The name Donald Yacktman does not come straight to one’s mind if you try to recall successful value investors over time. But Yacktman’s investing career is a classic example of what to expect when you doggedly follow one investing style and value at that. There will be good years and bad years, just like Yacktman’s had them. However, the lesson is that if you’ve done your homework right and you have the temperament and patience to hold on to your stocks, you stand to gain, even though you may have to wait for many years for your investment to bear fruit.

Yacktman, 68, has had good years and bad. In fact, in 2009 he has come full circle. From being venerated as a top stock picker in the mid-90s, to being vilified as having lost his touch during the years of the tech boom, and back to figuring among the five finalists in the competition for the Morningstar Manager of the Decade award, Yacktman has seen it all.

In the early 1990s, Yacktman evolved into one of the most sought after portfolio managers. His fund, which was launched in 1992, returned a respectable 14 per cent annualised through 1997, by which time he had $1.1 billion under management. But when the technology boom was in full swing, his investment style began to look old-fashioned. Like other value investors, Yacktman’s fund, which increasingly began to look at non-tech, small-cap stocks, began to falter. In 1998, the flagship Yacktman Fund, gained only 1 per cent as compared with the S&P that returned 27 per cent. At the height of the tech run, in 1999, the fund turned in its worst performance, losing 17 per cent, even as the S&P returned 19.5 per cent. By September 2000, Yacktman was managing only $69 million as investors bolted through the door.

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The favoured few

Though Yacktman’s approach is company specific, media, consumer goods and healthcare stocks constitute a chunk of the fund’s holding

Source: Morningstar

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All this while Yacktman stubbornly and unapologetically remained firm in his search for good businesses that had lots of cash and were available at a good price. Such stringent conditions meant that he had to look more towards small-cap stocks rather than the large-caps that were advertised in his fund prospectus at the time. This did not go well with Yacktman’s board of directors, with whom he got into a fight for survival. While some board members thought Yacktman was taking too much of a risk and that he ought to inform investors about the changed investment universe, Yacktman maintained that he was buying values wherever he could find them, irrespective of the size of companies into which he put money and would continue to do so. Yacktman eventually won the battle with the board late 1998.

Then, in the three years following the market crash, things started to turn around for the better for Yacktman. In 2000, when the S&P was down 10 per cent, Yacktman was up 13.5 per cent. In 2001, he bettered his performance by returning 19.5 per cent, as the S&P lost 13 per cent. In 2002, again he trumped the market by a huge 34 points, returning 11.4 per cent even as the S&P lost 23 per cent. Between 2003 and 2006, as the credit boom cycle picked up and consumer stocks fell out of favour, Yacktman’s fund trailed the index by between -1 per cent and -7.5 per cent. In 2007, he beat the index marginally by 2 per cent, but Yacktman was back in the game in 2008 as the credit crisis unraveled. That year, he outperformed the index by 11 points, and in 2009 (up to mid-December) his fund has returned 56 per cent, 31 points higher than the S&P.

Yacktman typically outperforms when everyone else is getting hit in the markets. Yet, the fluctuation in the performance is not a reflection of his investment strategy. He has adhered to it through thick and thin. Like other value fund managers, Yacktman has a field day when markets are down and value picks abound. When markets are euphoric, rather than investing in something that offers sub-optimal returns, Yacktman waits for his turn.

Yacktman continues to view buying stocks like buying a piece of a business, ferreting out companies throwing up tons of cash on a consistent basis, having low exposure to cyclicality and available at a bargain price. His insistence on waiting to buy at a good price has certainly helped. Take the case of Tyco. Yacktman says, “There were two days when it went below $10 and we were the only buyers in it. And most people thought we were nuts!” He quadrupled his investment in this company.

Donald Yacktman says he always looks at the forward rates of return when ascertaining the fair value of stocks. He also includes credit quality, valuation and future cash flows.

What has also held him in good stead is his long-term approach to stocks. As opposed to momentum fund managers for whom long-term investing means holding on to a stock for as much as 12 months, Yacktman can patiently stick with his investments for five, even ten years. Take the case of Lancaster Colony, a diversified company, that Yacktman bought in 2000. He eventually sold some stake in Lancaster between late 2008 and early 2009, to buy other more compelling values when the markets were being battered. Yacktman says he is comfortable holding on to his companies for long periods as long as they continue to generate cash and grow value internally. He isn’t overly concerned if the stock market does not vote in his favour immediately. “Stock market recognition can come later,” he says. Yacktman says that on a one-, three-, or even five-year basis he may not come out tops, but on a longer time frame he does beat many at their game. The performance of his fund is a testament to that. For the last ten years, the Yacktman Fund has returned 12.26 per cent CAGR compared with the S&P, which returned -0.57 per cent in the same period. A feat, according to Morningstar, that ranks the fund among top diversified US equity funds.

In an interview to Outlook Profit, Donald Yacktman talks about his investment process and the things he looks out for.

You are often credited as being a growth investor, who uses value techniques to pick up stocks. How do you do that?

Let me take you through our process. Our logo displays a triangle. Take the first part of the triangle. What we do is that we look at stocks as we would look at bonds. What we are trying to do is to put a forward rate of return on everything that we buy: credit quality, valuation and future cash flows. The second part of the triangle ­– we favor businesses that are highly profitable. If you put it on the graph, with one axis as asset intensity and the other axis economic sensitivity, we tend to favour businesses, with everything else being equal, having low capital requirements and with low economic sensitivity. In other words these companies have pretty steady and predictable cash flows, like Coca-Cola and Procter & Gamble. Rarely do we go into businesses that have high fixed asset requirements; we have never owned an airline stock for example. Think of it as how you determine the coupon rates. Which kinds of businesses have higher coupons, in other words high return on assets?

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Cash is king

Yacktman’s focus on consistent cash flows shows in his holdings, populated by huge cash-generating companies

Yacktman Fund’s top 10 holdings as of September 30, 2009 (in %)

Source: MorningStar

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The third part of the triangle – we look at the reinvestment of cash flows. The reason this becomes important is that we’re very long-term investors. We look at the options that the management has and how well it has done and managed, not just what they say they’re going to do. We look at how they allocate capital – if they make an acquisition we will look out whether they’re over-paying. Years ago, Quaker Oats purchased Stokely-Van Camp and basically got Gatorade for nothing. But several years later, they purchased Snapple and lost over a billion dollars because they overpaid and it wasn’t synergistic with Gatorade. That’s pretty much a summary of what we do.

Let’s take it one by one. You said you look for low asset and high capital intensity. Why the focus on these two? What do these characteristics do for the business you are looking at?

Low asset intensity is important because, the more assets a company has, it becomes like a big sunken cost. Such heavy asset companies are more vulnerable to downturns, a threat from labour, or a threat from government. There is a lot less flexibility. Look at General Motors over the years. What has happened is that it has declined because it was vulnerable in all those areas. On the other hand, take Philip Morris. Over the last 45 years, GM and Philip Morris were declining industries or very slow growth industries, yet the results are like night and day. The more the product costs, the longer the life of the product and the more the assets involved, which make it more vulnerable. Take the example of a tractor which has an average life of 17 years, and that for John Deere (tractor maker) is a pretty long cycle.

Do you invest in cyclicals or do you generally avoid them?

What happens is that most cyclicals are capital intensive, so they don’t make a lot of sense. On the other hand, there are companies that have asset intensity, but they also have relatively predictable cash flows, those are a lot easier to invest in. Things like utilities and telephones companies, cable TV. Comcast (a cable TV company) was our last investment. We look at the company, we don’t try to predict the economy, we don’t try to make a call on interest rates, and our efforts are focused on individual stocks and individual businesses.

So what do you look for in stocks?

You start with the price. Even poor businesses bought cheap enough can give you a decent return, but if you get all three pieces together it could be dynamite. Price is critical in stock evaluation. Let me give you a classic example. Coca-Cola is a great company. The stock maxed at $89 in 1998, and almost every year after that its EPS has gone up, but it would remain a poor investment if bought at near $89. We bought it at half that price. So, price becomes critical.

When you say price is critical, what are you measuring price against — earnings, book or cash flows?

Basically what we look at is cash yield plus growth rate. There are three elements to it. First, you look at how much cash there is. Second, how much growth is there. And the third is inflation, because inflation affects all investments. You basically get down to cash generation plus growth rate.

While looking at yields, is there any minimum yield you want from your investments?

Part of that depends on the quality of the company. We’ll take a lower rate of return on Coke than we would on something else. Coke is like owning an AAA bond, and part of the problem today is that with interest rates being pushed down so low, and ultimately everything is priced against long-term treasuries, the valuation of a lot of other assets is being pushed up. We rarely like to dip below double-digit returns. It has to be very high quality to be below this and there are not many equities out there like that.

Graham didn’t want to pay more than 10 times earnings. Do you have any similar pre-set maximum levels, above which you will not pay?

The problem with Ben Graham, is that by following his discipline you could stay out of trouble, but it is very defensive. One should start off from Graham, but sometimes it gets formalistic. Ultimately one has to evaluate the business. Even someone like Buffett, who is the best capital allocator of this century, has realised that even though you can buy some businesses rather cheaply, you are better off buying better businesses and paying up a little bit, though he is still very disciplined on his price. But he is a businessman who uses the stock market and not your usual portfolio manager or a mutual fund manager. What he can do, and what we can do, is different. He has the ability of buying the whole business and taking control of the cash flows and therefore taking control of the third leg of the triangle. We franchise that decision out to the management teams, we talk to them, and we depend of them and on what they do.

Buying stocks like you were buying a business and taking the approach that you take, does that not put you behind momentum players who can move in quickly and take advantage of trends, hot favorites and the like. How do you keep up with them?

That’s true, and I think 70 per cent of all the people in this business are momentum players. Patience requires a longer time frame and this most of them don’t have. On a one- or three- or five-year basis we may not always be on top. However, if you look at our 10-year record, we have consistently been above the S&P. Right now, our two funds are 12 and 13 per cent compounded every year, better than the S&P. So, over time it does work, but people are sometimes really impatient and look at things on a 10-day/10-week/10-month basis only.

If the assets have any value you could gain from liquidation, sure. But tell me, why would anybody want to buy you if you were not making any money?

So when you buy a stock how long are you willing to wait for it to give you returns?

Oh, years and years and years! It’s not a function of time really, it is a function of letting things evolve. Let me give you an example. We bought a position in Lancaster Colony Corp (a diversified consumer products company) back in 2000. It was dirt cheap when we bought it. It was a great company. It did have some vulnerability though. They are somewhat beholden to the price of soybean oil for their salad dressing product. It is a company that most do not hear about because it is a regional brand. They have a good track record. But soybean oil is affected by the price of oil. For several years the company was being squeezed by the price of soybean. But then all of a sudden when the price of the oil went down, its margins went up like an alligator opening its jaws and the earnings just went up like a rocket. In the meantime, the stock market was getting crushed in the last part of 2008 and early 2009 but the stock kept going up. So it gave us an opportunity when we ran out of cash, to reduce our position, to buy things that gave us more value. So what it was doing was growing its value internally, which the stock market recognised later. Eventually, it did get recognised and that’s why patience does pay! At one time it was one of our top 10 holdings. Now we’ve reduced our position, but while we held it we’ve doubled our money and we had a lot of dividends on top of it. It is one of those rare companies that have raised the dividend every year for 45 years. Eventually, markets are like a voting machine in the short term and a weighing machine in the long term. In the short term if the market does not recognise value, and it gets more valuable, then we will buy more of it.

But you would want it to get recognised to eventually sell it to somebody and make profits on your investments?

Not necessarily. We don’t care. We’d be very happy if the stock market shut down for five years. We are in those kinds of businesses that we would be just fine as far as it goes.

You were also once credited for looking at stocks based purely on asset values, but it has been reported that you don’t do that anymore.

Ultimately the value of an asset is based on the cash flows that it generates. Let me give you an example. When we bought the Qwest bond (telecom service provider) we bought them because they had a 7.9 per cent coupon and they were selling at less than 50 cents to the dollar, so on a current yield basis they were close to 16 per cent returns. But the market was nervous about the bonds following Enron, Tyco and Worldcom. Two of them were good ones and two of them bad. We had the good ones Tyco and Qwest. Behind every Qwest bond was a telephone line. While other telephones companies were selling for $2000 a line, you could buy them at $500 a line. That’s value investing, whether you look at assets or cash generating bonds. Either way you look at it, if you buy things that generate cash, then by that virtue you’re getting a good deal on it. But if you buy a dead asset, like say General Motors, and GM is a classic example, GM was selling below book value but we never bought GM. It wasn’t generating any cash. The book wasn’t any good, the assets weren’t any good, so why would you want to own that?

You could gain from liquidation of assets.

If the assets have any value you could gain from liquidation, sure. But tell me, why would anybody want to buy you if you were not making any money? It always comes back to the ability to generate cash.

Okay, do you use the discounted cash flow analysis to arrive at fair value?

A lot of people in this business use some sort of discounted cash flow analysis. The problem is if you’re an insider, like a businessman, it is a lot easier to do that analysis because you have a lot of inside knowledge of the business that other investors do not have, and it is very difficult to get that information. But we do use the dividend discount model. In our business, I think, everybody uses a shorthand method of discounted cash flow. The important thing is that in this process you could lead yourself to a number of errors. We would like to be generally right than precisely wrong. Like when Tyco was selling at $12 a share, we knew it was generating anywhere between $1.50- $2 a share in earnings. Now that’s a pretty big range. But at $12 a share it does not really matter, it was such a good deal that it really did not matter. We had plenty of room for error!

And how did Tyco turn out?

Well, we still own them, but it turned out pretty well. We tripled and quadrupled our money in it. There were two days when it went below $10 and we were the only buyers in it. And most people thought we were nuts! We just love it when things go down, but most people cannot handle it. A lot of that ability to handle it comes from a lot of homework that we put into it. We have a lot of comfort in what we buy. And it makes a huge difference in our business to buy things when they are cheap, and when they’re going down and nobody wants them, and you’re willing to stand there and be a buyer. Most people cannot do that.

So which measure do you look for to ascertain a fair value for your stocks?

What we’re looking at is forward rates of return (yield plus a growth rate). If the rates of return are high enough and the quality is good enough then we’re interested in it. Basically, it’s what rate of return in our estimate that we could expect to get if we were to hold the stock indefinitely. In other words, if the stock markets shut down 5/10/15 years, we’d be comfortable holding it.

How comfortable are you with borrowings in the books?

I’ll be a lot more comfortable with a company with a high ROA. They generate a lot of money, so debt will go down because they don’t need it

Well it depends. Here’s the way I would look at it. I would say, what kind of returns are you earning in this business without the debt? And how much debt do you need? In other words, if you’re going to need a lot of debt to get your ROE up, that means probably you have a low ROA (return on assets). I think I’ll be a lot more comfortable with a company with a high ROA. They generate a lot of money, so debt will go down because they don’t need it, and the problem then is exactly the opposite. They will be generating so much cash that they have no place to use the extra cash.

If you really want to look at cash allocation, look at the guys at Lancaster Colony. They’ve evolved over the years, they have better businesses, they sold poor businesses, they bought back stock, paid a one time dividend, they don’t issue a lot of options, the founding family still has a big ownership in it so they have a lot of stake in it, and that is a good situation. But again, if they get too highly priced, then it’s not so good.

Is there a maximum limit of debt that you would accept in terms of debt/equity ratio of a company?

It’s not the debt/equity ratio that one should look at, but the coverage ratio. What is the operating profit that the company generates and what are the interest payments?

So what is the minimum coverage ratio that you want?

That depends on the business. I remember Coca-Cola Enterprises had a coverage ratio of less than 2:1, but their cash flows are so steady that they can borrow a lot of money and they have a lot of fixed assets, so for them it could be a logical decision to take on debt. General Motors on the other hand, for them you wouldn’t want them to have any debt because they earn so little return, it’s so horrible. So, if there’s a ratio to look at, I would look at the coverage ratio.

You must have made some mistakes through your investing career?

Let me put it this way. This is a humbling business, because in reality we are wrong all the time. It’s just a matter of degree, because somebody does not buy everything at the bottom and sell everything at the top. Mistakes are if you buy something that is too high then you’re never going to get your money back. Sometimes we get a case of management that surprises us and does something stupid. We had a very small position in Fannie Mae and Freddie Mac, but they were very small positions. We also lost some money in Furniture Brands because management did things that were advantageous to them instead of the shareholders.

Do you have sell targets?

You just sell when the forward rate of return it too low and/or when we don’t have comfort in it anymore.

What books would you recommend?

There are three categories. I think someone should understand where Benjamin Graham was coming from. If you’re starting from scratch you should read ‘The Intelligent Investor’ and ‘Security Analysis’, you need to have a base. I think some terrific books were written by John Train: ‘The Money Masters’ and ‘The New Money Masters’, though the first one was better than the second one. And the third one, I think one should read more on Buffet. The latest one was ‘The Snowball’, though that was more for pleasure. Then there is ‘The Real Warren Buffett: Managing Capital, Leading People’ by James O’Loughlin that I think can be made into a business course. I think it’s a terrific book to understand business. Then, if one were to go back and read Buffett’s letters that would be excellent.

Rumors have it that you usually sleep every afternoon and you can sleep even through major market upheavals.

No, I try to get on the treadmill now. I think that may extend my life a little more than sleep. So I do that almost every day for half an hour after the market closes. I watch ESPN and relax a bit.

No CNBC?

No! But don’t tell them that, because I’ve been on there once in a while! I don’t watch any of that stuff. The problem that I find is that everybody wants to know what is going to happen in the next 10 minutes, but I’m a 10-year investor, not a 10-day investor. It just doesn’t do anything for me.