Q: Roger, please give us an overview of King Investment Advisors.
A: King Investment Advisors, Inc. (KING), located in Houston, Texas, is a bottom-up value manager applying the Business Valuation Approach. KING uses a broad definition of value with a growth overlay to identify attractive opportunities often overlooked by other investors. This approach has served our clients well in virtually every economic environment for 20 years. KING manages about $1 billion for institutional and individual investors. We manage our clients’ assets as if they were our own. Our personnel, including investment managers, securities analysts, and a dedicated administrative staff, maintain a thorough knowledge and understanding of our investment process. Our experienced portfolio managers have an average of 27 years in the investment industry. KING also has strong research capabilities, and four of our five investment professionals are Chartered Financial Analysts. We are committed to creating wealth for our clients over the long term. The firm is SEC-registered and it or its executives are members of the Association for Investment Management & Research (AIMR), the Investment Counsel Association of America (ICAA), the Institute for Investment Management Consultants of America (IMCA), the Investment Management Institute (IMI), the Institute for Private Investors (IPI), and the Philanthropy Roundtable. KING manages all-cap, mid-cap, and small-cap equity and balanced accounts as well as two equity mutual funds.
Q: Tell us about your investment philosophy and the Business Valuation Approach.
A: We use a “bottom-up” stock-selection process based on fundamental analysis, focusing on individual companies rather than adopting a macroeconomic, top-down approach. The latter attempts to identify industry groups and stocks based on an overall economic outlook. We do not place much confidence in the accuracy of broad economic forecasts. Ask five economists for their outlooks; you’ll get ten opinions. Our investment philosophy, which we call the Business Valuation Approach, incorporates three disciplines: 1) private-market valuation, 2) historical valuation, and 3) superior earnings growth. A company in which we invest will meet at least one of these three criteria. Most value managers are limited to buying primarily low-multiple stocks. But value managers who focus primarily on this measure of value needlessly exclude opportunities using private-market value or growth at a reduced price—both of which can often provide great values. We calculate private-market (or intrinsic) value in one of two ways: either as a company's worth if liquidated (although liquidation rarely happens); or its worth as a going concern, ie if acquired in a cash transaction. We ask one basic question: Would we be willing to buy the entire company at the current market price? With historical valuation, we identify stocks trading at the low end of their price/earnings, price/book value, or price/sales multiples. As far as earnings growth, we are very willing to buy growth - at a reduced price. While earnings growth is a positive attribute, investors often pay too much for it. When analyzing a stock, we look at whether it is trading at a discount to its growth rate of earnings or demonstrable cash flow. Our focus in recent years on cellular telecoms and cable-TV stocks was motivated partly by the fact that their prices were extremely low, based on reasonably predictable and growing cash flows. At the time, these stocks were considered pariahs by Wall Street. Those investments paid off handsomely in 1999, sometimes returning 300% to 500% on our original cost. We research prospective stock purchases extensively, and we also look at insider buying or ownership and hidden balance-sheet assets. Also, if a company is a potential takeover candidate, that is an added plus on the basis of either historical value or growth at a reduced price.
Q: Please elaborate further on your private-market value criteria.
A: We are distinctive in our emphasis on private-market value, or the amount an outside party would be willing to pay for an entire, publicly traded company. The target price takes into account such characteristics as cash flow, assets, management team, and goodwill, plus debt (if any). In addition, a premium is usually paid to take sole control of a company. A company’s strategic value to a potential buyer may also play a key role in its valuation. We buy a stock when its perceived value (ie its market capitalization) is at a significant discount to its private-market value; the wider the gap, the better. Quite simply, we try to buy a dollar for fifty cents. The spread can then be closed through price appreciation arising from a takeover, a restructuring, a spin-off to shareholders, or other catalysts. Often the company’s directors will seek to “create or enhance shareholder value” because they recognize that the publicly-traded price does not reflect the company’s private-market value. Even Wall Street may eventually recognize a company’s hidden value vis-à-vis its stock price, but the Street gravitates toward the safe and comfortable, and has very short-term time horizons. By exploiting inefficient segments of the market—what we often call the “unwanted and unloved”—we can buy low and sell high most of the time. One benefit of focusing on value (as opposed to trying to outguess Wall Street) is that, far from dreading volatility, we welcome it. If someone in a state of panic is willing to part with stock at a bargain price, we will gladly oblige them, and because we have the conviction to wait until the market price catches up to the private-market value, we can resist the temptation to sell. Conversely, when someone is willing to pay a fair or premium price, we are happy to sell. We have often said that our clients own pieces of businesses, not “the market.” In today’s environment, where commoditized stocks and bonds are used as vehicles for speculation in the short run, it is easy to fall prey to the urge to “do something.” We think it is impossible to time the market; we know of no one who has made a fortune doing so consistently. On the other hand, patient investors can do quite well over long periods of time by following our philosophy of buying a piece of a business at an opportunistic price. It’s only logical that if you buy companies at public prices below their enterprise value, others may eventually recognize this value as well. A corporation whose public stock sells at a significant discount to its private-market value will not remain on the bargain counter forever. Any number of catalysts can cause the stock price to increase, in some cases dramatically.
Q: What role does cap size play in your stock selection process?
A: Our Business Valuation Approach takes what the markets offer, regardless of cap size. Based on our criteria for determining value, there are many potentially rewarding investments available in the US today, especially in the mid- and small-cap areas. In years past, we have owned some very large companies. Today, the large, top-quality companies have been chased to such high price levels that we see little compelling value among companies in the upper tiers of such indices as the S&P 500 and the Dow Jones Industrial Average. If that were to change, we would consider buying these stocks. Our discipline will remain constant. However, I should add that we have small- and mid-cap products where we always maintain market cap parameters. In short, we certainly have a distinctive style, but we transcend narrow categories such as small-cap or growth. Our Business Valuation Approach results in finding bargains among a wide variety of companies—large and small, growth and value. Our focus on private-market value has contributed to our success over long periods through different types of markets.
Q: Last year was an outstanding one for your firm. Can you tell us a little something about where your results came from?
A: As far as performance, 1999 was our best year ever. Our traditional All-Cap Equity Composite returned 57.3% net of fees (according to preliminary estimates). We achieved high returns because we stuck to our investment philosophy, not because we chased hot, high-flying stocks. We had no exposure to pure Internet or dot-com plays or traditional large-cap technology companies. We believe those stocks, even excellent ones such as Microsoft or Cisco, possess much risk at such extreme valuation levels. Look at Lucent. Many believed it to be a “safe investment,” yet at 49.3x projected earnings, the announcement of an earnings shortfall led to a 25% one-day decline in the stock price. We believe there are significant opportunities elsewhere in the market that involve less risk. For example, rather than purchase the Amazons, E-Bays, and AOLs of the world, which trade at exuberant multiples, we made significant investments in the cable and wireless areas. These “real,” solid companies were inexpensive on a cash flow basis, enabling our clients to benefit from the technological advances in a manner that we consider less risky. Despite our rewarding results and the fact that the Dow Jones Industrial Average, NASDAQ, S&P 500, and other major indices hit new highs at the end of the year, 1999 was not a very good year for the average stock. In fact, the average unweighted return for the 6,000-plus publicly-traded U.S. stocks for 1999 was a mere 2%. In addition, at year-end, 230 of the 500 stocks in the S&P 500 Index were below their level of two years ago. However, it is encouraging that, thus far in 2000, we are seeing a broadening of the market. We look for that trend to continue throughout the year.
Q: Why doesn’t KING invest more in traditional technology stocks, like Dell and Microsoft?
A: This is a good question because many technology stocks have seen stellar but quite volatile performance over the last several years. KING has been underweighted in this group because few of these stocks have met the strict buy criteria of our investment philosophy. KING purchases only stocks that are trading at a discount to their private-market value, historical valuation, or projected growth rate. The last high-tech boom peaked in 1983. Investors in that era thought it would last forever. Remember Atari, Eagle, and Commodore, all now defunct? We do. Today, many tech stocks are experiencing rapid growth and frequently sell at multiples well in excess of their growth rates. For example, as the year 2000 began, Microsoft traded at 70.8x projected earnings. Is the appropriate multiple 30x? 70x? 90x? Because of their explosive growth, few tech stocks trade at discounts to their historical valuations. Thus, two of our buy criteria are rarely met. As for our third criterion, it is difficult to calculate a private-market value for most tech stocks. When calculating private-market value, we try to use the valuation of a comparable company. Since so many tech companies are unique, comparable peers are often difficult to find, and assessing values is almost impossible in any situation (e.g., determining what P/E or price/cash flow value, etc. should be used to determine its private-market value). We adhere strictly to our buy discipline, which has rewarded investors over long periods of time. We will not abandon it to chase a “hot” group of stocks to capitalize on potential short-term gains. However, this does not mean that KING will never invest in technology stocks. As some of these high-fliers stub their toes and their valuations fall to more reasonable levels (such as PLATINUM Technology, which we purchased in early 1999), we will analyze the companies, determine if fundamentals are intact, and decide if the risk/reward scenario is beneficial to our clients. One distinguishing characteristic of the valuation levels of recent market leaders is the high premium effectively superimposed on top of their already rather high P/E ratios. Why has this benchmark gained wide acceptance by those who “have to be in”? Having little or no earnings, these companies are valued not at a ratio of price to earnings but at a ratio of price to sales. We cannot help but compare much of today’s investment activity—in the Internet and in the chosen few, aka today’s Nifty Fifty—to a vast electronic casino.
Q: How do you achieve outstanding returns without taking on inordinate risk?
A: Investors often confuse business risk with stock-market risk. There is very little business risk with long-established corporations whose finances are strong, whose products and services are in demand, and who have a history of sound management. But investors often pay too much for historical success and perceived safety while paying too little attention to market-valuation risk. Value investing, which focuses on the intrinsic (not market) value of an economic enterprise, is aimed at evaluating business risk and valuation risk. Investors also tend to confuse volatility with risk. A narrow focus on individual stock-price fluctuation and quarter-to-quarter (or year-to-year) variability in portfolio returns can lead investors to conclude that they own risky stocks, or a risky portfolio. Stocks are volatile but, unless you must sell, the inherent volatility of stock prices or a portfolio’s return can be a very misleading measure of valuation risk. Investors who focus on business value and the long term know from experience that stock-price and portfolio volatility are inevitable and can present numerous opportunities. Over the last 25 years, disastrous operating environments have plagued (at different times) such industries as automobiles, aluminum, forestry, energy, technology, tobacco, insurance, and construction. Yet, out of turmoil opportunity arises. In recent years, the phoenix-like resurrection and restructuring of such industries as banking, cable TV, brokerage, and telecoms illustrates the benefits of a disciplined approach focused on individual stock values. The Business Valuation Approach should yield opportunities regardless of what “the market” is doing. We do not spend much time on market timing or on worrying about the market because our clients do not own the market. In corporate history, industries that have experienced bear markets or their own depressions in the face of a long-term secular upturn in stock prices are the rule, not the exception.
Q: What kinds of investment services do you offer?
A: We manage both equity and balanced accounts. All KING’s offerings draw on the value-oriented Business Valuation Approach. KING’s All-Cap Equity Portfolio has the flexibility of investing in stocks of any size, allowing us to screen a larger universe for the stocks with the most value. KING’s all-cap strategy began in 1981 with the firm’s inception. Our Mid-Cap Equity Portfolio emphasizes stocks with market caps ranging from $700 million to $6.5 billion. Mid-cap companies, often “diamonds in the rough,” have the potential to become big winners in the marketplace. Although these companies are smaller than those found in the S&P 500, their smaller management teams can often react quickly to market changes, leading to greater growth potential. KING’s Small-Cap Equity Portfolio emphasizes stocks with a market cap of less than $1.8 billion. Small-caps, though volatile, have historically generated higher returns than other asset classes over the long term. In addition, relatively few excellent small companies are followed thoroughly by Wall Street analysts or known to investors. We exploit this inefficiency by buying underfollowed companies that are trading at significant discounts to their intrinsic values. KING also offers a Balanced Portfolio, combining our All-Cap Equity approach with a selection of bonds. This product is appropriate for clients who are more income-oriented, yet still desire some long-term growth. Asset allocation is decided jointly at the beginning of the relationship by the client, his consultant (if applicable), and the portfolio manager, and updated as needed. Our clients’ asset-allocation decisions range from 50:50 equity-fixed income to an 85:15 ratio. If a client gives us latitude for asset-allocation, it is typically 70:30 equity-fixed income.
Q: How do you construct your equity portfolios?
A: KING’s equity portfolios typically include between 20 and 35 stocks. Due to our bottom-up stock selection process, portfolio holdings may be concentrated within the same industry, resulting in weightings dissimilar to the overall market. Individual security positions are initially limited to 5% of the portfolio at cost.
Q: Do you consider taxes when managing taxable accounts?
A: Yes, we are very cognizant of a client’s tax situation. For taxable accounts, we are more likely to keep holdings for the one year needed to achieve a lower capital gains tax rate. Also, with our private accounts, KING is able to sell positions at year-end if unrealized losses or gains are present, in order to offset realized capital gains or losses. These tax-efficient strategies help our clients generate higher after-tax returns.
Q: I understand that you have a newly redesigned Web site that explains more about your firm. What is the address?
A: We are at www.kingadvisors.com. We enhanced the site last November and have received many favorable comments. We welcome your readers to come visit our site, and thank you for the opportunity to visit with you and your readers.