Hail to the Chiefs

http://www.hedgefundletters.com/chieftain-capital-management-brave-warrior-advisors/

Chieftain Capital Management / Brave Warrior Advisors

The original Chieftain hedge fund was founded by Glenn Greenberg and John Shapiro in 1984 in New York City with a capital of 40 million dollars mostly from their family. In the first five and a half years of their operations, they averaged a compounded annual return of 28% for their investors. The media noticed and CNN compared the duo to Warren Buffett and his partner Charles Munger. The chemistry of the team – Mr. Greenberg brought a certain passion to the stock selection process and Mr. Shapiro tempered the passion with detached skepticism – and unanimous decision making accounted for the outsized returns.

From inception through end of 2006, they multiplied their investors’ money 100 times by compounding the funds over 23% annually. In 2008, however, they had their first significant downturn (reportedly 25%). Due to disagreements regarding management, the duo announced they will be splitting the 2 billion dollar plus fund in late 2009 and in January 2010 Mr. Shapiro started the new Chieftain and Mr. Greenberg renamed his own fund Brave Warrior Advisors.

Today Mr. Shapiro’s fund has 1.5 billion dollars assets under management and Mr. Greenberg’s fund has 1 billion dollars. From their latest filings, both funds hold 12 positions each, with the top five positions commanding more than 50% of the assets and the top position amounting to 14% and 17% respectively. This concentrated style validates their statement that they did not split the fund because of any differences in investment philosophy but rather managerial issues. The investment philosophy that helped them garner the impressive streak of returns for their investors continues to dominate their separate funds.

At the outset in 1984, the original Chieftain was founded on some basic rules as to how it would be run. First and foremost, both the partners would dedicate the majority of their time to doing their own ideation and research and portfolio management.  That meant brokerage firms were not allowed to call them with their ideas – in the rare instance if either of the partners needed outside research they would place the outbound call.

Secondly, the firm would not engage in marketing their fund as that would take time away from their core competency of managing money. Instead, they would concentrate on growing the assets organically through competent security selection. They would get new clients from word of mouth and the client would independently choose to invest with them. That ensured a good match between their investment philosophy and the client’s expectations.  They practically had no redemptions until the tumultuous year of 2008.

Thirdly, whatever they bought in the fund would also be bought in their own and families’ portfolios. The dictum of eating their own cooking would ensure alignment of interests with their clients and focus them on making the right investments as their money would always be on the line also.

Armed with this focused procedure that eliminated unnecessary distractions from the business of managing money, the matter of portfolio construction was addressed. In order to outperform the general markets, the portfolio has to be concentrated – alpha is generated by differentiation, far from the all too familiar “management” style of index closeting.

More specifically, every position should command at least 5% of the portfolio, and if the conviction is amiss to take the said stake then the investment should be eschewed altogether.  This construct also ensures that only high quality businesses with limited probability of uncapped downside make it into the portfolio.  The psychological corollary to this is that in a down market one holds on to the stocks as the probability of losing money permanently has been removed as much as possible – this in turn leads to having the patience and fortitude to hold companies for the long term which is often needed to achieve above average returns.  True to this, both the original Chieftain and the two new funds usually have the majority of assets allocated to ten or so stocks and are open to holding the portfolio for the long haul.

As to the actual business of stock picking within this frame, there are three elements that are crucial. 1. The management of the company.  2. The business model of the company. 3. The valuation of the company. All three have to be favorably aligned in order to be investment worthy. Actually, only about 1% of the companies they research make the cut.

In regards to the executive management of the company, first they have to be simply shareholder-oriented for the long term. For this to truly happen, the management has to be mainly interested in running the business well. Simplistic as these requirements are, they are not easily met thanks to many managers’ emphasis on achieving quarterly earnings or not understanding the ground level realities of their industry.

In today’s information overload in the financial analysis of publicly-traded companies, the management is faced with a barrage of questions and the important one’s get leveled or buried with the insignificant ones. The astute analyst pays attention to a maximum of three most key questions to see if the management has an essential understanding of their domain. For instance, prior to making an investment in Abbot Labs, when meeting with the management  the fund established that the management had a satisfactory strategy to address the fact that their top selling product (accounting for fifty percent of their revenue) was approaching maturation.  (In the case of Comcast, however, after the fund had acquired a significant stock position in what it believed was a good business model, it was disappointed in the management of the company and in an activist manner demanded the ouster of the CEO.)

Moving on to the second crucial element of the security selection, the business model they seek is consistent with their emphasis on downside protection. They are not attracted to brand new frameworks where the growth might indeed be higher than established businesses but the risk of the new business disappearing altogether is a very real possibility.

Instead they look for companies falling into any of these four business models: (1) One which enjoys a local monopoly in a field, (2) Has the advantages of low cost in a commoditized market, (3) Is engaged in a basic and essential service that will not stop growing in the near future, or (4) A company in a steady industry that is growing so slowly that there are no new competitive entrants.

Their investment in Quest Diagnostics which administers medical tests was a good example combining some of the outlined business models. It was in a mature business that was growing at a steady rate, yet not with such speed that it attracted too many new entrants. Additionally, any new competitor would have had a tough time in scaling up and penetrating the company’s already established reimbursement arrangements with the medical community. These barriers to entry resulted in the company enjoying extremely high and well protected metrics in regards to return on capital, free cash flow, and profit margins.

The third leg of the investment stool is the market valuation of the company. As Mr. Greenberg puts it, the aim is to get growth at an “unjustifiably” low price. A decent, not necessarily great, business generating about 10% of free cash flow and a 3% to 5% growth, adds up to an expected return of 13% to 15%, as opposed to the expected 6% to 8% of overall market growth.

While it is important to build one’s own financial projections, one has to be careful not to extend the estimates beyond three years. This is so because it is unreasonable to truly predict anything beyond that time horizon and also because one has to be wary of getting too involved in the complexities of financial modeling to the point where the competitive advantage of the company is overwhelmed by abstract number crunching.

When the fund started the valuation mispricings existed because of lack of information and today the computer driven markets pay too much heed to miniscule numbers that do not affect the long term prospects of the company. In both scenarios, the mispricings usually exist in the large cap companies of boring industries which is indeed the hunting grounds of the fund.

Ultimately the market recognizes the mispricing, but it can sometimes take five to seven years or longer for the actualization. For example, when the fund bought Freddie Mac during the Gulf War down market, they held on to the stock for nine years and realized a twenty times gain. Interestingly, the stock was not sold simply because it was a twenty bagger; rather, they saw the deterioration in the business fundamentals as Freddie Mac began to delve into riskier mortgages. While the higher valuation of the business also played a role in the selling of the position, more importantly it was the risk of Freddie Mac undergoing a dramatic change in its business trajectory.

In the instance of the cable industry in the early nineties, they found the mispricing driven by analyst exaggeration of the threat of satellite television.  While the latter was indeed going to compete for market share in the television, the cable companies were going to have higher growth in the DSL internet space and continue to command a good share in the television business (especially since the satellite companies were having their own technical rollout troubles). In any case, the cable companies they bought (at one point up to 40% of the fund’s portfolio) were definitely deemed to be undervalued as they were trading at an average EBITDA multiple of 5. By the late nineties, the multiples expanded to 15x and they sold for five time their original investment (with the exception of Comcast).

On top of all the filtering analysis inherent in their investment philosophy, an additional layer of risk management is added by limiting the buys to the US domestic market only, thereby both removing the risk of currency fluctuations and being exposed to unfamiliar accounting or regulatory issues. As for missing out on the faster macro growth being enjoyed by other markets, many US conglomerates now derive significant revenue from these markets.  In any case, the macro US or global predictions are only incidental to their concentrated hand-picked micro portfolios.

Manager Biographies:

Prior to co-founding the original Chieftain Capital Management, Mr. Shapiro worked at Central National Corporation and Merrill Lynch & Co. He graduated with an MBA from Columbia Business School and a BA from Wesleyan University. He made a donation of 3.5 million dollars to the Creative Writing Center at Wesleyan as he had aspired to be a writer when studying there but was, in his own humble words, “stymied by insufficient talent and a lack of discipline”.

By the time he co-founded the original Chieftain, Mr. Greenberg had garnered ten years of experience in the finance industry: First five as an analyst at Morgan Guaranty (now JP Morgan Chase) and the other as a research analyst at a small private investment firm. He has an MBA from Columbia Business School and a BA in English from Yale University.

Mr. Greenberg’s father was the famous baseball player “Hammerin’ Hank” Greenberg of the Detroit Tigers.

His son Spencer started an artificial intelligence driven quant hedge fund in 2007. The fund is tellingly named Rebellion.

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QUOTES

“Although Chieftain’s partners remain committed to the firm’s investment philosophy, differences on internal firm matters have led us to decide to separate”. (This quote is from a letter to investors announcing the break up, the rest below are from Mr. Greenberg.)

”That way [by making joint decisions on stock selection] we avoid blaming each other for our losers. We try to be competitive with the rest of the world, not with each other.”

“The firm broke up at the end of last year, and I started Brave Warrior with the same precepts”.

“So the question is why should a decent quality or good quality business be priced to give you a 13-15% return when the market is priced to give you a return of about half that? Eventually somebody discovers this, somebody wakes up – it is not necessarily that the boring company with a double-digit cash flow yield has got some major trick up its sleeve; it just gets recognized as mispriced relative to the market. I would say that even though the equity market has run up quite a bit, there are still a lot of those companies around.”

“Going for too much certainty can hold you back – there is no certainty”.

“But, the world looks a lot better today than it did [in the financial crisis of 2008]; the worst didn’t happen and stocks have done brilliantly. If you listened to people back then, you would have thought that not only were corporate profits going to collapse, but that there would be no recovery and stocks were a terrible place to have your money. That is what they call conventional wisdom – it may be that very brilliant minds come to the same conclusion, but it still becomes conventional wisdom and it does not mean that it is right”.

“I would say our edge is the willingness to take a longer view of a business”.

“This idea of an intrinsic value implies that all investors, or average investors, will insist on a certain rate of return. I don’t even know what the term fair value means and that seems to be bandied about a lot. I do not think we could agree upon what the fair value of the market is because we all have different return requirements”.

“I have never seen anyone who could predict the market or predict the macro economy with any degree of consistency”.