three-year view, so we think of ourselves more as busi­ness analysts than stock market analysts. Nobody analyzing a business would get too concerned about one bum quarter.

Kazanjian: What's more of the company-specific analysis you do when deciding whether to buy a stock?

Pilara: Above all, what we're doing is trying to assess the business model. It's all about unit economics and returns on capital. If we're looking at a retail concept, we'll go look at the store model. How much capital does it take to open one store? If the company is leasing this store, we will capitalize the lease. Then we'll look at the store model in terms of cash flow returns. If it looks like a company has an ability to earn above the cost of capital, we'll do additional due diligence. This includes looking at 10-Q's and 10-K's.We also look at the annual meeting proxy letter. This tells you how management is compensated. We always pay attention to the difference in pay between the CEO and the executive vice president or the CFO, whoever is next in line. If the CEO is making $1,000,000 and the executive VP is making $250,000 a year, you're wasting your time talking to anybody but the CEO.

We read annual reports backwards. The first thing that's usually inside the back cover is the board of directors. All of this has become much more important in our post-Enron world. We want to read the footnotes. It's sort of like being a detective. The best compliment I received was when a CEO said to me, "I feel like I'm talking to Detective Columbo." Columbo asked the apparently inane questions, but at the end of the day he solved the murder. That's what we're trying to do: ask simple questions that will lead us to an understanding of the business.

The first financial statement you come to by reading the annual report backwards is the flow of funds statement. I want to marry that with the balance sheet. Residually we look at the profit and loss (P and L) state­ment, because earnings result from capital deployment. That's why it's fool­ish to concentrate on quarterly earnings. The quarterly outcome has been decided a year or two before by the capital deployed to drive those earn­ings. When we visit with a company, we spend most of the time on our first visit discussing capital deployment.

One of the other ways we'll make a judgment about whether we want to continue with the analysis is by looking at the company's enter­prise value and capital account. I define the capital account of a com­pany as the total assets less non-interest-bearing current liabilities minus cash. We also look at it on a gross basis. By that I mean we add back the accumulated depreciation on the property account. What I'm really trying to do is see what we are paying versus the company's imbedded capital. The other things we'll take a look at are EBITDA (earnings be­fore interest, taxes, depreciation, and amortization) and estimated free cash flow.

Kazanjian: It sounds like a fairly complicated process, especially for those without an accounting background.

Pilara: It's really not. It's not high math. What's noticeable is there's not a focus on the income statement. If I look at one thing on the P and L it is gross margins. We want to know whether this is a commodity business, or one in which the company has a proprietary advantage. If somebody tells me he's got a proprietary product and I see gross margins of 17 percent, he's fooling himself. As far as we're concerned, a proprietary product has growth margins north of 30 percent. But the key point for us is cash flow returns.

Kazanjian: You do all of this research before talking to management. Is having a discussion with company executives required before you'll buy the stock?

Pilara: Yes, and we can't do a management visit without doing our home­work first because we want to be prepared.

Kazanjian: Perhaps it would help if you gave us an example of a company you bought and the analysis that led you to this decision.

Pilara: Several years back we bought a company called Fresh Del Monte. It's a fresh produce company that sells Del Monte bananas and pineapples. I first met the company when it went public. Management came into our offices. I liked the fundamentals of the business, and I admired the way they managed their capital allocation process. This was all confirmed when I went down to see the company shortly after the IPO. I sat down with the chief operating officer and asked him about the capital allocation process. He had a stack of papers on his desk and pulled out a paper with numbers on the acquisition of a motorcycle. He had the capital they spent and the rationale for spending it. I was impressed. Also, this was a company with new management and I saw there would soon be a material improvement in the balance sheet. They were using free cash flow to payoff debt. The returns on capital were above the costs of capital and it met our criteria at that time on our cash flow model.

Kazanjian: What happened to the stock?

Pilara: Subsequent to the IPO it eventually went down to $4 a share.

Kazanjian: Did you buy in at the IPO?

Pilara: We made an investment on the IPO. The stock price declined after the company went public.

Kazanjian: Were you buying more as the stock went down?

Pilara: We purchased more as the stock declined and substantially in­creased our position when shares were trading below $6. It was obvious that banana pricing was deteriorating, but while this part of the business had the largest revenues, it made the smallest contribution to cash flows. All the while, the higher gross margin pineapple business continued to im­prove. At $4 a share the company had a market cap of $200 million and an enterprise value of approximately $500 million, with cash flows in the $150-$200 million range. At that level, I figured I was buying a good brand name for cash flow multiple under 3. Within the next three years, the company's earnings per share were almost as much as the lowest price I bought the stock at. It went from $400 million in debt to zero in two and a half years. The stock went from $4 to $28.

Kazanjian: When did you sell out?

Pilara: I sold the stock in the $20s. Our target price was reduced after fun­damentals in the pineapple business changed and it became a more com­petitive business.

Kazanjian: Do you have specific rules for when you sell a stock?

Pilara: We have a couple of sell disciplines. If a stock reaches our war­ranted value and there's been no change in the fundamentals, we sell. If the returns of the business start to deteriorate, we make a call to management. We mayor may not sell, but it raises a red flag. If returns are deteriorating and we become uncomfortable, as at Fresh Del Monte, we sell. If the com­pany makes a large capital acquisition, we discuss it with management. If we don't believe it's creating value, we will sell.

Kazanjian: Fresh Del Monte turned out okay for you, but my guess is the average investor wouldn't have held on as the stock went from $16 to $4. They probably would have sold out sooner, to keep a cap on losses. Weren't you tempted to get out?

Pilara: This was an unusual example. I would say that 90 percent of the time if a stock goes down 15 percent and the fundamentals haven't changed, we'll add to our position. I think the reason for our good perfor­mance is not because we've had a lot of home runs, but rather because we haven't had a lot of big losers in the portfolio.

Kazanjian: Does that mean that if the price drops 15 percent and something has changed for the worse you'll get out?

Pilara: If the fundamentals have changed, we get out. Part of our philoso­phy here is that we're low-expectation investors. I tell my guys, "If you fall out of a window, fall out the basement window. Don't fall out the top-­floor window." Most times we go into stocks with low expectations. We're all about losing less, not making more. For the most part, when one of our companies misses its earnings, nobody cares because it's not a high-­expectation stock.

Kazanjian: 'True, although you mentioned that most of the names you buy are hav­ing some short-term problems. I suppose there~ an investment risk that these prob­lems will get even worse

.

Pilara: No. Most of our companies do not have short-term problems. Oc­casionally we look at companies going through some short-term problem, but we're trying to buy after the short-term problem has been worked out. We're not playing turnarounds. We still want a company with a good busi­ness model.

Kazanjian: One of your huge home runs over the last few years was China Yuchai. What led you to that unusual company?

Pilara: When I took over the Contrarian Fund in 1999, China Yuchai was in the portfolio. This was the second largest diesel motor company in China. Unit volumes were increasing at a dramatic rate. The fundamentals looked very good, and the stock was under $2. Within 18 months, the company would almost earn our inherited cost basis.Yuchai was a "10-bagger." Home runs like that don't come along that often. I certainly don't expect them. I'm just trying to hit singles and doubles without striking out along the way.

Kazanjian: Do you pay any attention to PE ratios at all?

Pilara: Sure, we look at the PE, but we don't think it's robust enough to give us the information we need as a primary assessment of whether this is a business we want to own. The reason is that when you look at the price-­to-earnings, you don't solve for how much capital it took to generate the earnings, which is really important. Nor will it tell us about free cash flow.

Kazanjian: Given that, let’s say you're looking at a company selling at what you deem to be 50 percent below what it’s worth, yet it has a PE of 30 or 40. Would you still buy the stock?

Pilara: That really doesn't happen very often. But there are instances where a company is currently losing money, there is no PE, and it is selling below its business value.

Kazanjian: How diversified do you keep your portfolios, in terms of the number of holdings?

Pilara: In the small- cap portfolio, we own around 60 names, and approximately 50 names in the mid- cap portfolio. Our core position is 2 to 4 percent at cost.

Kazanjian: When looking at the mistakes you've made over the years when it comes to picking stocks, do the losers tend to have any common themes?

Pilara: The common theme is that we made a mistake in evaluating the business model and its sustainability. Sometimes you make people mistakes, but more often it's not properly assessing the business model.

Kazanjian: Carrying that further, what would you say is the biggest mistake indi­vidual investors make?

Pilara: Not understanding the business and unreal return expectations.

Kazanjian: What are some realistic expectations over the next 5 to 10 years, in your opinion?

Pilara: Less than a 10 percent annualized total return from the market. I say that because when you look back at market history, a significant part of total returns have come from the dividend yield. Dividend yields today are only 1.7 percent. If you look at the last 20 years, you had a period of de­clining interest rates and declining inflation. It's been the best of times for stocks. I do not expect interest rates and inflation to exert such a positive influence on equities in the next few years. I believe we're in a low return environment for most asset classes.

While Pilara still loves sports, and emphasizes that just about everyone else on his investment team does as well, golf is about the only game he ac­tively plays these days. In his spare time, Pilara collects photography, espe­cially post-World War I social documentary photographs, but maintains his real passion in life is the investment business. "I'm one of those guys who says, 'Thank God it's Monday,' " he adds.”