By Tom Winnifrith | Wednesday 8 March 2017
Whitney George, portfolio manager of the Sprott Focus Trust, is a career-long value investor who has described himself at times as a "Buffett groupie" reflecting his long-standing admiration of the legendary investor. Like Buffett, George seeks to capitalize on the manic depressive behavior of the aggregate stock market, a group author Benjamin Graham memorably referred to as Mr. Market—the fictitious business partner who impulsively offers to sell his share of the business or to buy the reader's share every day.
Unlike Buffett, however, George seeks value investment opportunities in gold and silver mining stocks, a practice Buffett famously eschews. In this exclusive interview with the Sprott U.S. Holdings CEO, Rick Rule, George takes us through his career as professional money manager and explains his rare interest in both value investing and natural resource companies.
Rick: You are known to me as a value investor person who is interested in fundamentals and, like myself, a contrarian. I’d like to begin with discussing what sort of character flaws, what part of the early part of your upbringing caused you to become a contrarian and a value investor. Tell me something about what happened pre-Wall Street.
Whitney: Well, pre-Wall Street, I grew up in a family that had some of its own dysfunctions, was independently-minded, fought with my mother probably from the time I reached puberty until about the age of 30. And so, I was of—I was probably a difficult son. I failed at getting into Princeton University which made me the first in 3 generations to mess that one up. I did go to Trinity College and had a fabulous 4 years where I majored in history. But when I—it became time for job, I really wasn’t qualified for very much. A history major with summer jobs, a tennis pro and a yacht club manager and maybe a lifeguard really wasn’t ideal for getting a job on Wall Street.
My grandfather was a $2 broker or an odd trader on the New York Stock Exchange. My father was in institutional sales in the ‘60s and ‘70s and had an up and down career. So, I really didn’t know much about anything else other than everybody seemed to go to Wall Street. In 1980, that was a fairly difficult proposition. I believe I had 50 interviews over the course of 2 months and failed to get any offers except for a headhunter who thought that I was good at interviewing.
And finally, I was interviewing at Oppenheimer where I knew nobody and the manager said after about 10 minutes of my interview where he was paying more attention to his Quotron machine, the then-version of a Bloomberg at the time, and said, “Why do you want to be in this business?” And I told him in rougher terms, “Because I want to make a boatload of money.” And all of a sudden, the light went on and I was upstairs meeting the branch manager and on my way at Oppenheimer & Co. and started the day Ronald Reagan got elected.
And it was a difficult start. So, I started out as a retail broker. It had been my intention to be an institutional broker like my father because that sounded much more glamorous, but I didn’t even have a sniff at that. So, I started out in a very aggressive program at Oppenheimer. They were early pioneers of cold calling, and I produced $87 on my first month as a retail broker. I had to get registered very, very quickly. They had no training program. In fact, they hid me from the partners because they weren’t supposed to hire inexperienced underproducing people.
Maybe it was $287 the first month down to $87 the third month and soon, therefore, some of the partners discovered that I wasn’t an error account on the trade blotters but an actual person that was underproducing so miserably. And I was brought in to offices and screamed at by one partner after the other. One told me his dog could open more new accounts in a month. The other said his 7-year-old daughter could produce more.
And so that was my beginning as a retail broker. Of course, back then after a resource boom, the first ideas that I selected for those few new clients that I was able to convince to give me an order where resource stocks, which promptly in 1980 and 1981 went down the toilet. So I do have some experience in resource investing.
The next interesting thing I saw was Milton Friedman was a special limited partner of Oppenheimer in those days. And in 1981, he persuaded—or the management persuaded everybody to buy Ginnie Mae futures which was the first glimpse I had at derivatives. You could buy with 10:1 leverage. You could put a $10,000 Treasury bill down and control $100,000 worth of longer-term interest rates.
Rick: Theoretically playing commission on $100,000 with $10,000. Yes.
Whitney: Absolutely. And the minute the trade went in your way, you could double up and get even more leverage, and I watched that trade blow up the entire Chicago office and very early on decided the derivatives were not something that I wanted to play with. Shortly after that, we had our first technology boom in the early ‘80s and so I quickly migrated from buying resource stocks to investing in the first PC companies at the top for my second book of clients. And that ended very, very poorly and at that point I figured that it might be a better way to invest.
My mother had always told me to pay attention to Warren Buffett. Warren Buffett had served on a board of a family company called Pinkerton Detectives, very interesting company, originally started to be the Secret Service for Abraham Lincoln, not a particularly strong start for them. And Bob Pinkerton was the third generation to run Pinkerton Detectives and Warren Buffett served on the board and my mother got to know Warren Buffett and told me I should pay attention to what Warren was doing. Of course, you don’t—I was not listening to my mother at all until about 1985 when I hooked up with some other value investors.
We started to use Oppenheimer screens to find our own ideas and suddenly life became a lot better—looking at businesses, understanding business valuations, finding those that we’ve offered trading at a discount to what they were ultimately worth, made a lot more sense than chasing the recommendations of the partners and investment bankers at Oppenheimer.
The problem with that was Oppenheimer always told people you should invest in companies where you’d like to buy the whole company. And my 2 older partners at that time and myself convinced our clients to buy over 51% of an auto parts refurbisher in Chicago which resulted in a 13D litigation and so we had to find a new home. And off I went with 2 older partners and we started writing value research as The Value Group.
Rick: You were thanked and excused for following the firm’s instructions.
Whitney: Yes, absolutely. Well, I wasn’t so much in trouble because I wasn’t very important, but my 2 partners, they were going and I went with them. So, we went to Laidlaw, Adams & Peck.
Rick: Sure. I remember the firm.
Whitney: And a fine, old firm that was living off of some very aggressive sales practices with mounting legal woes in 1987. And so, I was there about 9 months when we had the ’87 crash. The next opportunity to watch derivatives are new innovations at work. It was a portfolio insurance gone bad at that point. But at that stage, I developed a client base of some fairly sophisticated value investors including Tweedy, Browne, Chuck Royce who became our best customer. And in the 1987 crash, I will not forget being able to get virtually no one on the telephone to talk about stocks, but Chuck Royce answered the phone and he asked me what I liked and I gave him name after name. I think it was Dinner Bell Foods, Stone & Webster, General Refractories, Elco Industries and there might have been a fifth one. And he said, “Well, what else?” And I said, “Well, Chuck, they’re kind of those all the names I’ve done research on recently. I don’t really know much else.” And he said, “OK. Well, buy me 10,000 shares down every 8th until they stop.” And—
Rick: And for our viewers, non-Wall Street viewers, what does that mean? Explain that instruction in English.
Whitney: That instruction in English is “Start buying the shares in increments and continue to buy the shares that you have high conviction in increments” because the market is flushing them out and by doing that dollar cost averaging in the middle of a crisis, you’re buying into a vacuum so that at the end of the day, all 5 of the orders I was given were profitable because at some point stocks stop going down and then rise back up in the vacuum. And by dollar cost averaging, you’re able to avail yourself of that opportunity as everyone is panicking and there are few that will bid—you know, bid for real businesses.
So, that really was a very important moment for me. And, having espoused being a value investor, actually seeing one do it and do it in a way that was unique. So I became very impressed obviously with Chuck and my career as a value analyst and institutional salesperson needed to end in 1991 when my first son was born and I determined that it was probably a better idea to own my work and work with somebody on the buy-side that owned the work rather than beg for commissions per share on a one-time fee for sharing my intellectual—what I thought was important—intellectual capital. And that was very important. It was a great opportunity. Royce was a small but well-regarded value investor and small in microcap stocks. There were 20 people at the firm at that time and my initial role was to sort of direct the research effort, interact with Wall Street, sift through ideas and help Chuck build the business.
So that had its ups and downs and challenges. Started out very well, but by the mid-‘90s, small caps and value; both concepts fell out of favor. Of course, that culminated in some—you know, some fabulous run-ups in growth stocks and then ultimately led to the internet boom. I did not buy into that particular boom for the first time in my career but avoided it and stuck to investing in good businesses.
And fortunately, in 2000, the world turned around and we had a fabulous time at Royce building products, mentoring new portfolio managers and analysts essentially running the research efforts and portfolio management efforts at Royce and enjoying a great career, which included investments in natural resource stocks. I think I figured out sort of around 2000 or maybe 1999 that money printing seemed to be the solution to every new problem whether it be Long Term Capital Management in the Asian crisis in 1998, certainly the recession in 2001.
And it became fairly clear to me as a history major having seen these periods before that if the money to buy things became infinite, maybe you wanted to own those things that were finite in their quantities, and so that included all versions of hard assets and developed a particular appetite for having 10% of my portfolio in precious metals and mining stocks. I was managing mutual funds, as it was you could not buy commodities, so that became kind of the default insurance mechanism and that combined with our value approach produced spectacular returns for our investors from 2000 until about 2011.
Rick: Royce was a—I shouldn’t say was—is, but was in particular—an absolutely legendary name in the mutual fund business. Maybe you could describe being part of the growth of Royce in the first instance from where to where in terms of AUM, in terms of market clout, but then more importantly, why. What did Royce do that was so much better than what everybody else did at that period of time? What differentiated Royce? What was responsible for that growth? I realize you’re a good salesman, but not good enough to experience the explosive growth that you all enjoyed.
Whitney: Well, I think as an organization, we had a very good culture and it was a portfolio manager driven culture, portfolio managers run the organization and so everything was done around accommodating them and supporting them to be able to do the best analysis, make the best investments possible. Chuck was an early pioneer in the no-load mutual fund business, took over the Pennsylvania Mutual Fund in 1972. That product actually grew in the ‘60s as a go-go fund. And Chuck was a growth analyst in the ‘60s and then that market peaked out—you know, the tronics market peaked out in ’68 and lost a lot of value by 1972. I think the fund had gone down about 50% and Chuck took it over and figured what else could go wrong then 1973 and 1974 came along. And I believe that fund got within one month of closing down with only a million dollars, but that’s kind of where Chuck really learned his lesson about balance sheets and sustainability and business quality. And fortunately, ’75 came along and by the time I got to Royce, he already had quite a reputation.
And again, it was about understanding businesses. It was about being willing to invest in areas where markets were illiquid with a long-term approach where the added work would give you a payoff because there’s not a lot of people that were interested in buying microcap stocks and it takes as much time to research in mega-cap stocks as it does a 300-million-dollar company but—it's much harder to put the money to work. So, doing that extra labor in a less crowded field clearly had a long-term payoff. Using a long-term horizon as a weapon certainly was helpful.
And then in the late ‘90s when everybody was firing their value managers because then making 10% or 20% a year is like losing money relative to being in the dot com boom. We hired a lot of very good people and have found that the best time to get talented, good people is when nobody else wants them because when things are going well why would anybody change jobs. So that when the world turned in 2000, we found ourselves in great shape as an organization. Our records were strong. We were well-positioned. We stuck to our discipline and we had attracted a lot of very bright people so that we kind of cornered the market in small-cap value and we’re able to enjoy and exploit the growth.
When I got to Royce, we had about 1.8 billion under management. Pennsylvania Mutual Fund was a billion-dollar fund which then was an absurdly large amount of money to run. We grew to about 3 billion by 1993 when small caps peaked out, went back to 1.8 billion when other institutional investors left us because our relative numbers fell down. And we’re probably about 3 or 4 billion when things turned around in 2001 and the firm was sold to Legg Mason, and subsequently grew to a peak of 45 billion in assets under management which is quite a challenge when the average market capital companies they’re investing in was somewhere in the neighborhood of a billion dollars.
And what it forced was some very careful long-term thinking. If you end up owning 10% or 15% of every company that you fall in love with, you are in a bit of an investment Roach Motel. You can come in but there’s no way you’re going to get out.
Rick: You’d have to be right. You can’t trade out.
Whitney: You have to be right or at least not too wrong. And again, it’s the mistakes and the stocks that go to money heaven are kind of most detrimental. If you buy undervalued assets and you’re patient, your worst case is probably making no money and losing the benefits of compounding. But, of course, if you get it about half right over time, the numbers are going to work out pretty well for you.
Rick: You said a lot of important things in the last 5 or 6 minutes, and I want to go back over them. In no particular order, you reminded me without quoting him of the famous Templeton maxim that you buy aggressively into maximum pessimism that that worked well for Royce and you learned a lesson watching a master investor, and that lesson had such an impact on you that in addition to emulating him, you joined him. That would seem to be one lesson.
Whitney: That was certainly one lesson. I had become a bit of a Warren Buffett groupie at that point and so I guess his quote is to be greedy when others are fearful and fearful when others are greedy, which I thought I would be most familiar with. And I wasn’t necessarily a small-cap investor in 1991 when I joined Royce, but I was—I was definitely a value investor. In fact, the first product that I helped launch at Royce was called the Premier Fund and Chuck Royce liked to use lots of stocks and Warren Buffett always had this idea about the—you know, the 20 punches and—
Whitney: Ticket. And so, I said to Chuck, “Well, why don’t we start a product that asks which 20 stocks would Warren Buffett buy out of the thousand that you own and your flagship product.” And, of course, since small and microcap 20 stocks would be a little bit too concentrated and so we selected 50 stocks. But that ended up being probably the most successful product in Royce’s history. It’s still one of their major products that they have today. We actually ended up owning a bunch of companies that Warren Buffett bought including FlightSafety, Dairy Queen, Clayton Homes. So I had become quite a student and tried to find the characteristics that he talked about in his annual reports in businesses, again, free cash flow, high return on capital businesses at—we didn’t have to pay fair prices. We could actually buy them at cheap prices because we were dwelling in the small and microcap zones.
Rick: So let’s go deeper into that. Let’s talk about what those criteria were in specific fashion. Talk about 3 or 4 or 5 characteristics that you look for when you buy a company, separate and apart from the fact that you prefer to do it when other people are running away. Talk about return on capital employed. Talk about the balance sheet. Talk about how you do what you do and why I should keep my money with you.
Whitney: Well, it’s become a bit formulaic but it’s still a lot of fun. The first thing is you start with a wide net. OK? And an open mind to just about any business. So, I’m not a tech investor. I’m not an insurance company investor but I owned all of those and a chicken processor as well. So, it’s the financial characteristics of a good business I’m looking for. I don’t have—I try not to have any prejudices about those businesses, although there are lots of businesses that I will not look at because they don’t have 3 really fundamental characteristics. One is a strong balance sheet. And I look at balance sheets and this is something I learned from Chuck in the simplest way, which is I never liked to see assets exceed equity by more than 2:1. It’s a very simple ratio and it’s interesting because it picks up all forms of leverage on a balance sheet that many on Wall Street don’t look at. They’ll look at debt to equity, debt to capital. They’ll have all of these ratios. They’re just looking at debt but they’re not looking at the things that sometimes aren’t debt yet but are going to become debt.
Whitney: So, if you’re a retailer and things are slowing down and your inventories are starting to build and your receivables are starting to get a little bigger and business is a little bit slow. You may not have debt, but it’s not long before you need to borrow some money and then not much longer than the banker convinces you maybe you want to borrow that money longer term because things aren’t going to turn around so quickly. And one day, the world wakes up and your debt is something quite different than what people expected to see.
So, you can watch it on a quarterly basis. You can watch it expand and contract, but by buying a company with a strong balance sheet, you are preventing others from getting in the way of you and success. You’re not going to end up with goose eggs and you’re buying yourself the staying power for whatever issues are to be resolved over a business cycle or sometimes longer which I define as 3 to 5 years. So to win the race, you got to finish.
Whitney: And so, start with the balance sheet. Then you look for good businesses and I found the best markers of good businesses are high returns on invested capital. I think it’s very difficult in the long run for an investor to make money in a company if the company itself isn’t capable of making a high return on its capital.
Rick: And that’s return on invested capital not just return on equity. In other words, you’re not looking for a highly financially leveraged business.
Whitney: No. The return on equity is something the chief financial officer can control and, again, that’s just a discretionary item that people get confused about—how much leverage, how you build your business. Return on assets would be a much purer way to look at it, but then that penalizes companies that might be conservative and carry a lot of cash on a balance sheet which would reduce. So, you’d kind of try and look through to what capital is required in the business, the plant, the equipment, the inventories that you must have and what kind of core return can you get on that investment. How you finance it is kind of up to you, but you want to get down to the core basics of is this a good business? Does this generate free cash for its owners? Or is this some manufactured thing that looked pretty to grow earnings per share in a consistent pattern every single quarter.
Rick: Talk more about free cash because many investors including institutional investors don’t segregate well enough from my own personal point of view between EBITDA and true free cash. So, talk a little bit about that. I think that’s an important concept.
Whitney: Well, anybody who’s a business owner knows that depreciation is a real expense. So, the EBITDA is very popular if you’re a leveraged buyout firm that plans to own the business for 2 or 3 years. You can go and buy that business based on EBITDA and pay off your debt or flip the company—
Rick: Strip it.
Whitney: Strip it out, that’s fine but you’re not actually enhancing or growing the business. It’s just a financial maneuver. So, as a long-term owner of the business, the depreciation matters. It counts. And you’ve got to assume that it’s a cost of doing business. In fact, it’s very hard to grow your business if you’re not reinvesting at least in some small multiple of your—you know, your EBITDA.
Rick: Buffett, in fact, prefers companies that are growing fast enough that they can reinvest all of their EBITDA. He said his idea of a good time is a company that’s earning 15% return on capital employed and reinvesting all of it in a business that’s growing 15% to 20% compounded.
Whitney: That’s very hard to find.
Rick: Yeah. I was going to say that.
Whitney: Particularly at the scale that he’s now a part of, so he’s not investing in those kind of businesses anymore because he needs to find bigger things. But you can still do that.
Rick: Expecting to date Ms. America.
Whitney: Right. I found that rapidly growing companies are problematic because they need financing.
Whitney: And that means share issuance and dilution or it means levering the balance sheet. Some of the most interesting companies to me are those that are growing—and in the small-cap world, you can find 15% growth is not considered breakneck. It would be quite extraordinary in the mega-cap world.
Whitney: But 15% growth is financeable internally and may generate a little free cash. Some of the best investments I’ve made are growth companies that slow down and mature and they go from 20% or 30% growth to 12% or 15% growth, and suddenly they’d go from requiring capital to generating free cash. At the same time, the growth investors all have to leave the party and devaluations become incredibly depressed while they look for a new fan club or constituency among value investors. And in that transition, you can buy some very, very good businesses that are growing at very reasonable rates, generating free cash flow, some of which they can share with the shareholders through the form of dividends and buy-backs.
So, free cash flow is kind of how a company can either reinvest in a business if the return opportunity is still there, or allocated back to returning to the shareholders if the reinvestment rate is not inappropriate. So, capital—how people manage their capital is—how managements allocate their capital is a very important consideration.
Rick: I think I’m hearing a couple of interesting consistent themes. One is that you believe, rather than the narrative, in the numbers, if there is a growth investor and the company has ceased to grow at 40% compounded, which is increasingly difficult as you grow, and that constituent leaves but you have a good business that’s growing at 15% self-funded. That’s a pretty good idea. It’s lost the growth narrative but it’s still a hell of an investment. Did I get that correctly?
Whitney: Yeah, you got it correctly because everybody comes to that realization at the same time and your growth investors have to move on and your momentum investors have to move on. And a whole lot of them with a whole lot of money versus not too many value investors to replace them. And so, the ensuing adjustment to the business valuation can be quite traumatic and one has to be careful to again, take their time, be patient, dollar cost average because no one is going to know where the bottom of a stock is. But if you have a notion of what the business is worth, one can buy into that kind of vacuum with a lot more conviction. And that’s fun for a value investor. That’s one of the things I learned from both Buffett and Royce.
Rick: One of the things that’s always interested me about Buffett is that the narrative ends up being fairly important to him. And I wonder because I don’t believe that I have the same degree of sophistication that he does. If you think that the narrative shows up in the numbers; as an example, when he talks about a moat around the business or a definable competitive advantage, do you think that that shows up reliably in return on invested capital? In other words, do you think that the numbers can define the narrative for you? Or do you think that you need to do qualitative analysis at the same time that you do quantitative analysis around the business? Do you have to be predictive with regard to that advantage?
Whitney: I think the numbers will show you something good is going on and then you have to start peeling the onion in terms of understanding the business. And finding the magic sauce has always for me been very interesting. And it—but it’ll show up in the numbers and, then what the job is, is to try and understand whether there’s something that makes that sustainable in those numbers or whether or not you’re just looking at something at a cyclical peak. And cyclicality is very interesting. I love cyclicality. I love volatility because if you’re trying to buy businesses at a discount and sell them at fair price, the more times you get to do it in particularly the same business where your conviction and knowledge grows, the better.
So, when you see high returns on capital, the job begins to try and understand how that occurs. Do they have a permanent competitive advantage or is it a moment in time? Do they happen to have a lead in a product cycle is soon to be replaced by somebody else because they’re underinvesting and somebody comes up with a better version and catches up? Clearly high returns attract competition and people are going to try and replicate whatever you’re doing if you’re a high return business because why wouldn’t you do that?
For me, buying companies in my portfolio is really—it comes down to a combination of two things—valuation and conviction. And it’s very difficult to develop conviction in a short period. Certainly, easy to judge valuation on a daily basis, but to build conviction that what you’re looking at is sustainable, that recovery takes, in some cases, years, I’d certainly say the minimum of one business cycle. That’s one of the advantages that I have having spent almost 24 years at Royce is I’ve watched a lot of companies go through a lot of cycles and I have conviction in a lot of different companies most of which I have no interest in current valuations but the world has a way of changing very, very rapidly. And my process is really a matter of being prepared, doing the work, treating research and portfolio management as two separate functions, knowing what companies are worth, knowing what I like and then waiting for the moment when Mr. Market is having a temper tantrum and happens to want to get rid of it at a price that is appealing.
Rick: For you and I, Mr. Market means something. For 20,000 or 30,000 people who are watching this, the Mr. Market illusion may not be obvious. Describe that sort of wonderful chapter.
Whitney: Well, it’s about the Buffett idea of you have a partner and he’s Mr. Market who is pricing businesses every day and some days Mr. Market wakes up in a very good mood and is euphoric and wants to buy everything at any price and you have to be prepared to let him have his way. And then there are other times when Mr. Market, may be due to a tweet or whatever event we might be in for, wakes up feeling very depressed and doesn’t want to own anything and that’s when great opportunities occur.
Rick: You have to write him a check.
Whitney: You write a check and gladly take the nice business that you’ve been watching for some time off his hands.
Rick: I heard Charles Brandes, who by the way had a career remarkably similar trajectory to your own, started off as a retail stock broker. He suggested he was too honest for the profession so didn’t succeed but succeeded as a value investor. He described the whole Mr. Market sequence as having a business partner who is manic depressive. And what you did is you accommodated him in both sides of this madness and as a consequence of that, did fairly well yourself, which— It’s always a discussion I liked. I want to drill down a little deeper into some of your ideas before we return to a more general sense including the discussion of what you do in natural resources. How important are intangible assets to you? Buffett talks about the power of brands, the power of reputation. And again, I’m interested in the difference between qualitative and quantitative analysis. Do you think that understanding a brand separate and apart as an example from the definable benefit in terms of return on capital employed is either possible or profitable?
Whitney: Well, again, I think the value of the brand shows up in the numbers that the brand helps create. I mean I’ve mentioned I’m a hard asset investor but Buffett has always said that a strong brand which can retain its price and power is good—
Rick: You don’t see it in the balance sheet but you may see it in the income statement.
Whitney: You see it on the income statement and, again, brands or like anything else, you have to make a judgment is to whether where that brand is, is it being overexploited for the short run, i.e., are they dropping their prices and offering more products under the same brand and trying to maximize the short-term return to make some options valuable? Or are they Chanel or one of these great brands who are always very—regard their brand very, very careful, very disciplined and, therefore, are able to year in, year out to retain their pricing power. So, it’s hard to build one. It’s very easy to destroy one, and so when you’re evaluating a brand whether they’d be things like Ralph Lauren or Tiffany or any of these other companies, one always has to be aware of the trade-off of the difference between short-term growth and maximizing the near-term opportunity versus kind of the long-term discipline that would allow the brand to continue to sustain its high return capabilities.
The trade-off between growth and maximizing—you know, and generating free cash. That’s tough for most management to deal with. People at the end of the day are going to do what they’re incented to do, so if you give an executive a whole bunch of options that are coming due in the next 2 years, he’s going to do everything to make that work out. Whereas if you invest alongside owner operators of businesses, founders, people who own a majority of the shares of the company that are outstanding, you’re going to find their behavior is very, very different and you’re going to find they don’t talk about EBITDA. They understand depreciation. They don’t like issuing options because at the end of the day that’s giving away a piece of the business every single year.
So, I tend to gravitate towards those companies that have an adult in the room in the way of a founder or significant family interest. It’s a bit old-fashioned but I tend to not be interested in companies that are big options issuers or management owns very little of the stock. I like the alignment of them eating their own cooking and managing their money along with my own. And, again, when I do valuation work, I use fully diluted shares. I view options as a real expense.
Whitney: And put that in the calculation. I look at these businesses. Once I find the characteristics I’m looking for in addition to building conviction and learning more, which takes time, I have a fairly simple valuation metric which I use as guidelines not as absolutes. But I want to know what I think the business is worth and I want to know at what price I can buy that business where I feel fairly comfortable in a good long-term outcome under most scenarios. And, I use something that real estate investors use which is a cap rate. Again, that was a Royce term and not my idea, but I’m thinking in terms of earnings yield, what is that company going to yield to me based on the current price.
I use operating income because again that compares apples to apples, different tax rates, different financial conditions, more leverage, less leverage are all kind of below that operating income line, so I want to be able to understand the business at its operating line. And so, I’ll look at a company. I’ll take its operating income and then I’ll say, “All right, what’s the market valuing the business for?” That’s the market cap, but that’s also adding the debt that they have and then subtracting the cash off. And that gives you kind of an enterprise value, what’s the business being valued for today in the market?
And what I like is to find companies with a 15% cap rate. That’s operating income over this enterprise value. That’s a 15% pre-tax earnings yield, or that’s like buying stocks at 10 times earnings if you fully tax them. And I found that generally has been a pretty good starting point—with a margin of safety for me underestimating or overestimating kind of what the conditions were and if the balance sheet is stronger, got plenty of time for whatever is disturbing the market today to kind of be overcome.
The other side, I found that if you own stocks at cap rates that are lower than 8%, that’s 12 or 13 times operating income, you’re in a zone with other investors that aren’t necessarily business buyers. An 8% cap rate or 12 or 13 times operating income is as far as one business will go to buy another business unless there is some enormous strategic value and usually that ends poorly anyway. The financial buyers certainly can’t go much beyond that.
Those are numbers I’ve used ever since I was at Royce. They haven’t changed with interest rates, and so this is an absolute approach, not a relative approach. And what I get is a buy price and a sell price for every stock in my portfolio and every stock that I look at. And all day—you know, most days I’m in my office looking at companies and I’m writing down a buy price and a sell price. Most of the time, today in particular, most of the companies I look at and like are trading much closer or above where I would sell them. But every once in a while, even today after 9 years of the market going straight up, one will fall down for some short-term—one hopes short-term reason—to hit the buy price and that’s when the work begins. That’s when the buying begins.
And so, again, it’s that buy and sell price and when I look at my portfolio, every stock in the portfolio has a buy and sell price which also gives me a risk/reward ratio, OK? Where is the stock relative to where I want to sell it versus buy it, and that helps me manage the portfolio to keep a positive risk/reward profile in the whole portfolio by adding to those that have a better risk/reward than an inferior one. It gives me prices to start to lighten up as they approach sell targets and prices to incrementally buy as they approach their buy prices. It’s quite mechanical actually. It’s doing the work and then sitting back and seeing what the market is going to do today and where I have an opportunity and it’s about being—it’s about being able to respond to opportunities intelligently as opposed to predicting where things are going to go.
Rick: I’m going to change topics a little bit, and I do this at some risk because it gives you a wonderful opportunity to insult me, which you may take me up on. Buffett has been famous for saying that he hates natural resource investments because they’re capital intensive and cyclical and you described yourself as an adherent to Buffett, but you’ve been a consistent natural resource investor and you’ve joined Sprott, so you’ve put yourself in ownership, in fact, of a brand that would seem to be in contradiction to the guru.
Now, for myself, I’m in natural resources because they’re simple businesses that I understand. I think about the mistakes I’ve made in businesses I understood and I’ve always been nervous about what I could do if I got outside my own sandbox. But you’re a generalist across businesses, so I’m interested in the contradiction between your self-described attraction to the Buffett maxim at the same time as you torture yourself in a business that’s capital-intensive and cyclical. For me, again, as you’ve described, cyclicality is a tool. It’s been responsible for my success. It’s not a—
Whitney: Right, right.
Rick: It’s not a penalty. It’s, in fact, a benefit. But talk a bit about resource investing and how that fits into the Whitney George spectrum of investment.
Whitney: Well, the first thing I’d say to that is all businesses are cyclical. We sometimes forget they’re cyclical after an extended period of robust performance and then typically come back to understand that they’re cyclical again in a very painful way. Technology is a prime example. It’s cyclical. Again, I’m sympathetic to the idea of not wanting to invest in things where you don’t really understand. So, nobody really knows what’s under the ground and so that’s very hard to analyze. I’d say the same thing about banks. No one really knows what’s in the loan portfolio so banks equally are hard to analyze. I don’t invest in banks because they don’t meet the valuation characteristic.
The Sprott thing—first of all, I love asset managers and I love the operating leverage they provide without the financial leverage, and Sprott Asset Management is an asset manager and it’s an asset manager with what I believe is a particular advantage and expertise in an area of the market that’s very volatile and, therefore, where there’s a huge opportunity to add value by helping people manage that volatility.
So, the part of me that bought gold and silver mining stocks actually started out with a company that had very high returns on invested capital. It was AngloGold in 1998. It was trading at 6 times earnings. It had a 6% dividend yield and the price of the rand was dropping faster than the price of the gold and it was earning high returns on invested capital and that’s how I found my first gold investment as a mutual fund investor. And then I started to find others.
And there are points in time when mining companies take on the characteristics of pharmaceutical businesses. And more recently, we discovered there are times when pharmaceutical businesses look more like resource stocks. So, it’s really kind of what your expectation is. Again, for me, there’s a little bit of an insurance factor in owning some—in precious metals stocks. I’m not a believer that the world is going to end. I think we’re going to muddle through and most of the portfolio is built on an optimistic view. But, over time, being diversified in precious metals has proven to be very, very effective at reducing volatility and actually enhancing returns.
I got very interested in silver when I discovered that in 1996, Warren Buffett had 130 million ounces of silver. So, with Warren sometimes you got to watch what he does and not so much what he says. He thinks everybody should pay more taxes but certainly Berkshire has built a reputation of being very efficient at managing taxes. So again, that doesn’t bother me. He has this view that gold is something that you spend a lot of money to dig out of the ground and put back into the ground and it pays you no dividend. So, I often buy resource companies that are just leaving the gold in the ground. That works for me. And in terms of paying no dividend, the paper bills and your pocket paying no dividend either. They happen to be a currency that everybody likes.
Rick: My bank account doesn’t even pay me dividends with these interest rates.
Whitney: If you get a period of—a combination of negative real interest rates and maybe a little lack of confidence in authorities, in governments, certainly precious metals have proven in the past to be very useful. What attracted me to Sprott was not so much a long-term commitment to owning precious metals stocks. I decided to leave Royce because I was having less fun than I thought I should and was less able to manage my client’s money the way I would manage my own money because of pressures to beat indexes and marketing issues.
I decided to leave and I looked at Sprott which we had a significant investment in at Royce. I think that we were probably the largest institutional investor during the crisis and maintain that. I saw Sprott where Royce was in the late ‘90s when nobody wanted small-cap value. I saw an organization where I had great respect for you, Rick, and your partners who were adding talent when everybody else was retreating, and understood the longer-term effects of what that would mean when the cycle turned.
And so, that was appealing. I’ve been there, done that myself. I’d never owned equity where I worked, so I bought myself a significant chunk of Sprott stock to actually be partners. For me, the concept in the final part of my career because we’ve discussed how the early—the rocky start in the years at Royce, but I hope to do is compound my own wealth and those who would like to come along through capital gains and dividends because I don’t like paying taxes more than anybody else does.
And being an organization that is run and managed by investors who eat their own cooking, who would offer their friends and clients the same proposition that they are taking for themselves. You know, and an organization that is majority are theoretically near majority owned by the people who worked there every day. So, it has all the characteristics that I would look to in a company that I might invest in in my portfolios.
Rick: Your description of being partners with the management rather than having them be employees resonates well with me. I know in my career investing when the interests were truly aligned, that is, when I was investing at a company where the management team were substantial owners and, thereby, had an incentive to increase the value of the business rather than merely their compensation. I did better for some reason.
Whitney: Right. Well, but—we’ve seen that.
Rick: One of the things that attracted me to having you come on board at Sprott as I looked at the two investment products that you managed and I came to the delighted realization that you are your largest client, that you eat your own cooking. I know something about your outside business activities so that I know that over time your cooking has tasted fairly good. It’s allowed you to make other investments, make other mistakes, sustain a great lifestyle. But perhaps you could—and just for the record, full and fair disclosure, I’ve invested a million dollars in the Sprott Focus Trust, symbol FUND, where you are, in fact, the largest shareholder. But perhaps you could talk to the extent that compliance will allow you to about the products that you’ve managed for investors through the Sprott banner and how you bring the experience that you’ve had investing for 30 years to bear today.
Whitney: Great. Well, when I left Royce, there were 2 products that were deeply important to me. At Royce, we had a culture of portfolio managers all having a significant stake in any product that they manage. In fact, if they didn’t have the means to be a large investor in the product, their bonuses were deferred and would track the products that they were managing. So, over the course of my years at Royce, I ended up being involved with probably 8 or 9 of the products in a significant way. I had significant investments in lots of the Royce mutual funds, and when I decided to leave, I consolidated those investments into the 2 products I was bringing with me. One is a closed-end fund; the most valuable part of which is that it’s got a ticker symbol of F-U-N-D, which is easy for people to remember.
Whitney: And again, I had been making large investments in that because I was able to not only buy my own—eat my own cooking but I was able to do it at a discount to NAV.
Rick: Stop one second. For some of our viewers, what’s the difference between closed-end fund and an open-end fund and what is the advantage from a manager’s viewpoint of a closed and/or gated fund?
Whitney: So, closed-end is permanent capital. That means that when Mr. Market is having a temper tantrum, you’re assured that you can invest the money as opposed to having your partners take it away from you.
And you also managed—this discussion is germane to qualified clients who might be listening. You also managed a hedge fund—
Rick: --which employs some short selling strategies. Perhaps you could talk about that and talk a bit about short selling as the other side of value investing.
Whitney: Sure. Well, it is—it’s certainly the humbling side of value investing. Your potential loss is infinite and you can only make 100% and—so, it is a—it’s difficult to manage. For me, the best I can say is it’s improved my tax efficiency because losses on shorts are always short-term.
Whitney: And the hedge fund probably over time has not in aggregate made money short selling. It has converted short-term gains to long-term gains for my clients and so produced a happy tax outcome of whatever return to this that I might—but it’s also—it provided a bit of buffer in some of the more stressful moments, and I think that’s the best that I can hope for it.
Rick: What’s important about your hedge fund I think, though, too often hedge managers put on what I call a taxes hedge. They make the same debt long and short and your hedge is actually designed to make the fund a bit more neutral. Is that accurate?
Whitney: Yeah. I mean the short component—I like to run that fund somewhere between 90% and 100% long fully invested. And to help me do that, typically I will short between 20% and 30% of the portfolio. So 65% to 75% of net exposure to the market—that’s taking the longs and subtracting the shorts—you know, without using leverage. I’m not borrowing to do any of these things—is kind of where I feel comfortable. I mean the market is going to go up two-thirds of the time and down a third at a time and so being two-thirds long kind of makes mathematical sense. I’m not sure that there’s any science behind that.
I like to short when I can find them accounting fictions. Sometimes it takes a very long time for them to go away. I’ve been short Sears ever since 2007 and it keeps having more lives. I unfortunately have a tendency to like to short overvaluation and, of course, overvaluation is usually on its way to getting to be even more overvalued. I’m not sure Amazon has a real business model. I certainly know it’s a popular stock. When one talks about liking free cash flow and high returns on capital, Tesla certainly would not be an example of the first thing that you would buy.
Rick: They may have very high cash flows in brackets.
Whitney: It’s just like only lost 900 and some odd million in cash the last quarter. You know, and it’s an auto company, by the way, which is historically not an industry that has been a great producer of free cash and returns for its investors over the long run. So, I like to short stocks. It’s intellectually very, very challenging. I don’t allow short positions anyone to exceed 1.5% of my portfolio.
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