Merryn Somerset Webb talks to value investor Charles Heenan of Kennox Asset Management about his investment strategy – and the financial benefits of doing nothing at all for long periods of time.
• If you missed any of Merryn’s past interviews, you can see them all here.
Merryn: Hi, I’m Merryn Somerset Webb, editor-in-chief of MoneyWeek magazine. Welcome to another one of our fund manager interviews. With me today is Charles Heenan, who is the founder of Kennox Asset Management and the manager of their only fund, the Strategic Value Fund. Now, Charles, tell us a little about the fund. I know it’s a value fund and MoneyWeek at the moment, we’re really interested in value investing. So we’re particularly interested to hear about how the fund works and why you invest it like you do.
Charles: Very good. So, we are value investors, like you said. That means price matters. It’s very important to say we really do believe that if you pay too much for an asset, it’s a huge risk. Right now, it’s an especially big problem. We also believe in quality. If we can buy the highest quality assets, we think we’re managing risk at another level.
Merryn: OK. So it’s a bit like wanting to have your cake and eat it, wanting to buy high quality stuff at a very low price.
Charles: Which brings me onto the next point. We have 29 stocks and their turnover is about 15%, which means we buy one to two stocks a year. In the last year, I’m afraid to say, we haven’t bought a single stock. So what we’re saying is it doesn’t happen very often. And “it doesn’t happen very often” doesn’t mean it doesn’t happen; it just means you have to be patient. We’re firm believers that it’s one of the hardest things to do, is to not do anything, is just to wait for the great opportunities there.
Merryn: Yes, it’s very unusual in fund managers. A lot of fund managers talk about being value investors, talk about waiting for opportunities, talk about patience. But when you look at their turnover, you find that, actually, inactivity is just too hard. They have to do something to justify their existence as an active manager.
Charles: Yes. Yes. I couldn’t agree more. It’s fascinating. We’re having a good year this year. 2014/2015 were not easy years for us. We faced the headwinds that a lot of value managers did.
Merryn: OK. Let’s talk about those headwinds. What were they?
Charles: Value manager was out of favour. It was fascinating. It’s classic investment behaviour and market behaviour. People wanted things that had gone up.
Merryn: So people just wanted to buy things that had gone up and were still going up. They didn’t want to buy the things that offered value.
Charles: And they’re still going up. And anything that looked cheap, anything that had any problems with it kept going down. A great example: Neopost, this little company that does franking machines. So we all know that post is declining and that’s a problem. These guys were well positioned in that they can manage that business. Of course, parcels are growing. So they can cross-sell into their 800,000 customers, small and middle sized businesses. It’s a lovely little business. But everyone was worried about it. Earnings were under pressure, etc. We bought it on ten times earnings and it went down to six times earnings. ten times earnings, there are not many quality companies out there with ten times earnings.
Merryn: Yes. But you say these were bad years. Actually, they must have been brilliant years because it’s very hard for a value manager to find good opportunities, as you say yourself, but if value is out of fashion and prices are falling over two years, this is fantastic for you. Opportunities abound.
Charles: Relative or absolute, Merryn. Relative or absolute. This has been the problem. It’s interesting. A couple of other points on the fund: We have up to 20% cash, and that’s all about conviction. If you’re not finding other beefs we have with the industry, let’s face it – If you trade 100 times a year, chances are you can probably find a buy and sell on the same day. If you trade twice a year, what’s the chance of finding a great high conviction buy and a great high conviction sell in the same day? I haven’t done that. I’ve been in the industry about 25 years now. I’ve never had the same high conviction sell and buy deal on the same day.
Merryn: You generally have quite a high percentage of cash. It’s what, at the moment? 15%?
Charles: Yes, 14. We’re sitting around there. Our problem is, I think, value has faced headwinds and there are opportunities, and we think our opportunities are really exciting. Our major concern, is in absolute terms, the markets don’t look easy.
Merryn: Before you get onto the markets, at the moment, let’s talk a bit about what a value investment is. When you’re looking for a stock, one of these 29 gems, what is it that makes you pick up one over another? What’s the parameters?
Charles: Talking about individual stocks, the first thing is we are long term investors. We are thinking along ten years. Our turnover is, we say, 15. It has been under ten. Certainly, Geoff and I launched the fund in 2007, and half the stocks that were in the fund in 2007 are still in the fund now. So we have been holding things for nine years. That’s the timeframe we’re thinking in. So, first of all, get an idea of what quality you’re getting all that time. Can you get any conviction whatsoever the company’s going to be around in ten years? IT is a great example. We can’t. So we don’t own IT, by your classic definition. Is Google going to be around in ten years? Is Microsoft going to be around in ten years? Maybe. Maybe not. What does it all look like? We found it extraordinarily difficult to get conviction on that, on a ten year view. So then, once you have an idea of what the value, what you think that company can earn, then it’s fairly easy. What are you paying for it right now? And if you’re getting that at a real discount, if you’re getting that at a real margin of safety –
Merryn: Discount to what?
Charles: When we’re looking at a company, we estimate, we spend an awfully long time trying to figure out what the ten year earnings look like – ie is the company going to be around in ten years? And can it earn any number, what it’s earned in the past, say? And then, once you’ve got an idea, you say, “Roughly, we think this company is earning X”, and we pay up to 12 times that. And that’s it.
Merryn: 12 times it. That’s your number.
Charles: That’s the number. It’s up to 12 times. And why 12? Ideally, as I said with Neopost, we’re probably paying eight for Neopost right now, seven. That implies a really, really strong 15% return, plus. If you do 12, you’re getting an implied return of high single digits.
Merryn: OK. So if you’re ready to buy up to 12, when do you sell?
Charles: We find it very hard to hold anything over 20. So in the high teens, we get nervous enough. Johnson & Johnson, great example. We like the high quality. In 2008/2009, you’re buying that and the stock was around 50 or 60, it was below 60. Everyone just said it’s a dull company, it’s too big, it just wasn’t exciting. And you’re getting out around 11 times earnings. It got up to 17, 18 times and we’re saying, “It’s starting to get uncomfortable”. It became one of the smaller positions in the portfolio, having been the biggest at one point. Then, at some point, you say, “Actually, now, we just think it’s time to go.”
Merryn: Not a value stock anymore.
Charles: Not a value stock anymore. The selling discipline, you have to trim as they rise and that’s definitely our discipline.
Merryn: This is another discipline that’s very, very hard for managers who start off as value fund managers and their initial portfolio can very easily be a great value portfolio but then five years later, of course, it’s not anymore. But they’ve got to know the companies. They don’t want to sell a company if it’s still a really good company, it’s just not, by definition, a value company anymore. But still they keep it. And then suddenly, you find that portfolio’s morphed: What started as a value portfolio is suddenly reinvented as a growth portfolio or as a quality portfolio or whatever it is. So it’s another difficult discipline.
Charles: It’s a discipline and there’s no question about that. We struggle with that. We struggle with making sure we’re happy, and not selling things too early because we do believe trends go on much longer than we’re in the markets. We look at the markets every day. And you get excited, “This thing is gone up for six months. Well, isn’t that exciting?” Industrial cycles last seven years, they say. You look at some of the investments that, the National Grid or an infrastructure or an oil company, they’re making 40 year investments. These trends last longer than you think. So we don’t want to have a high turnover. We don’t want to sell them as soon as they go from 12 to 15. But we definitely bring them down. And there have been good examples of that: As we said, Johnson & Johnson. When they were around 11, we had that as the biggest stock, at 11 times, the biggest stock in the portfolio. At the end, when it was up in the 18, 19, 20 times, that was a 2% holding. So it went from a 6% holding, in the top of our portfolio, down to a 2. We’ve done that recently with Admiral, the car insurer here in the UK, two years ago. They were having a tough time, the whole industry. We stuck that in as one of the biggest stocks in the portfolio. Almost immediately, it ran well. There was a 6% position for us. And now we’ve taken 3/4 of the position back as a 3% position. We sold 3/4 of the shares. We are value conscious. And maybe the last example there would be across the portfolio. We do look at these sustainable earnings. So it’s not headliner news because we want to take as many anomalies out of it as possible, and take into account the headwinds and tailwinds of cycles. But we’re looking at our portfolio and 12 to 13 times what we see is sustainable earnings. I would love it if it was ten but in these markets, we still think you’re getting paid to take that risk.
Merryn: Let’s talk about ‘these markets’. You’re obviously worried about ‘these markets’. What’s that about?
Charles: You need to take one thing into account, that I’m a permanent bear. I’m always pessimistic. I’m always convinced the world is going to end.
Merryn: But history is on the side of the optimist, as someone said to me the other day. History is on the side of the optimists.
Charles: Well, it’s true. But the important thing is it’s how you use your pessimism. I use my pessimism as a tool and I say, “Listen, I’m very nervous about the world and I’m very nervous about anything. This is how high my pessimism is.” So if I get an opportunity and it’s here, oh well, just have to let it go. But if it gets to here, we buy. What we do is inherently optimistic, buying equities.
Merryn: OK. So what’s the pessimism? Well, being in equities at all is an optimistic thing to be doing, obviously.
Charles: Exactly. So I use my pessimism to make sure we have a high enough bar. The few things we get above it, we think, are really good opportunities.
Merryn: What’s the pessimism based on? I suspect MoneyWeek readers are going to know the answer to this but let’s hear your take.
Charles: I’ll tell you. My pessimism is based on history. And history says that bad things happen. And if you can build a portfolio that you think can hold up, irrespective of what bad things happen, you’ve done extraordinarily well. That’s what equity investment is about. So if we can get them at reasonable valuations, imply good numbers, and we think that we have a real spread of businesses and diversification in underlying themes in the portfolio, then that is extraordinarily powerful. What am I worried about?
Merryn: Yes, what are you worried about?
Charles: You name it.
Merryn: Start at the beginning of the list.
Charles: It’s classic. We wrote the last quarterly, I was just rereading it because we’re writing the next one, and it was six days after Brexit. We didn’t predict Brexit. But we built a portfolio that was built for risks. It’s built for storms. And so, when that one came along, that one happened to work out very well for us. We’ve done very well. So what am I worried about? President Trump, for a start. An oil shock, again. Saudi Arabia, the Middle East, is disintegrating. Banking crises. Today, it just so happens, we’re looking at Deutsche Bank and the real question is, is Deutsche Bank going out of business? When clients start running away, when clients start pulling money, that’s a run on the bank and they go bust. Are we going to have another banking crisis? And then there’s the elephant in the room, of course, which is what are central banks doing? I know exactly what they’re doing.
Merryn: We know what they think they’re doing.
Charles: But do we know what’s going to happen? And we have no idea what’s going to happen. They say the future is always unpredictable. It feels especially unpredictable right now. You know better than I do, there’s no safe havens. I was having a chat with an individual yesterday and he was saying, “We’re all worried about risk and we’re all worried about how things are going to go. We have to assume that you’re losing 20% of your assets. I just don’t see how you – because you put the cash in the bank and it turns out you put it in Deutsche Bank. And that goes bust.” Risk is making sure that you have good savings for the long term. But risk cannot be, “I have a million quid now and I want to make sure I never drop below that.”
Merryn: Because that’s simply not possible anymore.
Charles: Because it’s not possible. The risks are too many. You look at the assets and it’s just impossible to see how all the assets…
Merryn: So all readers should assume that at some point over the next, say, five years, ten years, their wealth will drop by 20%.
Charles: I think, on average. I think that’s fair. Can you tell I’m a pessimist, Merryn?
Merryn: Yes, I’m digging around for the optimist.
Charles: But what I do is go buy stocks, and that’s the most optimistic thing you can do because you’re buying an unlimited duration asset. We hope.
Merryn: Let’s move on to the optimist.
Charles: Where are the opportunities?
Merryn: Yes, What’s in the portfolio at the moment?
Charles: Maybe the end of asset allocation, it makes you diversify. We just don’t know. Bonds look horrific but in deflationary times, they can work out. Having some cash makes sense. Don’t put it all in one bank. We believe, certainly, that having a bit of gold makes sense, and equities, long-term assets.
Merryn: Are there any gold companies in your portfolio?
Charles: It’s the biggest stock in the portfolio.
Merryn: And which one?
Charles: I’m talking about why in 2014 and one in 2015 weren’t easy. These were obviously tough times for it. As they bounced along, I bought them. Then, 2016, I’m running them through the roof. Newmont is the biggest stock in the portfolio. We talk about quality. What we do is we often look for areas that are having a tougher time and then you pick the highest quality ones.
Merryn: Gold miners now have had a fabulous run this year. But that’s still a value stock, is it? Has it made the turn yet?
Charles: Yes, they have. It hasn’t made the turn yet, no. We’ve taken about 20% off. But our big holdings tend to be between 4-5%. It was 5% at the beginning of the year. Obviously, it’s done extraordinarily well and now it’s about 7%. But that means we’ve still taken 20-25%.
Merryn: What’s the case for it continuing to do well from here?
Charles: The wonderful thing is talking about how long themes take to play out, and if you look at the world, there is oversupply. Even though we hear a lot about, “Are we investing enough, are we investing enough?” Probably the companies aren’t investing massive amounts. But at the same time, they’ve taken at almost no capacity. Everyone’s just added incrementally. They haven’t grown as fast as they used to. Very few industries you look at, we actually have seen supply streams.
Merryn: But that is one of the consequences of cheap money, right?
Charles: Exactly. I think it’s quantitative easing and also the psychology of the markets. The markets are desperate. Everyone’s got too much money and they’re desperate to support whatever it can. You’re ruining the economics of many industries. So one little downturn in demand and it absolutely destroys you. Swatch is one. I don’t know if you ever looked at Swatch. Swatch is a fascinating company. It’s off 50% from the top so we get interested. Now it’s below three Swiss Francs. They’re swimming in oversupply in that industry and demand is turning down a little bit.
Merryn: Interesting. I was in Switzerland the other day and someone gave me a Swatch. There’s huge piles of them hanging around for everybody so there is clearly an oversupply.
Charles: Swatch is an interesting company because they have the cheap plastic ones but they also have the brands right at the top – the ones where they are charging you £20,000-30,000 per watch. I don’t understand. I wear a £100 watch. It’s 15 years old.
Charles: This is depreciated over time. Over 15 years, it’s a bargain. But it’s just fascinating. The oversupply continues in the industry and the downturn in demand are really hurting it.
Merryn: Back to gold.
Charles: Look all the way around the world, what is the best industry in the world? Gold.
Merryn: Even, it’s one of the very few Industries where there is not oversupply.
Charles: Where the supply is coming off. There is not oversupply but also that you are seeing what has been a headwind turn into a tailwind. Shipping is the other interesting one but we can come on to that.
Merryn: Will all the ships be taken out of? It seems unlikely that that oversupply will go.
Charles: It’s far too early, whereas gold, actually, we are four years into it. The gold price peaked in August 2011, so we are five years into it. But the actual peak and capex, because, of course, the cycles take longer, we tracked the capex of all the major players, it peaked, of course, the year after. They don’t stop things immediately. They continue to believe that it’s going to be good. So it didn’t peak until December 2012. And supply started to shrink in the fourth quarter of 2015. So it took another three years. And we’re only starting to see that come off. What has been a huge headwind for that industry is now turning into a tailwind. And it’s one of the very few in the world.
Merryn: Interesting. So you watch the capital cycle at the same time, yes. And are you watching that for the rest of the quality sector, everything else is still in oversupply? And when will that turn, the capital cycle for the rest of the bit miners? What’s that, two years away?
Charles: We think it’s too early still. That’s why we don’t own any of those. We don’t the BHPs, the Rios. Antofagasta, I think, is a brilliant company and a really lovely, lovely asset. It does copper, if you don’t follow it. It still looks too early to us. It still looks like we’ve got another year, two years. And we love to say we’re long term investors and we don’t jump in two years early. You try and minimise that because the blow-offs at the end can be very painful. This is the thing. So from everything we’ve been looking at, we found it very tough to get conviction on those ones.
Merryn: What about big oil? When we talked the other day, you said that was looking interesting.
Charles: Energy is fascinating because, again, you’re looking at where are some of the very few places in the world where you’ve seen the supply getting absolutely decimated. We’ve seen estimates of up to two trillion dollars of projects being cancelled. We don’t know when that’s going to affect the oil price. But we know that BP and Shell and the Exxons of this world will be around to see it. On a one-year view, we’re still quite bearish. There was the OPEC announcement just yesterday, so everyone’s very excited about oil today. It looks flimsy. On the short term, I don’t buy it. But on a five year and a ten year view, we’re still convinced that those guys will survive. And you just can’t decimate that.
Merryn: Are they in the portfolio? Shell and BP?
Charles: 15% of the portfolio is in that. Gold is between Newmont and a smaller holding we have, it’s about nine.
Merryn: What’s the smaller holding?
Merryn: I don’t know that.
Charles: It’s a little Canadian listed one. We have a small holding in that one. It’s a low cost producer but it is riskier. It’s got more, specific mine risk and it’s in Latin America, in less safe jurisdictions. Newmont, if you’re looking for the blue chip safe one, which we all call it, operates essentially in North America and Australia. So you have very safe jurisdictions. They don’t have any of the single mine risk of a lot of the digger companies. Newcrest, for instance, has an awful lot. They have very low cost production but it’s all in one mine. So if that one mine goes wrong, you’re just bearing a risk. We’re not going to predict when those mines go wrong. And then Newmont is also a low cost producer. So for us, that makes Newmont a very easy one. In energy, yes, we do own BP, Shell, Exxon and, in fact, Statoil as well. We just think there’s the opportunity for the bigger players to be there, it’s very attractive. As always, build it inside out, inside a portfolio. We wouldn’t go punting on it but we think inside a portfolio on a ten year view, these things, they’re the survivors in one of the very few industries in the world where you’re seeing supply absolutely getting hammered right now.
Merryn: What about the banking sector? Would you ever see value there? When I was given the free Swatch the other day, I was at a conference in Geneva and we were discussing the extent to which the big banks of today will be with us in their current form in ten years or will they really be more or less irrelevant as a result of all the regulation changing their business models and as a result of all the new businesses coming up, nipping away at this business, that business, this business, and what’s left in ten years? But if you look at the prices and you assume a long term survival, maybe they would be valuable. I don’t think so, by the way.
Charles: Well done. Leading question. A lot of value investors are looking at a couple of areas that look outright cheap. Banking is one. Tech is one as well. A lot of guys are in tech because if you take all the cash pile out of Apple, it’s on ten times earnings, isn’t it? We have no idea what the sustainable earnings are for Apple. We don’t really care about the cash pile. We just can’t buy that. We just have no view on what it’s going to look like in ten years’ time. My guess is there’s going to be another product that we like better in ten years’ time than we like Apple. The same way it was Nokia and before that it was Motorola.
Merryn: And that could be true of a commerce bank or Lloyd’s or whatever, that it may be that in ten years, there are other financial products that are better for us than the ones being offered by banks at the moment.
Charles: I know a lot of people who say they’re just sitting ducks, that they will lose their best customers and they get left with the dregs. And, Merryn, just the quick answer to your one is that we wrote a paper this summer, saying why we will never own banks. At one point in the cycle, they’re bust.
Merryn: Yes, maybe today.
Charles: And we just don’t want to have to predict when. And Deutsche Bank looks like possibly today. But at one point in the cycle they are bust and we just don’t want to have to make that timing prediction of when they are going to be bust. We really struggle to see how banks will ever be the right thing for us. And that’s fine. It’s a big world out there. We only need to find 25-30 stocks and if we find the right ones, we don’t have to worry about the ones we missed. So we’re fairly happy to leave banks to someone else, people who were much cleverer than us.
Merryn: It’s a great fund manager thing to say, “I just concentrate on the simple stuff. I leave everything else to cleverer people,” by which they mean stupid people.
Charles: Keep it simple. A few big things is better than lots and lots of… You don’t want to make it too complicated if you can keep it simple and stick to your discipline. But, as you said at the beginning of this interview, one of the hardest things is to do nothing. It’s incredibly difficult, especially when times are a little bit tough.
Merryn: And difficult to explain to clients paying you 1% a year as well, “We haven’t done anything this year. But we’re still taking 1%.”
Charles: There are some clients who don’t understand that.
Merryn: They’re paying for strength of character.
Charles: The fund is performing extraordinarily well because of what we did before. I think it’s important for clients who buy funds how long you intend to hold this fund for. If you want to hold them for a decade, then a lot of the time the fund manager should be doing very little, making sure that what goes in is very, very high quality, and then sticking to it.
Merryn: We’ve got a lot of commodities so far. What else is in the portfolio? What else is really interesting?
Charles: I mentioned Neopost at the beginning. We do love our stock-specific risk. That’s a franking machine. That’s a duopoly, there’s only two of them. You’re getting paid a lovely, lovely price. And it’s completely different to what we have talked about. Western Union is a fascinating company, still at about 11 times earrings. It generates brilliant cash flow. And that is the remittance business. It is about sending money from here to there. There’s technology risk. Yes, there is risk. We bear risk all over the place. But if we can build a portfolio that has some commodities in it, some very specific – the energy and gold – but then mix it with things like Neopost and Western Union, you completely differentiate it.
Merryn: Neopost and Western Union.
Charles: Western Union, yes, the remittance business. Also, there’s been a few of our favourites in Japan. Recently, one that’s been doing well is one called Taisho Pharmaceuticals. Call it a Japanese GSK, Glaxo. They’ve got the consumer health as well as the pure pharma. One of their key products of the pharmaceuticals they have, osteoporosis – obviously, that is going quite well in Japan right now. They’ve got an antibiotic that’s done extraordinarily well. But they also have what is seen as the health drink, the energy drink for old people. It’s called Lipovitan and it’s got a 50 year history and it’s got about a 40% market share.
Merryn: What’s in it?
Charles: It’s healthy things. Mostly ginseng and those sorts of natural Asian roots and things like that. It’s seen as very healthy. So I don’t think it’s going to hurt anyone.
Merryn: This is interesting because a lot of value investors are now starting to look in Japan, which, ten or 15 years ago, you wouldn’t have found a value person anywhere near Japan. But now it’s beginning to happen. Is that because people are beginning to notice that Japanese companies are often very cheap and have huge amounts of cash on their balance sheet etc? Is that what it is?
Charles: I hope the value managers were there a few years ago because three years ago, all our screens were 80% Japan. We made a risk decision there. We said we didn’t think it was appropriate to have more than 20% because we were worried about the demographics, we were worried about the political system, we were worried about the banking system. And also about the corporate governance. We were saying will we ever get the money? Our companies are traditional Japanese companies.
Merryn: Corporate governance in Japan is improving.
Charles: And that’s why the share prices have gone up so much. Three years ago, all our stocks were half of what they are now. We had 20%, it’s now double. We’re down at about 15%. And, again, you know what we’ve done there, Merryn? Nothing. We bought the companies three years ago and we’ve done nothing new. We’ve been trimming them, bringing them back as they run and run. But still, our average company has about 50% of the market cap in cash. We’re desperately hoping these glimmers of daylight on the corporate governance side in Japan are starting to come through because our portfolio would be very, very well positioned there. Japanese – and you’d know it better than I would – always say it takes a long time to build consensus but as soon as you build consensus, they move very quickly.
Merryn: And that appears to be happening right now in the corporate governance space. Fascinating.
Charles: We hope so. We hope so. But we don’t need to bet on it. We’re very happy with what we’ve got.
Merryn: OK. I am going to let you go, on the condition – I know this is like having a favourite child and that’s not allowed but – have you got a favourite stock? One to hold for ten years from that portfolio, which one would it be?
Charles: You should never do that because there’s always risk in building a portfolio etc. I would pick four or five. But I’m going to play your game, I will play by your rules and I am not going to give you five. I’d stick with Newmont.
Merryn: Would you?
Charles: Yes. I still think the gold sector has all those fundamentals that really, really help. And what’s especially nice is we live in crazy times. The world is crazy right now. And to have something that is properly, properly diversified – and that in the form of Newmont – is a reserve of gold sitting in the ground. And I think that’s very attractive. It’s the biggest stock in the portfolio. We’re pretty happy that it’s still the place to be.
Merryn: OK. Brilliant. Thank you very much.
Charles: Nice to see you, Merryn.