Remember Mr Market? The amazingly accommodating but emotionally charged business partner, who approaches you every day with an offer to buy you out in business or sell his stake to you? You could either ignore him, or take advantage if he showed up in a particularly foolish mood, but if you fell under his spell, you’d be out of the game for sure.

The metaphor introduced by Benjamin Graham, the father of value investing, was to drive home the point that stock prices often deviate from their intrinsic value, and it is up to investors how they treat Mr Market.

There are times when people will pay more for a business but that does not necessarily mean that the value of the business has changed...

Several years later, Mario Gabelli introduced something similar called Mr Private Market. Someone as impulsive and unpredictable as Mr Market, Mr Private Market also brings the same incredible optimism and overwhelming gloominess as his older counterpart, the only difference being that the former was more knowledgeable about the value of business.

Mr Private Market buys a company so he can actually effect changes to make his investments more profitable – he can fire incompetent managements, close down loss-making units and cut costs to improve his realisations. Essentially, he’s open to doing everything that comes with the benefit of control. This concept is captured in a simple metric called private market value (PMV).

Sixty-seven-year-old Gabelli, who had his first brush with value investing in 1965, when he studied under Professor Roger Murray (co-author of the fifth edition of Graham & Dodd’s book, Security Analysis), is the founder and chairman of Gabelli Asset Management Company (Gamco). Set up in 1977, the company currently manages assets worth $18.5 billion (March-end 2009). The biggest of the funds, the Gabelli Asset Fund, boasts assets worth $1.7 billion and has returned 2.8 per cent (annualised) in the past 10 years compared with the S&P 500, which gave a negative 3 per cent over the same period.

Life after death

Gabelli consistently seeks out potential catalysts in his investments, even if it means waiting until the founder of a company passes away and someone else takes over the reins.

In an exclusive conversation with Outlook Profit, Gabelli spoke on an exhaustive range of subjects, from how he spots companies with potential catalysts and the outlook for Cadbury’s, to the Obama presidency. Contrary to popular opinion, he also believes that the moribund General Motors may still have some life in it going ahead.

But, first things first. Let’s explain what PMV is. PMV (private market value) is what a company is worth if it is acquired by an informed wealthy family, or by another private or public corporation, as opposed to the price it is trading at in the stock markets. Simply put, it is the intrinsic value of a company plus the control premium.

To calculate PMV, Gabelli first takes into account the free cash flow (after allowing for depreciation), deducts debt and net options (stock options) and adds back the cash. To this, he then applies an ‘appropriate’ multiple to arrive at the PMV. It sounds simple enough, but where you can go completely wrong is the multiple. Gabelli says he either looks at recent valuations of similar acquisitions or applies an appropriate historical industry acquisition multiple to arrive at the PMV.

“Some of the factors that we look at while deciding multiples to apply are: what the business is going to be worth in five years from now, what kind of return on equity can we get over time, how much further debt can be put on the company, the tax rate and what the company would be worth if there was no growth or at some particular rate (4 or 8 per cent for instance),” he explains. Of course, the multiple – and the PMV – changes over time, as it is a function of interest rates, the capitalisation structure and taxes, all of which have an indirect impact on the value of the franchise.

Getting it right

But as is the case with any valuation exercise, much depends on the external environment in which the deals take place. Analysing at what multiples similar companies have been acquired for in the past, based on earnings, cash flows, etc, works better when markets are depressed or in a steady state and certainly not when they are euphoric. The IT boom of 2000 saw takeovers at huge premiums to underlying value. If you blindly took what IT companies during these times were acquired for and based any conclusions on those numbers, God be with you!

We are willing to pay a fair price for a marginal company in an environment in which it is turning around. You have to look at the earnings power of a company over an economic cycle

One example of how things can go wrong is highlight by the acquisition of The Learning Company (TLC) by toy maker Mattel for $3.6 billion in 1999. TLC had, at that time, sales of around $392 million and reported a net loss of $475 million. Almost immediately, Mattel sold (read wrote off) TLC to Gores Technologies in 2000 for a share in the profits, whenever they came. It’s a prime example of how exuberant environments can sometimes edge ahead of financial sense. “There are times when people will pay more for a business but that does not necessarily mean that the value of the business has changed – it only means they are willing to pay more now,” says Gabelli.

This explains the problems faced today by private equity firms. Many of them acquired companies at huge premiums to their (the companies) intrinsic values. Two years ago, private equity firms were able to get 8-9 times leverage with few covenants on their debt, so they didn’t think twice before rushing into ill-thought out acquisitions. The amounts they were willing to pay were above intrinsic value; obviously, as a company owner, you’re not unhappy. But if you were a buyer, you’d be in a mess today trying to refinance that debt. “That’s why so many takeovers of 2005/06/07 are going bankrupt now,” says Gabelli. This is why Gabelli exhorts investors to always figure out the intrinsic value, or the underlying value of the business.

One other guide

His other favorite guide to a good investment bet is of course, the potential catalyst. Catalysts come in various forms: a merger/takeover announcement, a change in the management of the company, or even the death of a company founder. Remember the Reliance split post founder Dhirubhai Ambani’s death and how much value it unlocked for investors?

Similarly, the election of Barack Obama as US president, and his stress on cleaner energy resources and a greener environment, for instance, could eventually benefit natural gas companies in the US. Closer home, the re-election of Manmohan Singh as prime minister without the Left parties is also expected to bring about reforms and accompanying benefits to a whole host of industries here.

***

What’s in the kitty

Industrial materials and consumer goods companies account for almost half of Gabelli Asset Fund’s billion-dollar-plus portfolio

Gabelli Asset Fund has a diversified portfolio of companies

	In %
Telephone & Data Systems	1.8
Rogers Communications	1.8
Cablevision Systems	1.7
Deere & Co.	1.7
Newont Mining	1.7
Procter & Gamble	1.6
News Corp.	1.6
Chevron Corp.	1.6
Exxon Mobil Corp.	1.5
Flowserve Corp.	1.5

***

Another example of a catalyst, according to Gabelli, that can create opportunities going forward is the kind of merger of chocolate manufacturer Mars with Wrigley’s (which makes chewing gums) which took place last year. Gabelli says that merger created disequilibrium in the $140 billion global confectionery market – making the Mars-Wrigley’s combine too big for any other player to compete with successfully and paving the way for consolidation in the industry. That’s why Gabelli is betting rival Cadbury’s will either partner or merge with Hershey or Kraft in a bid to deal with the new dynamics of the market. Alternatively, it may just be taken over sometime in the future.

Give it some time

Of course, not all catalysts work the way investors want them to, and in fact, some of them may actually wreak havoc on the stock. The failed attempt of Microsoft to buy search engine giant Yahoo in May 2008 is one example (Microsoft finally did sign a deal with Yahoo in July this year). Yahoo investors lost heavily when the markets dumped Yahoo shares once it became clear that the offer was not going through; the stock tanked from $32 to $15.

So how do investors protect themselves from such an unfortunate turn of events?
Gabelli says he typically gives his catalyst stocks 2-3 years to work out. If they do not, he says, he doesn’t lose too much sleep over it because he’s at least got the first step right, that is buying shares below their intrinsic values. “The underlying business will keep on growing at its normal growth rate and since you have paid less than the intrinsic value of the stock, it will help realise gains in the future,” he explains.

In the worst-case scenario, the potential catalysts can turn against the company itself and destroy more than just the potential gains investors may have been counting on. For proof, Gabelli points to the recent case of Matrixx Initiatives Inc, which was developing a high-potential product called Zicam – a nasal gel to weaken the effect of the common cold. “Unfortunately, certain Zicam products allegedly had side effects,” explains Gabelli. “The stock fell from $19 levels to $5. In this case, the catalyst failed to produce any positive result for the company.” If the product had been a commercial success, Matrixx stood a good chance of being snapped up by its bigger rivals. But that’s the price you pay if you invest in stocks based solely on the ‘catalyst’ effect.

Spread your bets

An important point to note is that Gabelli assigns no value for these so-called catalysts. “The catalyst is not a part of valuation,” he says. “The valuation is based on the company’s market share, its growth rate, its management, the changing dynamics of the business, and the company’s pricing power.”

Part of the solution may lie in spreading your bets. For example, Gabelli is quite bullish on media companies, which now account for 11.6 per cent of his billion-dollar-plus Asset Fund portfolio. Ask him how he takes the risk out of investing in high-risk media companies for which it’s practically impossible to predict in advance the success or failure of future movies and Gabelli responds swiftly: “If the movie studio puts up $200 million or $500 million for a single movie or a few movies, that is a big risk for the studio. You want to make a smaller bet on a larger number of movies. If a studio does 20 movies a year, the risk of failure of some movies is cancelled out by the success on others.” Further fruits to be enjoyed come from selling DVDs, renting the movie to television, selling merchandise and selling license fees for video games.

Another good investment bet is holding companies or conglomerates, in which often a lot of value is locked up. Gabelli’s advice: “Look at where the owners are putting their own money. That is where you want to go.”

But instances abound where promoters of such companies do nothing to unlock the values underlying their businesses. In such cases, Gabelli advocates patience. If the owner is an old bum, sooner or later, the catalyst (read opportunity) will present itself. He recalls the example of a diversified manufacturing company called Sequa, which has operations in aerospace, automotive and specialty chemicals. Its founder Norman Alexander died at the age of 92 in 2006. Within a year, the company was sold to the Carlyle Group at a 54 per cent premium to the stock price then.Following are excerpts from the conversation with Gabelli.

Where do you see yourself on the Graham–Buffett continuum?

We have added our own approach to the Graham and Dodd approach. Back in the 1930s, it was very hard to put a value on a franchise or a brand. They didn’t value that, but we do. For example, what is the value of the brand Campbell Soup? It’s not in the balance sheet.

To really understand the value of the brand you have to look at its pricing power in an environment in which consumers are trading down. You also have to study what happens in an inflationary environment and if they can keep Campbell soups on the shelf of a new distributor like Wal-Mart as opposed to their private labels. You can’t say that Campbell soup is worth $1 billion. Instead, you ask, “Is the earning power of Campbell influenced by the ability of the brand to maintain pricing power in the face of economic challenges such as inflation/deflation, going against private labels and so on?

But ultimately do you attach a value to that?

No, we don’t specifically attach any value, but we do know the value is driven by the cash flow of the company which is driven by the strength of the brand. We are willing to pay a fair price for a marginal company in an environment in which the economy is turning around. You have to look at the earnings power of a company over an economic cycle. If you look at cyclical companies at certain times like during the up-cycle, one would find that leverage can benefit the company and is therefore desirable during those up-cycles, while in down-cycles leverage can cause more harm than good and is therefore not desirable. At that time you should sell such companies.

But in times like these would you want any company to have leverage?

At certain times leverage is important, at certain times it’s not. The question is does the company have cash flows? If you are a steel company, obviously it’s a cyclical business. If it is a highly leveraged operating company and heading into a down-cycle, it should not be highly leveraged. If there is high debt to total capitalisation, but if the business has recurring monthly subscription revenues, like perhaps $5 a month from 100 million subscribers, like a wireless telephone business, leverage is not necessarily bad.

Is it time to buy cyclical businesses?

You buy such businesses when they are ignored and unloved and doing terribly. We’ve been making money by buying auto parts companies. We started buying car retailers in the US about four months ago. Nobody wanted to own them and the stocks have gone up three-fold since.

But haven’t these auto companies gained because of government-sponsored bailout plans? Would they have survived left to free market forces?

In the US, we have 250 million cars on the roads; the average age is 9.4 years. In a given year, 11 million of those are scrapped. Demand in 2009 is nine million units, down from 16 million. Because of this reduced demand and because of the problems of General Motors and Chrysler, the number of dealers has reduced from 22,000 to 15,000, so the company that has the cash and the desirability to maintain its dealer base will have more sales when the economy recovers. Of course, it’s not going to recover next week; it’s going to recover in the next five years. In the markets, because the hedge funds are going out of business, and the mutual funds are selling, and because there are reporters saying that you have to sell your auto parts companies, stocks go well below their intrinsic values on normalised earnings basis. Those give us a catalyst based on economic dynamics.

So are you buying any General Motors shares now?

We are buying Auto Nation, which is the no.1 car dealership in the US. We are buying a company called O’Reilly Auto Parts, which sells replacement parts. We are also buying Tenneco, which makes original equipment.

You think GM still has some life left?

Yes, GM has a 20 per cent share of the US market and a significant percentage of the markets in Latin America, Europe and Asia barring Japan. At some point in time, when they have the reverse split and the stock goes through the re-organisation, you may want to own a cyclical company like GM. We are not telling you to buy GM today, just that at some point, the stock will be attractive. Not today.

What books, besides “The Intelligent Investor” do you recommend to our readers?

If you want to read about what happened in the US, you need to read J P Morgan’s Jamie Dimon’s 2008 Chairman’s Letter, that’s all. I read a lot of annual reports. To the readers, I would recommend reading the past 10 years of Berkshire Hathaway’s annual reports.

What do you do in your free time?

I read annual reports!