Picking
the Dirt, Peeling the Onion: |
By Richard Hefter, Editor, Small Cap Manager Phillip Butts doesn't mince words about the market. "My outlook over the next 2-3 years is bleak," he says, noting the Dow could sink to as low as 4000. But the 12-15 stocks in his concentrated, small-cap-emphasized portfolio are not market correlated, or so his strategy aims. They're value stocks with catalysts for growth that his risk analysis shows have limited downside. Gauging from the returns of his private accounts, which were up substantially in 2000 and 2001 but gave back some in 2002, his formula is working. Butts, a former Vice President with Donaldson, Lufkin & Jenrette and Senior Vice President with Salomon Smith Barney, shares the strategy behind his three-year-old Santa Barbara-based Silver Creek Equity Management firm, which runs $5-6 million in private equity accounts. |
 Phillip Butts |
What's your strategy?
I try to position 12-15 value, special situation, growth stocks
for my clients in order to provide another asset class in their overall
investment picture. I'm looking for value stocks that have the potential
or a catalyst to become growth stocks. Value managers want to buy $1.00
for 50 cents and sell it for 80 cents to $1.00. I'm looking for $1.00
for 50 cents that can end up being a growth stock that will sell at
$2.00 or $3.00. Many of these are what I call "onion stocks".
What are onion stocks?
These are stocks where you need to peel off a lot of layers over quarters
or even years to realize something that a lot of people want down the
road. Those layers can be debt restructurings, lawsuits, asset sales,
change in management or new product introductions down the road, etc.
I try to position my portfolios and equities so they aren't reliant
on the market going up, or the economy getting better, in order to outperform.
And that's what we've seen. The last few years with the market down
50 percent, I avoided telecommunication and other overvalued stocks
and got into the Mattel's at 10 and the Philip Morris' in the low 20's
-- stocks where I didn't think the market made much difference.
You mix larger cap stocks with small caps?
Yes. I'm a big believer in the "dead money" theory, that if
investors perceive something to be dead money for years they will sell
it no matter how cheap. I don't believe the litigation of Philip Morris
-- the worry of bankruptcy -- was as big a factor as the feeling that
there were going to be years and years and years of lawsuits and the
stock was not going to go anywhere. I understand the tobacco situation
very closely, so I was comfortable with the litigation. I was in oil
stocks when oil was at $12 a barrel and every oil analyst and every
industry analyst was telling us that oil was dead and wasn't going anywhere
for many years -- that there was an overcapacity. That's when I say
fine, but I'm buying these stocks at or below book value and I'll wait.
They're often but not always small caps.
I have a number of stocks at or under cash value, with no debt. I try
to stay a little bit lighter on the debt, unless I really know what's
going on. I bought Mattel when they had no CEO, when The Learning Company
was draining money from them, but I had to have a leap of faith that
the board of directors and management were going to make changes. I
asked: If it all blows up, what can I sell the assets for? What can
I sell Fisher-Price, Hot Wheels and Barbie for in a fire sale? And the
numbers I came up with were about $7-$8 a share, so I was happy taking
a position at $10 a share. I sold it a year or so later at $21.
Why 12-15 stocks, and how do you manage risk, given your concentrated
portfolio?
Everything I've seen in my research shows there's a diminishing marginal
return that takes place when you get above 20 stocks. In other words,
expanding a portfolio to 50 or 100 stocks does almost nothing for performance.
It doesn't minimize downside risk at all. All you're doing is resigning
yourself to tracking whatever index of stocks are in your portfolio.
It just makes the job easier for money managers to go play golf. I think
somebody said if you have two mutual funds in your portfolio you're
over-diversified. I'm not saying that 12-15 stocks should be in your
entire investment portfolio. I'm saying in the 15 percent of your invested
assets that I recommend be in this area, I'm going to have 15 stocks.
Which equates to about 1 percent of your entire portfolio per position.
I try to have all my 12-15 stocks non-correlated, so I'm not overexposed
to any one industry. I like all of them to be undervalued using a number
of valuation methodologies. You really have to go far beyond the P/E,
cash flow, EBITDA kind of common valuation methodologies, and I think
it takes a lot of time understanding them for each industry and each
stock. A lot of valuation is multi-layered and I think the mistakes
that are made are sticking to one particular methodology.
What additional methodologies do you use?
Let's look at Tenet Healthcare (THC), for example, here in Santa Barbara,
which I had been purchasing in the mid-to-high teens in the late 1990's
and sold it at $30 or so. Later, when it was at $50 or $60 the market
was really only looking at the P/E. In hindsight they were charging
clients too much, pushing earnings numbers higher. If you were looking
at another valuation parameter -- the price you're paying in the market
cap per hospital bed -- you were paying $1 million per bed. Any rational
investor would just run away from something like that. So, that's why
I avoided it. It is now in the mid to low teens where the valuations
are more reasonable.
On the other hand, for instance, one of my favorite stocks right now
is UnitedGlobalCom (UCOMA), which owns almost 70 percent of the largest
cable company in Europe, and John Malone and Liberty Media own 75 percent
of UnitedGlobalCom. But too much emphasis was placed on current cash
flows before the debt restructuring, indicating the stock was overvalued,
and not enough emphasis was on what the actual price reflected per user.
They were just giving the stock away, and using that valuation metric.
I though it was a tremendous buy. UnitedGlobalCom is an example of my
ideal investment.
How so?
I want to find a stock where the downside is very small over time if
everything goes wrong. UnitedGlobalCom had this big debt restructuring
situation in Europe and the stock was down to $1.50 a share, but what
the market wasn't looking at was that they had assets -- cable assets
-- that they owned in full or in part in Chili, one of the strongest
countries in South America, as well as in Argentina, New Zealand and
Australia. Any normalized valuation of those properties would give you
$1-$1.50 a share.
So, I'm basically buying this company at $1.50 and the downside is almost
negligible. Now, Europe could blow up and all those 8 million subscribers
and the majority value of this company could go away, and I'd still
be left with minimum downside. But if it works, which I felt it would,
I'd have a big winner, and it is proving to work. They've gotten through
the restructuring, they peeled off the layers of the onion, taken $11
billion in debt and reduced it to $3.5 billion in bank debt. The stock
is now at about $4 with a lot of upside over the next several years
if growth continues with cable and Internet in Europe. So, in this case,
I'm going to be holding it, hoping to get somewhere between a 5 and
10 bagger. This doesn't mean I am only looking for the 10 bagger; generally,
I look for 40 to 60 percent moves in my stocks.
How do you find these stocks? Where do you get your ideas from?
I think this is maybe one of the most important aspects of what I bring
to the table and what helps manage risk. I think your idea flow and
the quality of idea flow is a very important factor in managing risk
because a lot of investors stay in fully valued stocks hoping to get
a little bit more out of them because they don't have other places to
go that are very compelling. So having a lot of good ideas to choose
from in any market is key. I have developed over my 16 years in the
business a handful of colleagues who I believe share the same valuation
methodologies, are very astute, and we share ideas all of the time.
This is just one aspect of it. I will get ideas from TV shows, magazines,
newsletters I'm involved with. That on top of the investment firms whose
research I have access to - Salomon Smith Barney or Bear Stearns, or
what have you. The important factor is that I am the final decision
maker on all the ideas.
What themes would you say you're playing and what are a couple of
stocks that fit into those themes?
As mentioned, I'm buying stocks that are under cash value with little
or no debt. Some of these are simply stocks where you just have to be
there. I don't have a crystal ball, I don't know if they're going to
make it, but I know they're going to have years and years and years
of staying power to get through to the next product cycle.
For instance, Palm (PALM) is interesting to me because it's just about
at cash value with no debt at $9 a share. I don't know if the next product
cycle is going to be in six months or three or four years, but these
are the kinds of companies I think can see through to the next cycle.
When a cycle hits, multiples kick in and these stocks can be two, three
or four times higher, if that happens.
That's why ValueClick (VCLK) is another one of mine I like. With $3
a share in cash and no debt, I was buying it at $2 a share. They're
actually making money, and the stock is now at $4.00. They are in Internet
advertising. These are things that are going to be with us for a long
period of time.
I don't like the computer industry, but was buying SanDisk (SNDK) in
the low teens with $5/share in cash net of debt. They make the flashcards
for digital cameras and cell phones. That's an area that's just going
to keep growing for years and years, and I want to be a part of that.
Sometimes hidden assets compel me to own stocks. When JC Penney (JCP)
gets into the low to mid teens I usually buy it. Not for the 1,900 JC
Penney stores, but for the 2,900 Eckerd drug stores they own, which
in my view are worth as much as the stock at those levels.
As I've said, I always like some cushion down there so if everything
goes wrong I've got some asset that's worth a lot of money. I like Metro-Goldwyn-Mayer
Inc (MGM) because their film library could be worth more than the current
stock price. I'm looking at Midas Muffler (MDS). They're going through
a restructuring, got rid of their distribution plants, but the value
of their real estate could be worth well above the current stock price.
Those kinds of things. But I understand, there has to be some catalyst,
something to get the earnings growing, or these are going to be dead
for a long period of time.
These are companies I would have thought were large caps but have
come down into almost small cap land.
They've been killed. One of my favorite stocks, very controversial,
is Vector Tobacco (VGR). They're introducing a nicotine-free cigarette,
which has been out for the last couple of months in seven East coast
states. They've genetically blocked the production of nicotine in the
root. It pays about a 14 percent dividend here, but they are paying
the dividend out of capital as income is being used to introduce new
products, but the underlying discount cigarette business is what keeps
me with this company. Vector is exempt from the MSA payments to the
States, so their cash flows are very substantial because of this advantage
which helps fund these new products. The first product they had called
Omni did not work and it cost them a lot of money, and the stock got
hammered from the $30s and low $40s all the way back down to $10-$12.
Down here I think the value of the underlying business is worth far
more than the current stock price. I also look and see what Gabelli's
doing and what Ichan's doing. Ichan owns 20 percent of Vector. There are
certain guys out there that I respect, I like their methodologies, so
I'll look and follow things they do and may get involved with what they're
doing. I'll run the numbers and figure out what the kind of potential
upside is if things work out and then marry that with the downside risk
and see if that makes sense. With Vector, if Quest is successful, the
upside is substantial and the underlying discount business supports
the current valuation in my opinion.
What are your thoughts on a more macro level and how does that impact
your investing?
I don't disregard the macro level, but it doesn't get in the way of
a lot of what I do. Just like I said, in 2000 I thought the market was
absurdly overpriced and thought it was at a risk of falling 50 percent,
certainly the Nasdaq, yet I was fully invested. Right now, I've been
looking for a war rally and I think that could continue. But my outlook
over the next two to three years is very bleak. We could muddle through
it, but the risk is too great. When you look at other countries, it's
easy to see bubbles, it's easy to see Argentina, Mexico in 1995 and
Japan 10-12 years ago and say they're out of control. But when you're
inside one, it's hard to see the bubble. We're talking about huge consumer,
corporate, and government debt levels -- state budget deficit problems.
I see a dollar at risk and I see some real problems like interest rates
going up perhaps if the dollar falls. I see real estate pulling back
and the bottom line is I see consumers who have been spending out of
their minds for the last number of years, using their homes as ATM machines,
pulling back. That could cause serious problems and I think the Dow
could be at risk of going down 40 percent or more from here -- to the
4,000 area. Having said that, it's just going to be a matter of finding
more and more opportunities.
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