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   Interview

    Guest Interview:

   Towle & Co.

    1610 Des Peres Road, Suite 250
    St. Louis,MO 63131

    Telephone: (314) 822-0204
    Fax: (314) 822-1255
    E-mail: info@towleco.com

 

    Interview Quarter: 2Q2010

 J. Ellwood Towle
CEO/Portfolio Manager
Christopher D. Towle

 President/Portfolio Manager

  Let’s begin by your describing Towle & Co’s overall investment philosophy?  
  Woody: Towle & Co. is founded on the belief that the public equity markets provide an exceptional opportunity to create capital while partaking in the ownership of corporate America. Greed, fear, short-sightedness, and misunderstanding trigger pricing volatility. When this occurs, as it often does in the small cap universe, assets can become mis-priced relative to their intrinsic value. For the disciplined investor who’s willing to employ a patient, long-term investment horizon, these opportunities yield exceptional returns on invested capital.  
  What is your background and how did you get interested in small and micro cap companies?  
  Woody: I first became interested in equity investing as a teenager, after receiving a few shares of Ford Motor as a gift from my father in the 1950s. Further study of the value pioneers such as Warren Buffett, Benjamin Graham, and Sir John Templeton, solidified my lifelong interest in value investing. My early professional career, however, was spent working for Brown Shoe Company here in St. Louis. That was a foundational experience for me as I spent the last few years at Brown Shoe analyzing and valuing different businesses for potential acquisition. I left that post to form Towle & Co. in 1981 and began managing money for family and friends. As I honed my investment philosophy, sticking to the time-tested principles of value investing, it became very clear that small cap companies were a natural place to invest. Not only do small cap companies most often meet our strict purchase parameters, but they are easier to understand, their management teams are generally more accessible, and the potential for outsized returns is superior.

Chris: As you might imagine, value investing was just part of growing up in the Towle household. Around the dinner table we would talk about stocks and the power of compounding capital over time. During family road trips, Woody would take us on tours of a manufacturing plant or visit a retail location of a current holding in the portfolio. Ironically, my path to professional money management would also detour through the shoe business, as I worked for H. H. Brown, the shoe holdings group of Berkshire Hathaway. I had P&L responsibility for a division of the company which provided exceptional grounding for my work here at Towle & Co. As far as the attraction to small company stocks, by the time I was investing, it had been ingrained in me that they held the greatest potential. Now I’m passing along this knowledge to my own children.
 
  How do you operate in terms of managing the portfolio, is it a joint effort?  
  Chris: We manage the portfolio as a team comprised of Woody, me, and our Director of Research, Peter Lewis. Peter is a CFA who’s been with us now for almost ten years. He began his career as a credit analyst with the Bank of New York and then built and led the internal audit team for Edward Jones, here in town. We all bring our own experience and expertise to the table, and work together on all decisions related to managing the portfolio, from new ideas, positioning, when to sell, etc. Technically, any two members can outvote the other, but we prefer unanimity before moving forward.

Woody: This team effort allows each new idea or decision to be approached from different angles and leads to very candid, dynamic discussions about companies, the impact of news, and the economy. We can cover a lot of ground very fast which allows us to react quickly and effectively when making decisions.
 
  Please explain your overall investment strategy?  
  Chris: At Towle & Co. we scour the equity markets for companies trading at deep discounts to their intrinsic value. We look for relationships such as low price-to-book value or low price-to-sales and through our process we attempt to estimate what an informed buyer would pay for the entire company. This method works well to produce logical buy and sell targets. In all cases we look for well-seasoned, well-run companies with strong market positions. Candidates must also demonstrate characteristics that we believe present potential appreciation in the market of 50-100% within three years. One key to success is to decipher deep value opportunities from value traps and “perma-cheap” situations. Over the course of 28 plus years I believe we’ve proven an ability to do just that.  
  While I understand that large fund investment managers avoid micro and small companies because of liquidity issues, what makes them a better investment choice?  
  Chris: Well, if you are investing billions of dollars or are concerned with monthly or even quarterly pricing of your assets, this area of the market is probably not the “better” choice. However, for more nimble investors willing to take a longer perspective on their investment, this area presents wonderful opportunities. As in private equity, where liquidity constraints may expose discounted assets for an able buyer, we find the public markets to reveal similar pricing anomalies. The lack of liquidity coupled with limited analyst coverage and the short-term impact of news can cause stock prices to trade in wild swings. Whereas a privately-held Board of Directors has the ability to refuse a low offer, the public market will at times present opportunities to purchase quality companies at substantial discounts.

Woody: Much research has been done through the years showing the return advantage of small cap, and particularly small cap value companies over their larger counterparts. Since our primary objective is to grow capital over time, it makes sense that we would set our work in this advantageous environment. As Chris mentioned, the volatile nature of this space creates opportunity. Volatility has only heightened in the last couple decades as more and more money has entered the equity space through the implementation of high-frequency trading, ETFs, etc. We view this as a positive for long-term investors and believe the trend will most likely continue.
 
  How much emphasis do you put on current versus future earnings of companies?  
  Woody: The emphasis for us is certainly on future earnings or as we like to say a company’s potential earnings power. As we look at any candidate for selection we are making a projection of what their earnings will be three years into the future and from that number we extrapolate a target price or true value. With that said, however, ideally what we prefer to find in a company is a strong historical earnings profile. Perhaps, they have stubbed their toe, so to speak, on an acquisition or hit economic headwinds that have knocked them off course, but they have a proven ability to generate strong earnings during favorable periods in the business cycle. An issue then is their ability to get back to previous performance through operational improvements, recovery of revenues, etc.  
  How do you define ”intrinsic, underlying value”?  
  Woody: Simply put, “intrinsic, underlying value” for us is best described as the price an informed buyer would pay for a given company in a reasonable economic environment. While we look at many variables in determining a company’s worth, a key ingredient has always been the earnings power or operating leverage of a given company and what multiple market participants have historically paid for that company and industry.

Chris: There have been over 80 companies either merged or acquired while held in our portfolio. These transactions have often resulted in sizable premiums paid over our cost basis. This has certainly been a boon to our returns over the years and something we anticipate will continue. With the amount of cash sitting on corporate balance sheets today and greatly improved credit markets, we believe M&A activity will pick up considerably in the years ahead.
 
  How frequently do you adjust your earnings and other target estimates?  
  Woody: We make a practice of reviewing projections at least quarterly, however, information flows about a particular company or industry can trigger an ad-hoc review. Such reviews may result in adjustments, either up or down, but do not always result in a change of target.

Macroeconomic news may also cause estimate reviews, as was the case during the financial panic of 2008-2009, when many targets were adjusted.
 
  Please give us an example of a company you consider to be undervalued?  
  Chris: One company which we really like today is Aircastle Ltd, symbol AYR. They are engaged in the acquisition, management, and lease of over 130 commercial jet aircraft in approximately 33 countries across the globe. The management team possesses deep technical knowledge of all aspects of aircraft asset management and runs a high-quality portfolio in terms of geographic diversification, customer type, and credit quality. At a current price of roughly $9, AYR trades near 50% of tangible book value with a 2011 estimated P/E of 7.7x and a 4% dividend yield. With a market cap of less than $800MM, we believe earnings power is around $1.90/share providing a selling target of $17/share.  
  What steps do you take to control the volatility of your portfolios?  
  Chris: Investing in small capitalization companies is inherently volatile. Single positions can move 10-15% or more in single trading day. Rather than attempting to mute this volatility, which can prove difficult and costly, we believe it makes more sense to maintain a long-term perspective and look beyond short-term volatility. With that said, we do work diligently to maintain a diversified portfolio of quality companies and to trim and add to positions as appropriate.

Woody: Our primary concern has always been the permanent loss of capital. If we acquire companies at a discount to their true value, we provide, by default, an appropriate margin of safety. Ideally, we make purchases at the inflection point of an earnings expansion. However, that is an impossible task, so it is not unusual for a position in our portfolio to drop below the original cost basis. When that occurs, we review our original thesis. If our conviction holds, we may add more to the position. Some of our biggest winners of all-time have been holdings that dropped more than 50% from their original cost basis.
 
  What measures do you use that tell you when to sell your holdings?  
  Woody: There are three reasons for selling an entire position; 1) it has reached its sell target 2) we have lost conviction in the name 3) there is a more compelling alternative. The first reason is obvious. As a position approaches its sell target, we review the company and if no change is warranted to the target, we will let it go. Upon any review in which we determine our original thesis no longer holds up, we will sell the position. The third scenario, which does not happen as often, is less black and white. At times when cash levels are low we may be presented with an opportunity so appealing it warrants the sale of an existing position. In that case the decision would come down to appreciation potential of the two companies, tax ramifications of the sale, etc.

Chris: We will also “trim” positions for differing reasons. A position may be sold in part if its weight in the portfolio becomes too large. A typical position for us is 2-3%. A higher conviction holding may get as high as 6-7%, but that is rare and we don’t move beyond 10% in one position.
 
  What measures do you take to diversify your portfolios?  
  Chris: Typically we invest 2-3% of managed assets in each of some 35-45 companies and seek to maintain a balance across sectors. It is important to understand, though, that we do not follow benchmark weightings nor do we shy away from a reasonable amount of concentration in our best ideas. Certain securities may be over-weighted depending on the team’s assessment of the company’s future performance, understanding of the business, and/or recognition of the potential appreciation. We believe a certain amount of concentration is necessary in order to generate superior returns.  
  On your website you talk about periods of market disruption. Under what conditions do these disruptions happen and what steps do you take to help protect your portfolios?  
  Chris: We have worked very hard over the last couple of years to improve our ability to gauge the environment surrounding equity investing. While we make no effort to “time the market” it is critical to be ever watchful in our effort to preserve capital, as well as discover opportunities. Our internal analytical tool which guides our process is called ACME and monitors four areas of interest: Asset Valuation, Cost of Capital, Market Dynamics, and Economic Conditions. Each area is composed of several components, supported by years of historical data, and yields a reading as to the current state of the area and its relationship to the environment for investing in equities. Positive readings from these metrics support a fully invested portfolio, while negative results caution a more defensive approach. Depending on the macro picture a defensive or less cyclical approach for our portfolio may mean moving to higher quality companies i.e. those with more stable cash flows and earnings, or increasing our cash position, or some combination thereof.

Woody: It’s important to mention that our preference is to remain fully invested. We believe it is difficult to determine when upward movement in the market will occur. Research, in fact, has shown that 80-90% of stock returns occur in spurts that amount to only 2-7% of the total holding time. You simply can’t predict when the market will move up, but it’s certain you will miss it if you are not invested. Unfortunately, many investors were on the sidelines in the spring of 2009 and missed the tremendous lift off the bottom. For us the challenge remains to better identify those times when valuations and economic variables indicate periods of excess and, consequently, to respond by protecting capital accordingly.
 
  Before committing funds, what steps do you take to research your companies?  
  Woody: Research of any company begins with a thorough financial review that includes the analysis of historical and current profitability, liquidity, leverage, and asset management. This effort is supported by an examination of the industry’s dynamics and prospects as well as the company’s position within the industry. Contact with management can yield a better understanding of the company’s current outlook as well as the management’s willingness to consider value-enhancing activities, including merger and acquisition transactions. As the process continues, we project the company’s earnings power, cash flow generating capability, and financial condition. Private market transaction values and profitability characteristics of comparable companies are also utilized to determine the company’s fundamental earnings potential over the next three years. For inclusion in the portfolio, the company’s three-year earnings potential needs to provide a minimum return of fifteen percent. We call it Return on Market Value (ROMV). For example, a $10 stock dictates earnings per share of at least $1.50.  
  Where do you get your investment ideas?  
  Chris: Investment ideas can come from many different sources. We run screens weekly, based on our deep value metrics to discover companies trading in our space. We are all active readers and ideas come from the news or industry publications, research reports, analyst commentaries, etc. Many of our clients are business owners and investment ideas have come from conversations discussing activity in their industries or specific opportunities they have encountered. Woody religiously follows companies and industries through Value Line and that has been a great resource for decades.

Woody: We also will have ideas brought to us, from time to time, from institutional brokers. Through the years we have developed a few relationships with people that really understand our business and the types of opportunities we like to see. These resources bring ideas and also serve as good contacts for monitoring the markets, specific industries, and the economic environment.
 
  To what do you attribute your performance over the last 15 months?  
  Woody: First and foremost, we viewed the market in early 2009 as a once in a lifetime opportunity for investing in equities. Companies were trading at valuations that just didn’t make sense. While others were moving out of stocks we were fully invested at the bottom in March. Since that time we have worked diligently to trim or sell positions as they got ahead of themselves and redeploy capital into new or existing names with greater upside potential.

Chris: If you look at our historical returns you will see similar periods. Coming out of the credit crisis of 1990-1991, following underperformance for many months, we hit a stretch of significant, multi-year outperformance. To some degree that is the nature of our strategy. Returns can be lumpy. In light of the economic recovery now underway, the current equity market appears attractively priced. Even if growth remains muted, we believe long-term equity investors will be well rewarded.
 
  Who are the principals in your firm?  
  Woody: Chris is now majority owner of the firm, and I own the remainder. We have always enjoyed running a small, independent firm and believe it preserves the ability to do what’s best for our clients through all business and market cycles. The vast majority of our own personal capital is invested in the strategy and I believe our clients appreciate that their portfolios are managed in line with the firm’s principals.  
  Do you have a website or newsletter that can give investors additional information about Towle & Co?  
  Chris: We do have a brand new website at www.towleco.com. Hopefully, it provides beneficial information regarding our firm and deep value strategy. One can also signup to receive our quarterly investor letter through the website. The letter is a critical line of communication for our investors, containing our thoughts on the investing environment as well as a discussion regarding the portfolio’s composition.  
 
 
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