Q: What is your background, Ron, and why did you decide to start an investment firm?
A: After graduating from Miami University in 1982, I was hired to establish an internal research effort for an investment advisory firm, Dean Investment Associates. At the time that firm was relying on outside research and portfolio management services. In 1984, Dean severed the relationship with its service provider. Rob Suttman, a University of Notre Dame graduate, was there at the time of transition, and we immediately brought in Mark Brady, another graduate from Miami University. The three of us formed a triangle of responsibility, serving as the Directors of Client Service (Rob), Portfolio Management (Mark) and Research (myself). It was a leap of faith for Dean since each of us were only 24 years old, but it turned out to be a good move for them and us. The strong performance we generated helped the firm boost assets from $180 million in 1984 to $7.3 billion in 1993. The three of us (EBS) wanted to close the door to new assets so that we could preserve the efficiency of our small and mid cap investing. The owner of the firm felt differently, so EBS was born. Although our corporate history dates to 1993, the three of us have worked together for more than 18 years.
Q: Ron, could you please elaborate on the three investment themes EBS uses to define investment value.
A: First, we focus on understanding intrinsic value of the companies we evaluate - that is, the price that a knowledgeable person would pay for an entire company. The approach emanates from a Graham and Dodd discipline. We concentrate on the underlying economics of companies while ignoring the ever-changing sentiment of other investors. Our objective is simple: Get more than we pay for - buy dollars for 50 cents.
Second, we want to buy the best businesses possible at a discount to intrinsic value. This requires a deep understanding of a company's operations and the metrics that define good businesses. For example, we like companies that generate strong cash flow, have low capital investment needs and produce high returns on capital. These characteristics are often found in franchise-type companies, low cost producers and industry leaders.
A third theme in defining value relates to margin of safety (risk) in our investments, which is a byproduct of the first two themes. On the reward side of the equation, we can prosper because of rising intrinsic values and shrinking of valuation discounts (as typical price-to-value ratios rise). In more normal investment speak, if cash flow per share rises 16% in a year and the price to cash flow multiple rises 14% from 7 to 8, we gain 30% in the stock price. The risk side of the equation is equally as important. We can be protected by either the discount at the time of acquisition and/or the quality of the business. We only have to correct on one front and still provide some margin of safety. Building a portfolio with this approach has historically produced high returns with low volatility, something investors increasingly appreciate.
The investment world is generally separated into two distinct camps * growth and value. Typically, growth managers are viewed as those who are willing to pay a premium to own fast growing companies. Value managers tend to be classified as buyers of statistically cheap companies. Our perspective is different. The core of our investment philosophy considers value and growth as part of the same equation. Growth is the aspect of what you are going to get at some point in the future and value is how much you must pay today to receive it.
We are not interested in stocks that are selling for low price-to measures if we do not see an opportunity for the value of the business to grow. Likewise, revenue growth rate is meaningless unless it is accomplished in conjunction with a return on capital that exceeds a reasonable rate. We have found that many companies destroy shareholder value by concentrating on revenue or earnings growth without regard to the amount of capital deployed. In our analysis, we attempt to distinguish between the capital a company needs to grow the business versus what is needed to sustain the business.
Q: Please explain how you use quantitative and qualitative methods in your investments.
A: Our investment process involves both quantitative and qualitative methods. Quantitatively, we look at the economic characteristics of a business to arrive at what we deem an intrinsic value. This analysis considers the company's financial strength, anticipated cash earnings, return on capital, capital requirements, etc. On the qualitative side, we consider a company's competitive position, quality of management, compensation structure, insider ownership, corporate culture, risk of obsolescence, and other factors. Management compensation is closely scrutinized to ensure that incentive comp is tied to the metrics that reflect the creation of shareholder value. Our experience indicates that long-term success is highly correlated to the quantitative and qualitative measures painting a consistent picture.
Q: Would you describe yourself as a top down or bottom up investor?
A: We are bottom-up. We are constantly on the hunt for the best price-to-value relationships on the street, without regard to index sector weighting. We do not use macro economic analysis or interest rate forecasting in our security selection process or asset allocation decisions.
Q :What steps do you take to avoid the "herd mentality" on Wall Street?
A: We call it "group think" in our shop, and certainly recognize the importance of keeping emotion out of the investment process. It is a difficult task during periods of great volatility for most investors. The field of behavioral finance is gaining prominence, but is not a new concept. Charles Mackay, who wrote "Memoirs of Extraordinary Popular Delusions" in 1841, detailed several early examples of investor "herd mentality". In 1634, Tulip mania captured the imagination of the Dutch before imploding. Less than 100 years later, the South Sea Bubble swept through England. The common theme that we have seen is that investors tend to be emotionally driven by either fear or greed.
We rely upon our investment process to maintain an objective outlook. Our first line of defense comes from shunning sell side research. We conduct our own independent analysis. It's very time and labor intensive, but worth the effort. Whereas the street focuses on quarterly earnings, we focus on long-term corporate value because we expect to hold securities three to five years.
Adhering to our discipline keeps our focus on absolute values, not just relative ones. And, Wall Street's fascination with momentum holds no appeal to us. In fact we think opportunities can be created when a company's quarterly results fall short of expectations. It is fascinating to observe that the appeal of a security grows after the price increases. This approach is completely opposite to the way consumers behave with other purchases. Last, it is part of the herd mentality to own recognizable names. To EBS it is far more important to own the right names, not popular ones.
>Our focus is to capitalize on market opportunities that appear during periods of investor fear and to avoid the inherent risks that exist during periods of euphoria. Warren Buffett has said he prefers to operate in an environment of pessimism because pessimism drives prices lower, creating opportunities. Our experience confirms this, which explains our enthusiasm about the investment opportunities we find available today.
Q: How important is the quality of the management team in choosing your investments?
A: The quality of management is an important consideration with any investment - but especially in the small- and mid-cap securities that we tend to favor. The smaller the company, the more likely it is to have a void in top and middle management. Small companies are at the stage of evolving from individual people to an organization that takes on a life and culture of its own. The CEO is usually an entrepreneur and there is the risk that his/her vision and talent are not transitioned to the culture of the company. Confidence in the CEO and top management is vital in these situations. In large companies, culture usually proves more important. We place great importance on a management team that not only knows how to run their business, but also understands what creates shareholder value.
Q: What do you mean when you say you prefer to invest in "franchise-type businesses?
A: Franchise type businesses have a competitive advantage that is difficult to replicate or dislodge. Often these companies have dominant market positions, are low cost producers, have strong brand-name recognition and pricing power. These companies are capable of generating consistent above average returns on capital far into the future with a minimal amount of additional capital needs.
These characteristics are often associated with large companies like Coke, Gillette and Microsoft, but can also exist in small and mid sized businesses. Examples include Tootsie Roll, Smuckers, and International Dairy Queen, a position that we held for several years until Warren Buffett purchased the company.
Another company that fits this mold is NVR, Inc., which operates in the unglamorous homebuilding industry. The street seems uninterested in the company because of its correlation to interest rates and the economy and the stock is trading at modest price-to measures. We see an attractive business. NVR utilizes very little leverage (debt), generates health return-on-capital measures and has shown consistent growth the past 10 years. An understanding of return on capital and the importance of the balance sheet are prevalent in the division managers. The company is usually the number 1 or 2 player in each of its markets, has an identifiable name (Ryan Homes, Fox Ridge Homes and NV Homes) and is a low cost producer. Insiders own a significant stake and the company has been very aggressive in repurchasing shares.
Q: How did you avoid last year's "bust" in the high tech sector?
A: Our avoidance of last year's "tech wreck" is the result of our value discipline. An important component of this discipline is found in what we don't do. Our typical avoidance of technology-related investments is not because we are technophobes. We are enthusiastic consumers of technology in our day-to-day business, but we believe that determining the long-term winners in this industry is a difficult task.
The pace of change and rate of obsolescence makes it nearly impossible to gauge what a company will look like five years out, let alone what its cash flow will be. Continuous price erosion and large capital investment requirements for product development are also difficult hurdles. It is amazing to reflect on the pricing pressure of most technology companies. In 1977 the cost of one megabyte of memory was $5,000. By 1994 this cost fell to $6 and today a megabyte costs about 11 cents. As a business owner, you prefer to operate in an environment with some ability to raise prices.
An important component of any investment bubble that we have studied is the flow of capital. Whenever large amounts of money are directed toward a specific area, future returns are unpleasant. The capital investment results in excess capacity, which destroys profitability. The tech bubble clearly fits this pattern, but so did the energy bust in the late 70's and the real estate market in the late 80s.
>We were astonished at the valuation of Internet and technology companies during this period. Despite tremendous pressure from clients to jump on the bandwagon, we did not and followed our discipline.
Q: Do you ever use cash or marketing timing?
A: Most of our institutional clients restrict the use of cash in their portfolios, so market timing isn't a consideration. However, we do manage balanced accounts where we have some latitude versus the benchmarks. Typically, the equity exposure in these accounts ranges plus or minus 10% around benchmark targets. Primary factors affecting the equity exposure include our bottom up analysis and absolute valuations. We do not view ourselves as market timers.
Q: What resources do you use for your investment research?
A:We employ a wide range of resources and tools in our research effort. Ideas are generated from many sources, including database screens, Value Line reports, periodicals and a knowledge base of companies that goes back nearly 20 years. Street research sometimes gets us up the learning curve quickly, but we rely upon internal analysis for the final decision. Studying company filings and reports coupled with management interviews and discussions with competitors round out our process. Ultimately, we also pass judgment on other companies in the same industry.
Q: How do you manage risk?
A: Purchasing securities at a substantial discount to intrinsic value creates a margin of safety in our investments, which we believe is the best method of minimizing long-term risk. This reduces the risk of permanent capital loss in any single position. Equity portfolios normally have between 25 and 35 positions, an adequate number of securities to capture a significant portion of the benefit of diversification. We prefer to own a larger position in companies that we know very well, which allows our winners to have a measurable impact on the portfolio's performance. Of course this is a double-edged sword, which necessitates a high level of confidence in our assessment of a company's value. In order to avoid compounding any misjudgments, we limit an individual position size to approximately 5% of the portfolio at cost.
Q: What factors into your decision to sell a security?
A: There are four reasons we will sell a position.
· It has become fully valued based upon our appraisal of intrinsic value.
· Company fundamentals, management, strategic direction or the long-term outlook for the business has deteriorated. A rising or falling stock price does not by itself signal this condition, but will cause us to review our assessment.
· Other stocks are more compelling. We evaluate each stock against current and potential holdings to determine which businesses offer the best price to intrinsic value relationship. Occasionally we will replace a position that has not reach fair value but is less compelling than the value found in another business.
· We made an error in our assessment. Evaluating the intrinsic value of a business includes judgments regarding management, margins, business prospects and industry outlooks. When we make a mistake, we correct it and move forward.
Q: How do you use portfolio managers to help with client communication?
A: We do not employ the typical portfolio manager system. EBS has relationship managers instead of traditional portfolio managers. They are the primary point of contact with clients and are responsible for serving client communication needs. We work as a team in our decision-making. Each account will be assigned a relationship manager and a portfolio administrator/trader. The Investment Committee and research group work in concert with the relationship manager assigned to each client. Together, they manage the portfolio based on objectives specific to that client.
Q: Tell us how you implement your client guidelines.
A: Clients engage EBS to manage specific strategies. Equity strategies include Small, Smid, Mid and All Cap portfolios. The equity component of Balanced portfolios is All Cap in nature. All clients with similar strategies are invested in a similar manner and portfolio administrators ensure compliance with specific requirements and/or restrictions. However, special consideration is given to taxable portfolios.
Q: How much emphasis do you place on after tax investment returns?
A: For our taxable client base, we actively manage for after-tax returns. We recognize the inherent advantage that a long holding period creates because of the compounded growth of deferred taxes. Our annual portfolio turnover is quite low, especially relative to many of today's mutual funds, which operate with an annual turnover that often exceeds 100%. The obvious result is that the majority of their gains are taxed as ordinary income. This is not an enjoyable situation on April 15th for an individual in the higher marginal tax brackets.
What is less obvious for many people is the benefit of a lower tax rate (capital gains versus ordinary income) compared to the benefit of the tax deferral when considering a tax-efficient strategy. The longer the time horizon, the greater the benefit derived from the tax deferral.
Our low turnover, long-term holding period and routine loss harvesting creates tax efficiency without compromising our mission of striving to provide a superior, risk-adjusted return for our clients.
Q: What methods do you use to communicate with your clients?
A: Routine client communication includes quarterly reports, periodic security and market updates, face-to-face meetings and a newsletter. Relationship managers are also available as often as necessary to satisfy clients' individual needs.
Q: Who are the other principals in your firm and what are their backgrounds?
A: Bernard Holtgreive is also a Partner at EBS. He joined our research team in 1987 after graduating from University of Dayton with a B.S. in economics and finance. His primary role continues to be security analysis.
William Hazel joined our firm in 1997, after 4 years at another investment advisory firm. Bill's responsibilities include client service and marketing. He holds a degree in management from Capitol University, Columbus, Ohio.
Please describe the "typical" EBS client.
A: Our typical client is a diverse group including individuals, trusts and institutions. Individuals tend to be high net worth and/or small business owners with personal assets, retirement assets and trust accounts. Our institutional clients include public funds, private corporations, foundations, Taft/Hartley accounts and funds of funds.
Q: What are EBS's plans for the future?
A: We have a narrow focus and a simple view of the future. Know our area of expertise and excel at it to the best of our abilities. Value investing may or may not be in vogue at any particular point in time, but we believe it is the winning long-term strategy. If we do a good job at producing returns and serving clients, then our business will take care of itself. Last, we keep a watchful eye of the aggregate assets that we invest. We don't want to grow too large, because it would affect the securities that we can buy and sell. We can only hope to have the good fortune to close our doors to new clients, someday. At $650 million in assets, we have plenty of capacity. We can continue to effectively manage up to $1 billion in small cap assets and $2.5 billion in mid-cap assets.