Merryn Somerset Webb talks to Hutch Vernon, co-portfolio manager of the Flexible Equity Fund, Brown Advisory, about Warren Buffett, American equities and the death of cash (Audio only – click here to listen).
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Merryn: Hi, I am Merryn Somerset Webb, editor-in-chief of MoneyWeek magazine. And I’m here today with Hutch Vernon, who is the manager of the Brown Advisory, US Flexible Equity Strategy. Now, there are lots of things on the face of it that we approve of in this fund, and that it’s concentrated isn’t it: 35-40 equities. So it’s something that you think about very carefully with each one, it’s not particularly benchmarked. But, of course, like all US funds, MoneyWeek readers would worry about the price of American equities, full stop, regardless of how well they’re chosen.
Hutch: Well, you have to think of the environment that we’re in. And particularly we’ve had pull-back recently in the US market. The environment that we’re in in the US, and actually globally, is one of very low interest rates, and the pricing of investments is going to be tied to those interest rates.
With the US Treasury’s ten-year Treasuries at two 15, maybe they’ll be a little bit higher, maybe a little lower. And you could actually pay much, much higher valuations and justify them for US equities. And the long-run record of compounding of earnings underlying the US equities would argue for some exposure even if you had a somewhat negative view according to valuation, which I don’t agree with, but if you had a negative…
Merryn: OK, go back to that. You don’t agree with…
Hutch: Well, the US long-term compounding of earnings… and I’ll give you an example. Let’s go back 25 years ago, 1990, the earnings per share of the S&P 500 were on the order of $23, we can look this up and confirm the exact number, but it’s $23. And today they are on the order of 115; so you’ve gone from 23 to 115. That’s a big increase.
Merryn: Yes, but let’s go back to that. This has been a stunningly good period for earnings, super-low interest rates, interest has fallen over the last 30 years regularly, that’s amazing for interest rates. There’s been a falloff in the power of labour, so real wages have stagnated, etc. There have been a huge number of things that have been phenomenally good for earnings for American companies. And you could argue, I would argue, that that’s turning around.
Hutch: Well, you could also go back further and further, yes, the US is a dynamic system that has created value corporately for over long periods of time. That 23 to 115 which sounds, you know, that’s an incredible increase, it’s only 6.25% a year, and that’s the growth in the earnings.
Now, the companies 25 years ago that make up our index are not the same as they are today. Some have disappeared and many new ones have come into play, and that’s part of the dynamism of the US market. We are constantly creating new things, but that’s a good universe in which to choose good investments from.
And then in terms of the valuation with the US market, somewhere in a mid to upper teen’s p/e [price/earnings] ratio, you know, if you were buying a bond, a US bond, or even a European bond, that would be a worse comparison, but US bond, Treasury, two 15, you know, that’s the equivalent, inverting it, that’s the equivalent of paying almost 50 times earnings to buy something where the earnings don’t grow, but you do get your money back in ten years, you’re sure of it. But if you get a 6% compounding, equities are going to do better than bonds.
Merryn: Yes, but I’m also slightly challenged on this idea of constantly comparing an equity to a bond at the moment. This has been a relationship that’s held good for some years. But nonetheless, now that we know for a fact that bond prices are wrong, because they’re manipulated to a degree, there’s an unusual buyer in the market, all these things, you know. The thing that people always say, which I think is quite right, is, we don’t know what the price of money is anymore because it’s so deeply manipulated. So is it reasonable to use that model of comparing an equity yield with a bond yield anymore? I would say maybe not.
…it’s just a metric and I think you’ve got to be more thoughtful than just to take the absolute metric and say, “oh, I’ve got the right answer”
Hutch: Over the long term, it is, but let’s look at an un-manipulated price and you can see a comparison of the ten-year US Treasury trade relative to inflation. And it trades, historically, over a long period of time, not absolutely, but there’s a good correlation between a two and a 3% premium to the inflation rate.
Let’s say inflation is low and so we even peg it higher. So it has been running lower but let’s peg it up to 2%, which is the Fed target. And yes it could be higher than that. But so, let’s take two or 3%, add in that two to 3% premium, and so an un-manipulated US Treasury rate could be in the range of four or a maximum of six. And again, if you invert that, you’re still going to have a p/e ratio that’s less than the p/e ratio of what you were buying a Treasure bond. So that’s a comparison that I think is valid over time.
Merryn: What if you compared it to Cape… to the cyclically-adjusted p/e?
Hutch: The cyclically-adjusted p/e…
Merryn: A little bit more scary there, right?
Hutch: Well, it looks more scary then, but, again, you’ve got to look at individual companies and that is such a formulaic approach. We’re going to take the earnings of the last ten years, average them out and… oh, we’re going to adjust them for inflation and do all this other stuff. And it’s just a metric and I think you’ve got to be more thoughtful than just to take the absolute metric and say, “oh, I’ve got the right answer”.
Merryn: But it’s a good indicator of the market as a whole.
Hutch: I think you’ve really got to go beneath the surface and raise the hood on it, look what’s in there and then you can then go to individual companies and sectors, and so forth. I think this, and the other argument against US equities… well, aren’t profit margins so much higher than they’ve ever been in the past? The absolute profit margins are higher. The types of companies have changed. So you really, you can’t just take these static ratios and say, it’s always this way.
And in our fund, we are value-oriented in our philosophy, and we’re based on the principles of Benjamin Graham and Warrant Buffett. A lot of people get confused about being based on principles, and they want to go back to Benjamin Graham and say well, didn’t he have this if it’s twice the double, the triple B bond yield and all that. He had a lot of these metrics which were his way of helping to get the message across to people who maybe weren’t as sophisticated as he was. But those metrics, you have to adapt over time, because the markets are constantly changing.
So you forget the metrics, but you apply the principles which is – think about stocks, it’s a bit of buying businesses. Think about the price fluctuations creating opportunities; think about margin of safety and the fourth point really is one of just think about it. Don’t just take these absolute metrics and say, oh, I’ve got the answer.
Merryn: OK, so we agree with his ideas, but not with his metrics?
Merryn: So where, if you’re looking for value now, let’s take 35, how many companies are there in the fund at the moment?
Hutch: We have 41.
Merryn: 41, OK.
Hutch: The ten largest holdings are today about 40% of the portfolio.
Merryn: OK, so those companies, what’s the unifying value concept across them?
Hutch: The unifying value is…
Merryn: What’s the value you can say tells us that all these stocks are a reasonable price.
Hutch: Well, in a discussion stand point, we use p/e ratios, but p/e ratios are meaningless on their own. You’ve got to look at each individual company, what are you getting for the money that you put out. And our idea is to get a lot for what we pay.
Merryn: OK, just chuck this out as an idea then – what’s the average p/e of a company in your portfolio against the average p/e in the market as a whole?
Hutch: The average p/e… averages to averages compress the differences, but our average p/e on…
Merryn: I know you disapprove of these questions, but the answers are quite useful, they really are.
Hutch: The averages, and actually I’m going to open up the book to get the specific numbers, but the averages are about… we are a little more than the market, we’re about 15 six and the market is 15, and this is next year’s estimates of… Y2 estimates, 2017 estimates.
Merryn: OK, so we’ve got an average p/e of 15.6, the price to book of 2.4… I think that’s really high.
Hutch: It depends on what you’re getting and…
Merryn: We can go and invest in Japan, we can have a price to book of one.
Hutch: You are also getting companies that earn practically nothing on their return on equity and don’t…
Merryn: But there’s room for improvement.
Hutch: Well, there’s a great room for improvement, but the pace of change has been, you know, very slow over there. Now, it would be great if it all changed. If every Japanese company went from earning two or three, or 4% on its equity, if it earned that, and started earning what the US earns on its equity, US companies on average do, Japan would be a steal, you know it would be the best investment made in history, if that happened. Is that really going to happen? I don’t know. I’m not making that prediction.
Merryn: OK, so we’ve got an active share, I’m looking down the readers that have listed the metrics for this fund. And the active share is 78%.
Merryn: It’s higher than a lot of funds, but it’s low compared to a lot of the very active funds. Is that because you’re holding some of the very big companies that make up a lot of the index? What’s the price over there?
Hutch: We hold some of the big companies, we hold some small companies. Our active share is historically averaged about 80%; we will go as high as 8% in any one position. Today, our larger positions are in the range of four to six. As I mentioned, the top ten are about 40% of the portfolio.
Merryn: And what are the biggest holdings at the moment?
Hutch: The biggest holding is Visa. I’ll just read them all for you. Visa, which is 5.5%. We also own MasterCard, which is a little over 4%. So together those two are just over 9%. Berkshire Hathaway is in there at four point six; Google, four four; Wells Fargo, MasterCard I mentioned; Express Scripts; Kinder Morgan and Price Line, and Canadian National Railway rounding out the top ten.
No, he still is a genius. And anyone that wants to argue the point of that will find themselves pretty foolish, just given time
Merryn: Berkshire Hathaway always bothers me. You’re a great Warren Buffet fan, right?
Merryn: Tell me about it. What’s so great about Warren Buffett?
Hutch: Well, the philosophy makes sense. He’s a genius, so we base what we…
Merryn: Is he a genius, or did he used to be a genius?
Hutch: No, he still is a genius. And anyone that wants to argue the point of that will find themselves pretty foolish, just given time.
Merryn: Do you think? Do you really think?
Hutch: Yes, absolutely.
Merryn: I always wonder. I mean, I think…
Hutch: One of the most memorable…
Merryn: When Warren Buffett dies, I’m sure it’s a long way off, but it will be quite interesting to see what happens, what’s really in there. Have the valuations really worked? There’s some kind of a mystery going on in there.
Hutch: No, you can add up the pieces. And if you do add up the pieces today, you’ll find that Berkshire is selling for less than adding up the pieces. Now you may not agree perfectly with how you should add up the pieces, so there’s some range around that of what you’d come to, but it’s at a discount.
Merryn: What kind of a discount? So, if it was in an investment trust, for example, what kind of discount would we say it was on?
Hutch: If it’s an investment trust, we are on the, let’s see, we are about 132 on the price today, and the sum of the parts is around 175. And there’s compounding that goes on, and the compounding is not perfectly regular, but the belief, if you buy Berkshire Hathaway, it will compound at least at the S&P 500 rate of compounding.
Now when you talk about active versus passive management, or Berkshire Hathaway as an active manager, you have to ask the question – can Berkshire Hathaway pick companies and allocate capital better than the S&P investment committee?
And so are their weightings and selections going to be better than the S&P selection committee over time, and I think, well, the history is that it has been, and given the structure that he’s putting in place to sustain them, I think it will be better over time. Given the capital that they manage, it will not have the same advantage, but that’s not priced into the stock, at all. That the same advantage would… I mean, selling it at discount, you can add up the pieces, so you’re not paying a premium for Buffett at all. And Buffett is indeed every bit of the genius that he wants, clearly was, in terms of this advantage.
Merryn: You’re a regular at his shareholder meetings, aren’t you?
Hutch: Yes, I am. I’ve been to 29 out of the last 30, so, yes.
Merryn: I went to one. Never, ever again. It was a folksy shtick… I really couldn’t cope with it at all. Some little girl got up and read a poem about, you know…
Hutch: Oh, there’s…
Merryn: Every single question was about – “oh, Mr Buffett, how can I be brilliant like you?” I was like, oh jeez, I need a drink. It was nauseating. Nauseating.
Hutch: I’ll give you my notes of the meeting, and you can see how I’ve cut through that. But I don’t know what year you went, but there was a period when it got very bad, and then they changed the format.
Merryn: OK, so I can brave it again?
Hutch: Yes, you could.
Merryn: And then I was outraged by the prices in his jewellery shop; I thought it was wrong of him to try and gouge his investors like that.
Hutch: I don’t know that he was. There were discounts available. I mean if you were… if you had your pass, the discounts were there.
Merryn: No, I know, but the original prices were way too high. I was just like, you know, it must have been ten years ago, because I had just got engaged, so I knew a lot about the price of diamonds. What a ring should cost and all this kind of thing. So I went off to his jewellery store, what’s it called? You’ll know… you’re in there all the time.
Merryn: Yes, and the prices were obscene, absolutely obscene relative to the other prices of gems I’d seen. And that just put me off the old boy altogether. I mean, he’s prepared to rip off his investors with a yellow diamond, or whatever it is, what’s he doing behind the scenes with the rest?
Hutch: Well, I don’t know what that may mean, but I will tell you, years ago when it was a smaller meeting, not quite… you know, it’s a mob scene in proportions today for their events. And years ago it was quite accessible, so you’d walk up to him and have a conversation.
And one year they had the jewellery items priced in shares of Berkshire. I don’t think Buffett ultimately liked that, because they only did it that one year. But I did walk up to him and said this piece here, this was when Berkshire was much lower, I said, this piece it’s five shares, six shares, something like that, would that be a good purchase?
And he very quickly said – that depends on your sense of value. And that goes back to the point before we started recording, about knowing what you’re getting and what you should value.
And in every other aspect of shopping, people really do consider what they are getting when they part with their money. In much of, and this is one of the things that’s wrong with the investment approach, when people try to limit it down and say, oh, I’m a growth investor, I’m a value investor. And they define growth investors; I’m only going to buy companies that are growing faster or a certain rate. Or I’m a value investor, I’m not going to pay anything more than, you know, 15 p/e or 12 p/e or some price to book ratio. They totally abdicate the decision of… they mostly abdicate, there’s a little bit of it, but they abdicate what they are getting for the money that they are putting out.
And the flexible equity approach, we don’t want to have any constraints, we want to be open and we want to look at each company individually on its own merits; what’s its business like, is it a business that you would be quite happy to own, over a long period of time, if this were your family business, and it could be in your family multi-generations? How would you feel about owning that?
So it’s the businesses that are hard to displace, that have good economics, no bad traits of things that could put you out of business. And then because these businesses do trade every day, and the markets swing from greed to fear or back and forth. Individual companies; people get worried about this or that, or take too short-term a horizon. You do get opportunities to pick up something on a bargain basis. It’s not every day, but periodically you do. And so opportunities are not spread evenly over time, nor are they spread evenly across your portfolio. You want to always be gravitating towards where the opportunities are.
But if you’ve got a good business that you bought at a bargain price, it doesn’t necessarily mean let’s part with it – let your winners run.
Merryn: Let’s talk about the interest rates in the US. Were you disappointed the interest rates weren’t raised? I know I saw a comment from one of your colleagues on interest rates in the UK. He’s… what’s his name? Is it Kevin O’Keefe?
Hutch: Yes, he’s our future analyst.
Merryn: He is disappointed that rates are still so low in the UK, because they should have gone up by now. Because of the distorting effects of low interest rates, are you now more extreme then the positive effects of low interest rates? And I completely agree with that stance. But where do you stand on that in the US?
But, you know, I’ve learnt you don’t argue with billionaires
Hutch: Well, ask him about the recent decision. Yes, I have a portfolio that would benefit more from rising interest rates than it does from keeping them the same, because of some of the financial investments that we have in the portfolio. But does that cause me to go out and sell the ones I have? No, I’m comfortable that these are good values if interest rates do not rise, and they’re better investments if interest rates return to a more normal rate.
Merryn: And earlier you said that you had a couple of the investments in the portfolio that were outside the US?
Merryn: Where is that?
Hutch: We have two in Canada, which would be Canadian National Railway and Canadian Pacific Railway; we’ve been in Canadian National for over 20 years. And then we bought Canadian Pacific three years ago when the former manager of Canadian National came out of retirement and started running Canadian Pacific.
Then we have Teva Pharmaceuticals, which is based in Israel, but it’s a global company. And we only buy companies that are either US based or trade in the US. And if we’re going outside the US, it is companies that – and that’s only seven or 8% of our portfolio – it’s companies that are large global enterprises, or in the case of the two Canadian rails, essentially that’s very comparable to US Rail.
Merryn: What about that Canadian company that everyone refers to as the Canadian Berkshire: Fairfax?
Hutch: We don’t own it. Prem Watsa has had a terrific record there and I don’t know if I would call it the Canadian Berkshire, but he’s had a great… And it is insurance and in some aspects they are modelling behaviour at Berkshire. But he’s had a terrific record, but I think some of his investments have been a bit more speculative. But, you know, I’ve learnt you don’t argue with billionaires.
Merryn: So, OK, last question. Your number one favourite stock at the moment –what are you in the middle of buying, about to buy, just finished buying? Top favourite.
Hutch: Oh, well, the largest holding is Visa. It wouldn’t be the largest holding if that were not a long-term compounder, reasonably priced…
Merryn: Could be on the way out, something on the way in, for all we know. But that’s your favourite?
Hutch: That… yes, and they would not be the largest if it were not my favourite investment.
Merryn: OK, and what’s the main driver behind loving it this much?
Hutch: It is a toll booth on spending with a giant tail wind that more spending is done on cards than paying in cash. And that’s not just in developed economies, but it’s around the world. They have built their business, the network, it’s very hard to displace.
Apple Pay, which – and, Android Pay and the other things – there were a number of efforts made to recreate something new, but the ubiquity of having millions of merchants and billions of cards out there, makes it very hard to displace. And actually now these things are. Apple Pay etc are riding on the same network as Visa and MasterCard.
Merryn: OK, so is it basically a huge play on the death of cash?
Hutch: The death of cash, but also the growth over time of spending and the reinvestment of the free cash. These businesses generate lots of free cash which they are allocating well, buying back a lot of stock. And there’s also potential opportunity in Visa to benefit from if there’s an agreement made for Visa Global to purchase Visa Europe, which is a separate entity at this point, there could be a lot of synergies that happen through that combination. Now they have to pay to buy that but, yes, the idea that putting them together would make it an even stronger franchise.
Merryn: OK, and the challenge from mobile home payments or blockchain-style payments etc, is not big enough to be a concern?
Hutch: It’s a concern that you constantly monitor, but it’s been very difficult and, in our view, it would continue to be difficult to have… a competitor is not going to sneak up on them; they’re going to see it coming.
Merryn: OK, brilliant, thank you very much.
Hutch: OK, it’s a pleasure.