Tim Hartch has been a co-manager of the BBH Global Core Select fund (BBGRX) since inception. He has also co-managed the BBH Core Select fund (BBTEX) since October 2005 and an investment partnership that invests in a select number of small- and mid-cap providers of essential products and services since 2001. Mr. Hartch joined Brown Brothers Harriman & Co. in 1996 and became a partner of the firm in 2010. He received an A.B. from Harvard University, where he was elected to Phi Beta Kappa. He also received an M.B.A. and J.D. from the University of Michigan.
I spoke to Tim on March 29.
We last spoke in 2011. Let’s start by briefly reviewing the history of the BBH Core Select fund and its core investment principles. Also, please tell us a little about the BBH Global Core Select fund, which you introduced three years ago yesterday.
The current team took over management of the BBH Core Select fund in October 2005, so we have been managing it for about ten and a half years. It’s a buy-and-own approach, focusing on high-quality businesses that are trading at a discount to proprietary intrinsic value estimates. We aim to achieve attractive returns and protect capital in down markets and outperform on a relative basis over time. We have historically outperformed in most down markets, such as the 2008 time period, while participating in up markets. We have trailed the S&P 500 the last two years, but we are pleased with how the businesses we own are performing at an operating level.
Our focus is on identifying high-quality businesses. We look for companies that have a loyal customer base, provide essential products and services, have a strong competitive position, operate in an attractive industry structure, have high returns on capital and a good balance sheet and offer an opportunity to partner with good management. We view ourselves as owners as opposed to traders. We try to select businesses and get our returns from the cash flows and the success of the underlying business.
Our Global strategy uses the same investment criteria and process as Core Select with the main difference being that it owns more international companies. We are very pleased with the quality of the companies we’ve been able to invest in outside the U.S.From a performance perspective, the Global results have been consistent with Core Select – generally outperforming in down markets and participating in up markets.
Your investing style relies on a determination of the intrinsic value of a company. How has your calculation of intrinsic value changed as a result of Fed policy over the last seven years, and has monetary policy affected the criteria you use for buying or selling companies?
The changes in Fed policy have not had a big impact on our investment process. We still insist on equity returns of 8% to 11%, depending on the characteristics. The cost of debt that we use in our valuation models has probably come down, but we have a minimum return that we don’t go below. Accordingly, the discount rates we use have not changed much as a result of the near-zero interest rate policies.
It’s critical to recognize that Federal Reserve policies and those of other central banks around the world are distorting the real economy and the financial markets and have pushed valuations up across the board. It’s made it harder to buy businesses at a large discount to intrinsic value.
Where you see this effect the greatest is in the search for yield and in its effect on fixed income investors, as well on income-oriented equity securities whose yields have been pushed down. Returns have been pushed down to historically low levels.
In the previous question, you asked about our global fund. In Europe and Asia, similar policies have been followed by the European central banks, and in Japan it’s been even more aggressive. In my opinion, the effects of those policies have been negative and won’t solve the problems they are supposed to address. Negative rates are particularly painful for banks in those countries, and I hope the Federal Reserve doesn’t implement negative rates here.
In the Core Select Fund, you own the voting class shares of Berkshire Hathaway and Comcast but not Alphabet. Are those voting rights properly valued, and how do they factor into your investment decision?
The voting rights are not a huge factor in our investment decision. We select a share class based on liquidity and spread between voting and non-voting classes. The key for those three companies is that we have a family or a group of individuals that control the company. In all three cases, as well as Discovery – another company we own with two share classes – the controlling shareholders have a great track record of capital allocation, and they want to build the company over the long-term.
We are not trying to change control of these businesses. The economic interests are the same for the different share classes. It really comes down to liquidity and how large a spread there is between the share classes. In some cases, we have chosen to buy the non-voting share classes.
What is the investment argument for owning Berkshire Hathaway that does not mention Chairman Buffett or Vice-Chairman Munger?
I would highlight the great collection of businesses that are a part of Berkshire. That includes great insurance franchises like GEICO, and probably the best portfolio of reinsurance businesses. It owns excellent industrial companies that they continue to add to, like the railroad, Lubrizol, and Precision Cast Parts.
It has a very strong balance sheet in terms of its ability to deploy cash, and it has an attractive valuation.
Buffett is a great capital allocator and CEO and has done a tremendous job. But we don’t see a Buffett premium being attached to Berkshire’s valuation. If anything, Berkshire appears to be trading at a discount due to concerns about succession.
Ten percent of the Core Select Fund’s assets are in two banks, U.S. Bancorp and Wells Fargo Bank. What are these banks doing that their competitors are not doing?
The two banks we own have the highest returns on tangible equity (ROTE) of any large commercial banks in the U.S. In the case of Wells Fargo, in the most recent quarter ROTE was approximately 15%, and for U.S. Bancorp it was in the high teens. Those figures are much better than what most of their peers did.
They both have strong and growing deposit franchises, which is key for a bank. Wells has $1.2 trillion in deposits and that grew 6% over the past year with a cost of just 8 basis points. U.S. Bancorp is a smaller bank, but it has $295 billion in deposits, which grew 7% year-over-year with a 15 basis point cost. Both banks can fully fund their loan portfolios with their deposits. Having a stable and low cost funding base is a huge plus for both banks that compares well to their peers.
They also have strong capital positions and the highest debt ratings among their peers. They have the ability, because of their strong capital positions, to make substantial and growing distributions to shareholders while continuing to grow their deposit bases.
I would also like to note what they do not do. Wells and particularly U.S. Bancorp are less complex than the big money center and universal banks with much smaller sales and trading operations and smaller derivative books. Because of that, they are less complex and we believe less exposed to systemic risk. Accordingly, they have lower systemically important financial-institution (SIFI) buffers than the money center banks.
The management teams at Wells and U.S. Bancorp have consistently executed well. They have avoided most of the problems that have occurred at other banks and have allocated capital effectively.
U.S. Bancorp has benefited from other high-return businesses, like payment services, merchant processing and its corporate trust business, which are meaningful to their earnings stream.
Banks are facing increasing regulatory pressure that is requiring them to maintain more capital and have greater liquidity. There is the prospect, albeit somewhat remote, of negative interest rates. How do those issues and risks factor into your assessment of your bank holdings?
Those are real concerns. The regulatory pressure on all financial institutions is significant. Banks are required to hold more capital than ever before and to have greater liquidity. There is a concern that what is happening in Europe and Asia, with negative interest rates, could happen in the U.S.
We treat all those issues -- as well as others banks could get into trouble with, like credit losses over time -- as real concerns that should be focused on.
One of the reasons we own those two banks, Wells and U.S. Bancorp, is that they have a simpler business model when compared to money-center banks that results in less regulatory pressure and a greater ability to meet capital requirements. In terms of selecting which banks to own, we have been influenced in part by the regulatory environment and the need for greater capital and liquidity.
With respect to negative interest rates, I think it would be a big mistake. I hope the Fed understands that and does not move in that direction.
We recently carried an article that forecast a problem with home-equity lines of credit (HELOCs). The author’s thesis was that many HELOCs will soon convert to fully amortizing loans and homeowners will not be able to afford the interest payments. The author cited Wells Fargo as having $67.3 billion in HELOCs on its balance sheet. Have you looked at this issue?
My colleagues have looked at this issue. With banks it is always important to focus on credit quality and think about what could go wrong.
The current figure is $69 billion in home equity loans and about $16 billion of those are actually in a first-lien position and not the traditional second-lien position. Of the remaining $53 billion in a second-lien position, approximately $12 billion is already amortizing, and there is an additional $25 billion that doesn’t amortize until after 2021. Those were post-crisis loans so they are likely to be pretty solid credits. That leaves approximately $15 billion that will begin amortizing between 2016 and 2020. With respect to many of those loans, Wells Fargo may realize some credit losses, but we think it will be manageable. Only about 10% of Wells Fargo’s home equity borrowers have a FICO score below 640.
I also want to put that $15 billion into context; Wells has $1.8 trillion in assets, $900 billion in loans, $37 billion in pre-tax pre-provision income and $140 billion in tangible equity.
Credit is definitely something to focus on, but our view is that the home equity loans will not have a material impact on Wells Fargo’s near term earnings, and it is an issue that they have been managing appropriately.
You have significant positions in the media and technology sectors. Some of those companies, like Comcast, Microsoft and Oracle, have engaged in significant share buy-back programs over the last several years. Can you talk in general about why those companies are attractively priced right now, and specifically about how you adjust for share buy-backs when you determine the intrinsic value of those companies?
In addition to those companies, we also own Discovery, which has historically repurchased a meaningful number of shares. In terms of what we like about those businesses, I would highlight the strength of the operating businesses and the capital allocation skills and strong execution of their managers.
Using Comcast as an example, it has done a phenomenal job of rolling out its X1 video platform. In its most recent quarter and for the first time in eight years, Comcast had an increase in its video subscriber growth. It has also done a good job in its internet data services, business services, theme parks and in turning around NBC. When we look at those businesses historically and then project them going forward, and discount back the cash flows, we arrive at a valuation that is above its current price.
A traditional discounted cash flow model, where we model the cash flows and discount it back to the present to determine an enterprise value, won’t pick up share buy-backs. But we sometimes also look at an internal rate-of-return (IRR) model, where we look at the expected operating and financial performance of a company using a leveraged balance sheet and project how the company will be valued in the public market five or ten years out. In that kind of a model, we can model free cash flow being used to buy back stock. Assuming the share buy-backs are done at attractive price levels, we will see a higher return or IRR with the share buy-backs as opposed to distributing cash flows as dividends.
Of those four companies, we view Oracle and Discovery as trading currently at the greater discounts to our intrinsic value estimates.
Equity investors have enjoyed a seven-year bull market that has left valuations – by many measures, such as the CAPE ratio – at historically high levels. What guidance can you offer to financial advisors who fear the next bear market and are adjusting their asset allocations accordingly?
The question is correct. When you look at equities based on a P/E or CAPE-ratio basis, it suggests that equities are reasonably expensive. To me, that suggests you want to be very strict in applying your investment criteria and be disciplined on valuation, owning companies that provide have-to-have products with very loyal customer bases that have a demonstrated clear competitive position, a good balance sheet and generate a lot of capital and free cash flow that gives flexibility when there is the inevitable recession or market downturn. You want to be very careful about valuation and avoid very clearly overpriced securities.
That is what we are trying to do today, as we have done in the past, to protect ourselves in a relatively expensive market and for a potential market correction or bear market.
It is very difficult to time the market. We believe in owning businesses over a long time period. The current period is not too different from when we took over the fund in October 2005. Values were relatively high, and in 2008 there was a sharp bear market.
I believe that we will be able to achieve reasonably good returns and protect capital in bear markets, as we did in 2008. But nothing is guaranteed. There are a lot of macroeconomic challenges, such as the impact of central-bank policies and the potential for a global recession. One could argue that there is a disconnect between the relatively high valuations and the significant macro challenges that exist.
I want to highlight the high-quality businesses we own, like Wells Fargo, Oracle, Nestle and Zoetis, which is in the animal health business. These are very high quality businesses that, in our opinion, are positioned for both good and bad times.
Timothy E. Hartch
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IM-2016-10-19-3332 BBH001765 Expiration Date 01/31/2017