He Buys What Everyone Else Is Selling
The manager of a little-known fund has compiled a terrific record by staying true to his contrarian instincts.
In describing America more than 170 years ago, Alexis de Tocqueville may have unwittingly anticipated the nature of modern financial markets when he wrote that he knew of no other country in which there was "so little independence of mind." Nowadays, once people become fixated on the desirability of a particular investment, they pile on, often mindlessly, boosting its price and creating a self-fulfilling prophecy. The cycle eventually ends, and many investors, particularly those who have arrived at the party late, take a licking.
Fighting the tyranny of the majority is a dangerous game. Robert Kleinschmidt, who runs the aptly named Tocqueville fund, knows just how dangerous because he approaches stock picking from a diametrically opposed perspective. If the crowd loves a stock, he stays away; only when a stock is reviled does he get interested. And even if his analysis that the crowd is wrong is right, Kleinschmidt may have to wait a long time before the majority accepts his position.
This master contrarian has delivered stellar results since taking over the Tocqueville fund in 1992. The '00s have been particularly successful. The fund (symbol TOCQX) beat Standard & Poor's 500-stock index each year between 2000 and 2007. Over the past ten years to June 2, the fund gained an annualized 7%, beating the S&P 500 by an average of three percentage points per year.
To learn more about this independent thinker's approach to stock picking, read this edited version of our conversation with Kleinschmidt.
KIPLINGER'S: You're more than halfway toward tying the record for the most consecutive market-beating years. What's your secret?
KLEINSCHMIDT: Actually, that's not what I'm most proud of. What I'm most proud of is the fund's dramatic underperformance in 1998 and 1999.
Our underperformance showed we didn't try to do what we didn't know how to do. I didn't chase things that I didn't understand and whose prices violated my disciplines. I couldn't bring myself to participate in the madness -- the run-up in the 50 biggest stocks in 1998 and the Internet craze in 1999 -- even though it was costly in the short term. But in many respects, the performance since then owes a debt to what we did not do in 1998 and 1999.
Is being a contrarian the primary driver of your investment approach?
Unless you're an ideologue, it's not a good idea to label yourself when you invest money and then confine yourself to the label you've created for yourself. What draws me to a stock is what I perceive to be a negative investor consensus. So I guess you could say that's contrarian. Most of the ideas in this portfolio are stocks for which the prevailing investor consensus was negative when I bought the stock.
Is the consensus always wrong?
No. Very often it is right. My colleague François Sicart likes to say, "Just because everyone says it's raining outside is no reason not to take an umbrella." It's just that the consensus is a very hard place from which to make money because, in most cases, the consensus view is priced into a stock. So I look for stocks for which the consensus is negative and try to make the case that over my time horizon, which is three to five years, the consensus will change.
Didn't some contrarians buy Google after it went public on the grounds that the market didn't appreciate its growth potential?
It's not a stock I owned at $100, but when the stock fell from about $750 last fall to the low $400s in March, I was buying. I now have a 1% position in Google and a profit of $100-plus per share.
Do you pay attention to the economy when buying stocks?
No. It's cocktail chatter. I run the fund almost entirely from the bottom up, stock by stock. But I own some things that are based on top-down judgments. I recently bought an exchange-traded fund called Horizons BetaPro NYMEX Crude Oil Bear (HOD-TSE).
You're betting on oil prices falling?
All the oil-company executives we speak to say they can make money at $40 to $50 a barrel. At $139 a barrel, the rate of return is very high, so I'm convinced that there will be more supply. I'm also convinced that high prices will result in substitution of other energy sources for oil as well as dampen economic activity. As a result, I'm confident (although I've been wrong so far) that when people wake up and see that the emperor really isn't wearing any clothes, the price of oil will fall precipitously. Of course, as my son says, markets can stay irrational longer than you can stay solvent.
Does your portfolio reflect any other top-down calls?
I own an exchange-traded fund that's tied to the Japanese yen. Everybody thought that the yen would fall because players in the so-called carry trade were selling the yen short to take advantage of interest-rate differentials between Japan and the U.S. But that kind of trade has never made a lot of sense to me because the movements in the currencies can quickly swamp the rate differentials. The yen has strengthened and still has a way to go, but I've reduced my position in the ETF.
Where do you get your ideas?
About half the ideas in the fund originally came from me, out of the ether. The other half come from other parts of the shop. When you look for companies with negative investor psychology, you don't have to look very hard because that psychology tends to get publicized. I've never been a fan of screens, but I do look at the new-lows list. There isn't a good systematic way of finding cheap stocks. By definition, it has to be an eclectic process.
What stocks have you been buying?
One recent purchase was PNM Resources (PNM), the old Public Service of New Mexico and the largest utility in the state. Until recently, the utility had not had a rate increase for many years. But my hope is that the state will grant PNM a fuel-price adjustment. Revenues from that adjustment would swamp the revenues from the recent rate increase. Unless the governor decides that the largest utility in New Mexico should go bankrupt, PNM will get reasonable regulatory treatment, I believe. Under $15 a share, the stock is a reasonable bet.
What else have you added to the fund?
I bought Zoltek (ZOLT) after the stock broke down from $50 to $20. It's a carbon-fiber company [and a member of the Kiplinger Green 25]. Half of its sales go into turbine blades used for wind power. The company is having some internal problems, and there are questions about its accounting, so there was a lot of negative investor psychology. My feeling is that no matter what happens to the price of oil, governments will be subsidizing wind power until kingdom come, so this is a good opportunity.
Any other recent buys?
I also bought Steelcase (SCS), which is a well-run midwestern company that makes office furniture. The stock dropped from $18 to about $11, where I was buying it. One reason for the decline was that Steelcase paid out a special dividend because it had built up so much cash. The other reason is concern about the U.S. economy. But it turns out that Steelcase is growing rapidly overseas. It generates a lot of cash, and the stock yields 5%.
I also just started nibbling on Kohl's (KSS), the retailer. The stock is down from the mid $70s to the mid $40s. If the economy does better, it should do better. If the economy does worse, then consumers should trade down to it.
Pfizer is a large holding, and you also own Bristol-Myers Squibb. Talk about a despised sector.
Big Pharma satisfies a number of our criteria. First, the stocks are truly out of favor. Second, the stocks are cheap on any measure by historical standards. The companies generate strong cash flows, which could be even stronger if they were to reduce their largely unproductive research-and-development expenses. The storm clouds over their heads are very well known. Everybody knows that there's governmental pressure on pricing and that it's getting harder and harder to get new products through the Food and Drug Administration.
You then have to ask whether the drug business is a good business. On balance, the answer is yes. You have a large but rapidly growing customer base. Maybe prices for your products will be under pressure, but the demographics are in your favor in this country, in Europe and in Japan, so you can be pretty confident that your volumes will be good. And although the demographics are not necessarily in your favor in emerging markets, the economics in those markets are in your favor. As those countries become wealthier, their populations will be more likely to use drugs because they'll be able to afford them.
What's the catalyst to get the group moving?
The consensus will change when there's widespread recognition that drugs are part of the solution for health care, as opposed to being part of the problem. If you think medical costs are a high percentage of the economy now, imagine what they would be if you couldn't solve a lot of medical problems with a pill and had to solve them some other way. Using pills is a cost-effective way of keeping people out of hospitals, preventing operations and avoiding use of medical devices.
Yes, drugs will come off patent, and that's an issue for Pfizer and some others. But these companies are not going to sit around, wait for the drugs to come off patent and then say, "Oh, my goodness, we'd better do something." They're focusing on the problem right now. Pfizer (PFE), for example, has an immense and talented sales and marketing force. So it's in Pfizer's best interest to partner with smaller companies with promising drugs, and I think it will. In any case, you have a margin of safety when you can buy these stocks at ten or 11 times earnings with yields of 5% or 6%. If you buy Pfizer today at $20ish and five years from now it's $30ish, and you collect a 6% dividend along the way, that's a hell of a good return for not a lot of risk.
Speaking of an out-of-favor sector, you've also bought financial stocks, such as AIG, Fannie Mae, MGIC and Moody's, in the past year.
It turns out we were early, but in these types of things we will always be early. There's both a cyclical and a long-term, secular case for these companies. The secular issue is that everything is lining up for there to be less leverage in the overall economy. Less leverage on consumers' balance sheets, less leverage on corporate balance sheets and, most important, less leverage in financial companies. For example, investment banks may go from being leveraged 33 to 1 to being leveraged 20 to 1. And consumers, instead of thinking they should have no equity in their homes, may decide it's better to have 20%, 30% or 40% equity in their homes. Deleveraging throughout the economy could be seen as a long-term negative for financial companies from an earnings point of view -- the more leverage they have in their balance sheets and in their businesses, the greater the assets they control. But deleveraging is likely to make these companies more stable in the long run.
And what's the short-term case for financial stocks?
Cyclically, the lock-up that occurred in the credit markets was a hyperbolic overshooting of this trend toward less leverage. All of a sudden, people weren't willing to take any credit risk. As a result, a lot of these companies are dirt-cheap, and you can make a lot of money with them as the next cycle unfolds.
When do you sell?
Some reasons are easy. I sell when I'm really right or when I'm really right sooner than I thought I would be. And I sell when there's a portfolio issue. I don't like to have more than 4% to 4.5% of the fund's assets in any one position. I also sell when I realize I've made an egregious error -- whatever scenario I constructed to persuade myself that the problems of a company were temporal in nature was inaccurate.
An example of that?
A recent example was Lee Enterprises, a small newspaper chain that in 2005 bought Pulitzer, the owner of the St. Louis Post-Dispatch. Lee, which operates mostly in small markets, took on debt to buy Pulitzer, and it did so in the face of a long-term decline in the newspaper business. That was something I was fully aware of. But now you have a more cyclical decline based on a softening economy. So you have a combination of a softening economy, some lack of execution and the higher leverage, and I concluded that it's going to be a very long time, if at all, before Lee rebounds.
When is the sell decision more difficult?
François Sicart likes to say, "Just because a stock goes up is no reason for you to sell it." As a value investor, it took me a long time to learn that lesson. So I'll hold a stock that has done well as long as I don't see the euphoria opposite of the investor psychology that I saw when I first bought the stock. For example, I have sold almost all of my commodity and energy stocks because of the euphoria in those areas. Murphy Oil and Schlumberger are the only ones I still hold. Murphy is my largest holding; I've owned Murphy for 15 or 16 years. Sooner or later, probably the day after I die, the company will be sold to a much larger oil company. My obituary will say: "He knew they would sell the day after he died."