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Mutual Fund Q&A: 
Price and Value Convergence
Artisan International Value Fund
Management: Daniel J. O’Keefe

Author: Manish Shah
Last Update: 9:19 AM ET January 12 2010

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When a good business falls out of favor, trading at a substantial discount to its long-term value, the discernible investor faces the challenge of analyzing the reasons behind this. Daniel J. O’Keefe and the team at Artisan International Value apply a disciplined approach to assess the soundness of a business as they look for companies with sustainable advantages that are trading at a discount.

Q:  What core principles drive your investment philosophy?

A : Generally, there are three parts to our investment philosophy. First, we seek to buy a business at a discount to what we believe to be its intrinsic value. Although, we may see growth in the underlying value of the business, we look for the majority of the return to come from the narrowing of the discount between market price and intrinsic value.

Second, in order to buy a business at a discount, we have to have a long-term investment horizon because generally if a company is out of favor, investors are not willing to attribute fair value to the business in the short-term.

Third is risk management that is to a large extent tied to the first principal of buying at a discount. With risk management we are talking about two concepts that emerge as traps for value investors: time value of money risk and business value volatility.

We believe that buying high quality, discounted businesses is a way to protect the portfolio against time value of money risk, and that if they are what we consider financially strong businesses, we may gain protection against business value volatility. Also, we want management teams that understand how to protect and maintain a company’s competitive advantage, to manage a balance sheet and to protect a company’s equity value.

Q:  How do you convert this investment philosophy into an investment strategy?

A :
In broad terms, the revaluation of a security (going from a low P/E ratio to a higher P/E ratio) is the largest expected source of our investment return. However, identifying statistically cheap securities is merely the beginning of our analytical process. We also like a better than average business, with a strong balance sheet and a value-building management team. We emphasize these qualities mainly to help protect us against risk, but there are several return generating characteristics that are sometimes less obvious to those focused simply on statistically cheap equities. For example, we think the balance sheet is an underrated source of value creation. Just as a highly leveraged balance sheet is a source of risk for equity investors, an overcapitalized balance sheet can be a source of opportunity. If cash is deployed to take market share, buy weaker companies or repurchase and cancel shares when valuations are low, it can potentially offer significant growth in earnings and hence value realization. We also prefer businesses that generate significant current cash flow at levels approximating or even exceeding net income. The more cash a business generates, the greater its ability to pay a return to its owners either through dividends or share repurchases. We believe a strong balance sheet and current cash flow in the hands of a competent management team can be a powerful value creation tool.

Q:  How can high-quality companies trading at a discount generate opportunities for your fund?

A :
High-quality company valuations may move around for many reasons which is why we believe you cannot expect high-quality companies to maintain their valuations without ever becoming what we consider discounted, or “cheap”. Here are two examples.

A few years back, when Microsoft Corporation was growing substantially, we believe it tended to be owned by more aggressive or growth-oriented investors. Then, its business slowed. Growth shifted down to about 10% from the 30-50% range and we witnessed a noticeable transition from one constituency of owners, growth investors, to a new set of investors.

Microsoft is, in our view, a predictable business with strong cash flows and a solid balance sheet. However, we view the company as transitioning to slower growth with the price-to-earnings ratio shrinking from almost 90x to the 10x range. With this transition, investors are changing their perception of the company from a high growth company to a more moderate growth company resulting in the shareholder base shifting from growth to value investors. We currently own Microsoft in the Artisan Global Value Fund (ARTGX).

Another example is Unilever Plc, one of the largest consumer products companies in the world, which we have owned for several years. Unilever has dominant market positions in many emerging markets as well as strong market presence in food and consumer products in the developed world.

While we believe Unilever is a highly attractive business with strong market positions, we also think the value of the business is not apparent because management, in our view, has not necessarily maximized the value of the company. In the past we believe management has made some operational missteps and has historically been criticized for being insular, slow to innovate and slow to respond to market conditions. However, we believe management changes in the last couple of years have resulted in the company’s operational performance beginning to more accurately reflect the value of the brands and its market positions and the stock price has reacted accordingly.

It is our belief that Unilever possesses tremendous brand value and is well-entrenched in the market. With management moving in the right direction, we think the way the company is perceived in the market will change.

Q:  What makes a business highly attractive?

A :
We believe it is difficult to replicate an attractive business even if substantial resources may be available to a competitor. The value of brands, or distribution, or customer reach represents business value and strength that are not easily replicated.

Our largest holding is Experian Plc, a global credit information group. The business has been discounted recently because of the credit crunch. As the amount of credit issued in the market has declined, the demand for credit reports and data has also declined. As the pressure of those cyclical challenges weighted on the company, many investors started selling the stock.

However, in our view, there are only three real players of any size in this industry, Experian, Equifax and TransUnion. But, we believe only Experian and Equifax have any significant global scale, and we believe Experian’s footprint, product portfolio, and customer reach is greater than Equifax’s. This information is the life blood of all those consumers. We believe it would be quite challenging to replace the customers of Experian or the service that Experian provides and to us that translates into a valuable business.

Q:  What are the analytical steps in your research process?

A :
Our investment philosophy translates into a research process focused on four key characteristics. The first is undervaluation because determining the intrinsic value of the business is the heart of the process. As long-term investors, our core belief is that investing at a significant discount to fair value is the most crucial determinant of stock market return over the long-term.

The second characteristic is business quality. We seek to invest in companies with a history of generating strong free cash flow, improving returns on capital and strong competitive positions in their industries to help rule out businesses that are statistically cheap, but whose values are deteriorating over time.

The third is financial strength. We believe that investing in companies with strong balance sheets helps to reduce the potential for capital risk and provides company management the ability to build value when attractive opportunities are available.

The fourth characteristic is shareholder-oriented management. Our research process attempts to identify management teams with a history of building value for shareholders.

When we find something interesting we do a lot of reading including historical annual reports, transcripts and the presentations of companies that are in similar businesses and that compete with a company. We also interview the management teams of the company and the company’s competition.

We try to understand the business model and what influences the demand for its products and the profitability of the company to try to assess if this is a sustainable business model. Are the people honest and capable, what have they done with the cash, how have they managed the company historically, and what's the reasonable basis for making a long-term forecast of free cash flow generation over the next three to five years? All that research eventually is distilled into a financial model, where we will make a series of projections and build a discounted cash flow model through which we assess the value of the company.

Every business is different, and therefore, every assessment of what is an interesting price to pay or what constitutes fair value for a business depends on the individual characteristics of the business in context with the dynamics of its industry and competition. Ultimately, it requires a lot of judgment to know what to look for, where to look for it and how to think about things. And frankly, a lot of that comes from experience.

Q:  How do you construct your portfolio?

A :
We employ a bottom-up investment process. We do not form a macro-economic view of the world in order to put together a portfolio that reflects that macro-economic outlook; however, we do not completely ignore the macro-economic situation.

We build our view about whether the company is undervalued, fairly valued, or overvalued, by focusing on the company and looking at the perspective and the environment it operates in. As we step back and start thinking about the portfolio, we are also considering our exposures.

The fund tends to hold between 40 and 60 stocks, diversified across most major sectors and typically at least 5 countries. The portfolio turnover typically ranges between 30% and 50% but the dollar turnover is probably higher than the name turnover. Again, our turnover is generally a function of the price and intrinsic value target of each of our stocks.

Q:  What is your sell discipline?

A :
Our sell discipline is organized around the price to intrinsic value relationship. In short, our sell decisions are generally driven by the target price we set for a company.

The price to intrinsic value relationship is primarily what leads us to be interested in and to buy a position. As they converge and we have generated our return, we begin to evaluate selling.

However, we may find another company at a similar or greater discount that we view as a higher quality company, and consider selling the current holding in favor of the new name. Another reason for considering selling a holding would be if we believe we made a mistake in assessing the intrinsic value or quality of the company.

As we discussed, we generate the majority of our return from the unwinding of market price to intrinsic value. But, we also strive to generate returns from the underlying growth in the value of the business. And that is a very important element to us as well.
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