In a 2011 letter to our clients, we briefly described the process we follow when selecting stocks for their portfolios. To illustrate how we arrive at a decision to purchase a specific stock and continue to monitor it, we included a report on one of our positions. The stock may still be in our clients’ portfolios, but certain comments in the report may no longer be accurate or applicable.
To comply with rules on performance advertising, we have not included the real name of the company in the report, and we are not recommending it for purchase. Because of changing circumstances, the position, if still held, may or may not be profitable.
LETTER TO CLIENTS, OCTOBER 14, 2011
During the past few years, we have periodically sent you letters attempting to put things in some perspective in view of the financial and economic turmoil. As we have stated on numerous occasions, these are indeed unusual times. In spite of the obvious problems, both domestic and global, we remain optimistic that better times are ahead. Unfortunately, it may take a while to get there.
Two of the worrisome characteristics of this current environment are the volatility and correlation of the stock market. Most of us certainly understand what market volatility entails. It seems that every day the market fluctuates somewhere between 1-3%–sometimes up, but lately more often down. Market volatility of this magnitude is understandably very stressful and confusing. I fear it may be alienating more and more investors the longer it persists, especially since it is occurring at a time when alternative vehicles offer very unattractive returns. Modern technology that supplies us with instant access to markets no doubt exacerbates the stress, which increases the alienation.
Market correlation is probably not so widely understood. It refers to how individual stock fluctuations compare to the fluctuations of the stock market as a whole. Put in simple terms, if a stock were perfectly correlated to the S&P 500 Index, the stock would go up X % every day the S&P rose X % and go down X % every day the S&P fell X %. By calculating the correlation for each individual stock in the S&P, a measurement of correlation for all of the stocks in the Index can be determined. Today’s correlation is extremely high. In fact, according to Oppenheimer Asset Management, it has reached levels during the past few years not seen since the early ‘80s.
Many observers have concluded that these extremely high readings are a sign of the “herd mentality” that prevails in times of panic. Others attribute them to the proliferation of exchange traded funds and high frequency traders. No one knows for sure how long they will last or what they portend for the markets.
What we do know is that these high market correlation levels have caused us considerable frustration. When a market selloff indiscriminately pulls down stocks regardless of their fundamentals, we are tempted to question whether our research efforts are worth it. However, by stepping back and examining the market’s action from a historical perspective, we are able to remind ourselves that this condition is temporary. We also realize that it can be exploited by our long-term value-oriented philosophy, which as you know, is the cornerstone of our investment approach.
Unlike the majority of our competitors, we invest in individual companies in the stock market and buy bonds from single issuers. In other words, only in certain instances do we utilize mutual funds and thereby “farm out” the individual selection function. Buying and selling individual stocks and bonds obviously entails more time and effort on our part, but it has many advantages, including keeping client-borne costs down.
Our stock and bond selection is based on thorough and constant research. We obtain pertinent information, including analyst reports, from a variety of sources. In some cases, we meet and visit with management of the companies. With most of our stock holdings, we maintain an ongoing dialogue with top company executives.
In every situation, we listen to and participate in quarterly conference calls between management and analysts/portfolio managers. This process begins well before we take a position in a company (in fact, many times our research convinces us not to invest in a company) and remains consistent throughout our investment relationship with the company.
As you have no doubt noticed, our efforts do not always guarantee substantial outperformance. But I can say that over the many years, our results have been favorable. Indeed, we are more convinced than ever that our approach is sound and conducive to long-term success.
Occasionally a client will ask me about a current holding and why we own the stock. As an illustration of our stock selection process, I have included a summary of one of our holdings with a brief description of our assessment of this company. Incidentally, we have owned the company for a number of years and have yet to reap the reward that we think is still probable. We chose to feature it in part because it is a company with which most people have little familiarity.
If you have any questions pertaining to the issues presented in this letter, feel free to call me. Hopefully, the volatility and high correlation will subside in time and allow us all to return to less stressful and more prosperous days.
THE COMPANY: ABCD CORPORATION
October 11, 2011
What ABCD Does
ABCD develops, manufactures, and sells temperature-activated and other specialty polymer products for food, agricultural, life science, and licensed partner applications. Some of its key products and ventures are discussed below.
ABCD sells fresh cut vegetables in bags incorporating the company’s proprietary membrane technology, which increases shelf life. In addition, ABCD is the market leader in sales of vegetable party trays in the U.S. and sells its products under its own brand name in grocery stores and warehouse clubs throughout the country. In St. Louis, its products can be found at local Shop N Save, Costco, and Sam’s Club stores.
ABCD’s shelf-life extending technology is also used in its partnership with a major international produce distributor. This technology has enabled the distributor to sell its bananas in markets that were previously unprofitable because of perishability issues. Currently, the distributor ships bananas in bags manufactured with ABCD technology to various retailers, including Starbucks, convenience stores, and gas stations. In addition, the distributor has recently entered the avocado business and is using ABCD’s technology to ship ripe avocados. As you may know, avocados are typically rock hard when bought at the grocery store and need to be left on the kitchen counter for a few days to ripen. The ABCD technology allows already ripened avocados to be shipped to the stores and lengthens the time they are ripe. Locally, you can find the distributor’s avocados in Dierberg’s stores.
Recently, ABCD entered into an exclusive partnership agreement with a Canadian company to utilize ABCD’s packaging to extend the shelf life of greenhouse-grown cucumbers, peppers, and tomatoes. As part of this deal, ABCD purchased a 20.1% interest in the Canadian company and additional preferred shares, which yield an annual cash dividend of 7.5%.
In 2010, ABCD purchased a premium provider of sodium hyaluronate used in medical applications. In cataract surgery, its sodium hyaluronate product is used to keep the eye lubricated and cushioned as the old lens is removed and the new lens is inserted. In addition, it is used in the orthopedic setting as a supplement to provide lubrication and cushioning to the knee, relieving the pain and discomfort of osteoarthritis. As the average age of the population increases, we expect the market for sodium hyaluronate products to continue to grow.
Intelligent Polymer Partnership
ABCD also has a partnership with a major industrial company that supplies intelligent polymer materials that are used in over 50 cosmetics and other personal care products. The intelligent polymers are designed with a “temperature switch” that allows physical properties such as viscosity and permeability to be controlled. The major industrial partner’s customers are recognizable names in the personal care and cosmetics industry.
ABCD is also working on applications for the technology in other areas, such as seed coating, adhesives, and drug delivery.
Why We Like The Company
ABCD possesses the attributes we generally look for in potential investment candidates:
A strong balance sheet
The company has a minimal amount of debt, which carries a low interest rate. In fact, it has more cash than debt on the books, and it continues to generate cash that can be used to invest profitably in its businesses and to make accretive acquisitions.
Value, as measured by low price/book and low price/earnings ratios
History has shown that over the long term, stocks selling at relatively low price/book and price/earnings ratios outperform those selling at higher multiples. ABCD certainly qualifies as a value stock under these criteria.
Management incentives that are aligned with shareholders’ interests
We look for management that is incentivized to deliver for shareholders. ABCD executive officers and the Board of Directors own over 8% of the company shares.
Good growth potential
Although we focus upon stocks with limited downside, we also want to see substantial upside potential. ABCD through its various businesses and partnerships is well-positioned to benefit from trends such as more healthful diets, the aging baby boomer population, and the need for businesses to reduce waste and transportation costs while at same time introducing new products that meet customer needs. Unlike many other companies that have halted research and development during the economic slowdown over the past few years, ABCD, relying upon its strong balance sheet, has continued to invest in new product applications. When the economy resumes its upward path, companies like ABCD that have maintained their research and development activities will profit. Companies that have hunkered down during the current tough times run the risk of being left behind.
How We Follow The Company
As noted in our letter, Sterling Capital takes a hands-on approach to selecting and monitoring its investment candidates. We speak with research analysts, read analyst reports, and participate in company conference calls as we search for investment opportunities. We also like to develop relationships with management to get a grasp on their business acumen and their objectives in running the company.
During the five and a half years we have held ABCD in our portfolios, we have had the Chief Executive Officer of the company in our offices, and we have met with the Chief Financial Officer separately many times as well. In addition, we typically speak with the CEO or CFO on the phone every couple of months.
What Concerns Us
Assessing the downside possibilities of a stock position is just as important as identifying the potential for meaningful appreciation. We therefore spend a considerable amount of our time trying to understand the risks in owning a company’s stock. Below are just three of the risks associated with ABCD that warrant our attention.
A slowing of the pace of acquisitions, joint ventures, and licensing deals
ABCD has pulled out of a number of acquisitions and potential licensing transactions before the deals were finalized because the other parties insisted on terms that were not in the best interests of shareholders. It is certainly possible that deal making will continue to encounter obstacles as long as the economy sputters. The slowing of deal flow is disappointing since accretive arrangements generally boost the stock’s price. On the other hand, management’s cautious approach demonstrates its discipline and emphasis on the long-term interests of the company and its shareholders.
Reliance on other companies and consumers to adopt ABCD’s technological solutions
It often takes a while before an innovator’s products are accepted by the market. In ABCD’s case, it has to convince not only the end consumer but the manufacturer to whom it is providing the new technology. When a product does not deliver results when expected by analysts, short-term wobbles in the price of the stock may occur.
Although ABCD may correctly be viewed as a technology company, it is still in the food business. Its prime growing region is California, which has recently been the target of unusual weather. A bad harvest, of course, can affect profits.
Nearly all stocks will be whipped around by macroeconomic factors to some extent, especially in a volatile market environment. The recent U. S. financial crisis, whose effects are still with us, and the possible defaults of European sovereign debt make additional volatility likely. In these turbulent times, it is prudent to focus on companies that have not only the balance sheet to weather the tough times but the technology and management to prosper when the economy turns around. We believe ABCD is one of those companies.
William G. Lauber