Q: Roger, how many investment styles do you use to manage money?
A: Groh Asset manages six different types of accounts: Global big and small cap equity accounts, international big and small cap equity accounts, a global convertible account, and lastly, our conservative balanced account. However, the companies we purchase tend to share similar traits. The differenceshave to do with market capitalization and where the company is based. With all our styles our investment approach has never changed. We buy the highest quality company we can find
Q: How do these styles differ in their objectives?
A: Our customers represent two types of investors: institutional and individual. Generally our individual client base uses our balanced portfolio. Balanced is designed to provide significant long term rates of return, diversification and have less volatility than the overall market. Institutional asset diversification has become much more specific, especially in the international and small cap categories. Our customers are asking for country and capitalization specific styles. Our product mix is geared to meet these geographic and capitalization objectives.
Global big and small cap equity, and international big and small cap equity, all have growth as the primary goal. Our target market is the customer that is making market cap and geographic asset allocation decisions, generally mid-large seasoned individual investors and institutions. Groh Asset is traditionally one of several managers employed.
The convertible portfolio is a relatively short term (average four year) corporate bond portfolio. We manage these assets as a traditional corporate bond portfolio with maturities/puts laddered over a ten year time frame. However where we can find a convertible with the same yield to maturity/put and quality we will substitute the convertible. The effect is we get the upside for free. Overall returns are superb but we are especially proud that we have never had a negative year. We market this as an institutional high grade corporate bond style.
Q: Why would investors settle for straight corporate debt given the convertibles?
A: Investors should not settle for what amounts to less. The ability to capture solid rates of return, through the bond portion, and the potential to have even higher rates of return via the equity side make convertibles a terrific investment vehicle. By keeping the maturities short to medium term these bonds prove to be less volatile than stocks, yet provide equity type returns. Gradually institutional and individual customers are recognizing the benefits and adding Groh Asset as a manager of that portion of existing portfolios. The pace of individual customers using converts is likely to accelerate as municipal bonds become less attractive ( because of declines in quality and after tax differential in yields). If an investor needs higher rates of return than treasuries, but cannot afford the volatility of the stock market, our convertible strategy represents the solution.
There are plenty of pension plans, foundations, IRA's and individuals who use single managers. Our balanced style is designed to fill this void. Providing income, growth and low volatility a balanced style is a good fit for large portions of any portfolio. Our balanced portfolio is a mix of stocks and bonds found in the equity and convertible styles mentioned above. Typically the stock portion is low during periods of high market valuations (1987 and 1995 being representative years) in order to avoid major losses during significant market declines. More importantly during major declines we go against the crowd and add high quality companies that have declined in price because of the decline. McDonalds, Johnson & Johnson, Procter & Gamble, Thermo Electron, Gillette and Coca Cola are representative of what we would like to add on days of major declines. In all of the portfolios mentioned above we diversify among many (10-15) industries. Diversification reduces volatility and provides safety. To further diversify we limit the size of each position to betweenone and five percent of the total assets managed.
Q: It sounds like you have something for everybody. With what style is most of your money managed?
A: Today most of our assets are in the balanced account. The mix is likely to change as we attract larger families and more institutional customers. This type of customer is likely to demand one of the pure equity or debt styles. We expect all the styles to grow, but the smaller capitalization styles we would expect to quickly become the larger portion of our total business.
Q: What is the length of the performance period in each of the styles?
A: We opened our balanced style in 1986, convertible in 1987, domestic big cap in 1989, domestic small cap in 1993, international big cap during 1993 and international small cap during the second quarter of 1995.
Q: Where do you find your research information for your global growth portfolios?
A: When I first started in the business my research universe consisted of companies within the U.S. (The same held true for Japanese analysts who looked at Japanese companies, German analysts who looked at German companies etc.) Today most analysts get data on each company in every country. The result is we are able to search for even greater values. However we do believe local market knowledge is critical. As a result we created what we believe is the strongest research team in the world. We have teamed up with Morgan Stanley, Smith Barney, Merrill Lynch, Nomura Securities, Jeffries, Ong, Barings and Peregrine, picking the local analysts who best understand their country and industry. This is the most powerful edge we have. Once an industry is understood we can then segment the data by size and location to meet a specific need. I spend much of my time with management teams making sure we understand the company's plans.
Q: Where do most of your investment ideas originate?
A: Our research effort is broken down by industry. Our objective is to understand every company's history and long term growth plan no matter the location or size of the company. Take the telephone business (as most countries have public telephone companies). We have in-country analysts following the industry in most countries. That does not mean we will necessarily buy any of the telephone companies, but we will understand the industry. Should we decide to increase our telecom holdings we are able to quickly make decisions as we have already done our homework on the industry. Two telephone analysts on our team have worked in senior management slots for telephone companies, helping us further to find quality long term value.
Q: Exactly how does the economy influence your decision making?
A: We use economic trends in two ways. Over the long term, companies operating in countries with higher rates of economic growth are likely to experience higher rates of growth in their profits. It therefore makes sense to be exposed to those countries. This is a long term view, but perhaps most important we believe that stock prices reflect value created through profit. The second way we use the economy is in the timing of purchase of deeply cyclical stocks. As core holdings we purchase companies that grow consistently. However during deep recessions unusual values are created in the cyclical stock area. During deep recessions we would add car and steel companies to our portfolio, as traditionally these sectors provide the highest rates of return during the very early stages of economic recovery.
Q: Do you use asset allocation as part of your investment strategy?
A: We are not allocators. Our customers have hired us to buy very specific types of securities, having decided beforehand that historical volatility is acceptable. As a result we generally intend to remain fully invested. Even with our balanced style the mix between stocks and bonds does not change significantly. It is important to remember that the equity markets have risen over long periods of time, but there will be many bad markets along the way. Knowledgeable investors tend to increase equity commitments during bad markets rather than pull money out.
Q: Where would you rank earnings growth as a factor in your decision making?
A: Long term growth in free cash flow, or EBITDA earnings, is a critical part of our decision making process. As long as free cash flow increases, companies can expand their businesses, pay dividends, make acquisitions all of which increase a company's value. I would like to distinguish EBITDA earnings from earnings per share as EBITDA represents true earnings without the accounting distortions in earnings per share. The next question is one of valuation. Let's say we have identified a company that has the consistent growth characteristics we tend to look for. The next question is can we make money in the stock or does the share price already reflect future growth? Wall Street is trendy and there are usually stocks which have gone up faster than earnings growth. If the price is too high the company then goes on what we refer to as our wish list. The wish list is companies which we would like to purchase but that are unreasonably priced. With the anticipation that there will be significant market declines in the future we simply wait until those market declines provide lower prices. We are contrarians and buy high quality companies when they are out of favor.
Q: How do you control risk?
A: I would like to differentiate between risk and volatility. To me risk is centered on any company's failure to grow and increase net income. Translated that means a company will ultimately be valued on the basis of the growth of assets over long periods of time. As long as earnings go up regularly we will do wonderfully. We control risk by investing in companies which have shown the ability to grow consistently. Volatility has more to do with short term market conditions, an item we cannot control. However we all know that there are bad days in the market. Our intent is to take advantage of this volatility by adding great companies during periods of poor market performance.
Q: If there is just one rule you follow as an investment manager, what would that be?
A: Buy the best company and management team we can find.
Q: How would you describe your typical portfolio? How many companies would it have, how diversified is it, and are the companies generally recognizable to the public?
A: Typical portfolios would have 15-25 investments, equally weighted. In most cases the corporate name of a conglomerate is not easily recognizable to the average consumer. The corporate name may or may not be recognizable, but many of the products manufactured would be. An example might be not knowing of Procter & Gamble but using Crest toothpaste at home. Another example is being familiar with Holiday Inns but not knowing Bass is the franchisor. Try this as a test. Name three Intel products. (For the answer call me.)
Q: Do you consider yourself to be a fundamental or technical manager?
A: We start with the fundamentals striving to find companies we feel will provide our investors with the highest rates of return. Once we have identified a company we would like to own, the next question is whether we can make money if we were to buy the stock at that moment. Technical evaluation is used in the latter part of the decision making process, primarily to view whether the company is overbought or oversold.
Q: How important are major market trends and how do they influence your decision making process?
A: We buy operating companies and as a result individual valuations are of more interest than major market trends. Excellent companies do not stay undervalued for long periods. During periods of rapid increases in market values we may be slow to invest. Conversely when the industry or overall market is going down in price we find tremendous values and tend to add to our clients' portfolios.
Q: Are you always invested or do you ever maintain large positions of cash?
A: We tend to be fully invested. However, there may also be periods when we have significant amounts of cash because we have not reinvested sales proceeds. That is completely different from doing asset allocation and setting aside cash for strategic purposes.
Q: Please tell us how you became a manager.
A: It all started with McDonalds. During college I worked for McDonalds. As a starving student I was a member of the crew doing everything from making milk shakes to cleaning floors. Gradually I worked my way up the managerial chain, eventually opening stores. I understood the restaurant business thoroughly. As a result I was hired as an industry analyst by Cigna, then Dean Witter, Smith Barney and in 1986 was named Director and Senior Portfolio manager. I have always thought of myself as an owner asking several basic questions. Does the core concept make sense, is the management team seasoned enough to perform and do I understand the corporate goals? Incidentally McDonalds is a company that exhibits the long term growth characteristics we look for and remains one of our larger holdings.
Q: Please review those earnings growth characteristics.
A: Corporate management teams are generally open about the company's strategic growth plan. In the case of McDonalds' that would mean continuing to increase revenue in existing stores, as well as adding new stores to the system. There would be a discussion on how the expansion would be funded, the impact on the balance sheet, and ultimately a projection of revenue growth given this expansion. We track actual developments versus planned growth. High quality companies tend to achieve their goals and patient shareholders are well rewarded.
There are plenty of cases of companies doing something completely different from the business plan. Inevitably this involves a move into an industry the company knows little about, resulting in expensive lessons. If we own a company that does deviate significantly from their stated plan we will probably sell our holdings. Companies need to grow, experiment, and have ideas that both work and fail. There is nothing wrong with that as long as moderation is employed. Companies understand that their future relies on their ability to develop new products. In a smaller company all those activities become more obvious. And as a result, over short periods, smaller companies have greater price volatility. A new fund that Allied Capital Advisors launches has a tremendous impact on revenue and net income. Conversely if a fund's launch is delayed there is tremendous disappointment. This does not mean the company has problems. Disappointment usually means a lower stock price, creating a potential buying opportunity for us. What I am driving at is that smaller companies tend to be more new product driven than large companies. It is important to be able to forecast sales and expected net derived from that product.
Q: Discuss the developing markets.
A: Most of the world is underdeveloped and waiting for electricity, telephones, and running water. The ultimate in basic consumer products has become rapid growth industries. Especially attractive in that these services are so basic most consumers keep paying their bills, even during recessions. There is not much growth in the electric business domestically, but yet most of China's one billion inhabitants are still waiting for a hookup. That's not to say these countries do not have wealth. Drive down the streets of Bangkok, Shanghai, Manila and you see tremendous amounts of construction in progress, with consumers filling retail stores. Coca Cola, Gillette, Pepsi, McDonalds, Motorola, Sony, Hitatchi are aggressively targeting these markets for expansion. Do you know that 70% of Gillette's earnings come from non-U.S. operations? Kodak signs are to be seen almost any place one goes. The most exciting news is that this trend is still in the early stages of development. The U.S. has 250 million people and 11,000 McDonalds, Japan has 110 million people and 1000 McDonalds, China has one billion people and 10 McDonalds. The wait to get a telephone in Bangkok is one year, in Sao Paulo two years. How many boxes of Pampers will Procter & Gamble be able to sell to the three billion people located between China and India? I get carried away, but clearly the opportunities are tremendous.
There are pitfalls though. Governments will change, there will be religious backlashes, current account deficits will prevail. Due to this we anticipate high volatility in share prices. However the long term trends will hold. Most of the world population has seen better living standards through television, movies, or video. In the last ten years most governments have become pro development. My sense of things is that these are the very early stages of massive, long-term global expansion. Making things all the more interesting are how inexpensive the prices are for local companies in undeveloped countries versus similar companies in the developed world. The largest amount of capital will flow to these markets because of their rapid growth and low cost environment. I am not talking about second tier companies; I am talking about the local divisions of major companies. Do you know you can still buy Coca Cola franchises in eleven countries?
Q: Will there be any fallout of the U.S. small cap market because of the number of non U.S. issues you can buy today (versus almost none 15 years ago)?
A: In the past, investment managers would load up on cyclical stocks during recessions. Over the following year prices move up and become unrealistic. When they did, managers switched to large cap consumer companies and for the next 3-6 years held them until they became overvalued. Small cap equities are the only sector that does not move during this period. The result is that managers eventually rush to buy small cap companies. Managers are forced to do this because they need to be in this sector to perform. Now there is greater choice within the small cap market and there are now many well managed small cap companies. Managers now have the opportunity to purchase very well managed companies located outside the developed economies. This both reduces volatility and increases return.