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Fund Manager Focus - August 2012


Michel Raud & Benoit Flamant, FOURPOINTS Investment Managers - Paris


Michel Raud

Benoit Flamant

FOURPOINTS Investment Managers was created in May 2012 as a result of the merger of IT Asset Management and PIM Gestion France. IT Asset Management was created in 1994 by Muriel Faure and Benoit Flamant while PIM Gestion France was created in 1998 by Beatrice Philippe and Michel Raud. FOURPOINTS remains part of the Philippe group, established in 1931 with offices in New York and Paris. FOURPOINTS now has $1 billion in assets under management in a mix of open-ended equity funds and institutional mandates. About 95% of assets are invested in equities and approximately 45% in US equities. The firm has 10 portfolio managers/analysts running concentrated portfolios of 30 to 50 stocks.

Michel Raud obtained an MBA from Hautes Etudes Commerciales (HEC) and was Professor of Finance at HEC. Prior to joining the Philippe Group in 1988, he was at Banque Financière Cardif, a member of the Paribas Group. Michel co-founded PIM Gestion with Béatrice Philippe in 1998 and is now Chief Investment Officer (CIO) at FOURPOINTS Investment Managers.

Benoit Flamant is a graduate of Ecole Centrale de Paris. He started his career as a researcher at Carnegie Mellon University, USA in 1984. Benoit then worked as a computer engineer at ADP/GSI and later worked for both IBM and Microsoft in engineering and sales roles. He co-founded IT Asset Management in 1994 and is now Deputy CIO and Head of Tech Investments at FOURPOINTS Investment Managers.

What was the rationale for the merger?

"PIM Gestion specialized in global equities, and while most of our assets were in US equities we also managed European-only and global portfolios. We realized we didn't have the investing expertise the information technology sector requires, as skill in more traditional sectors may not always transfer well to tech. We were therefore interested to merge with IT Asset Management as that was their specialty and they had a deep knowledge of the sector we couldn't hope to match. We were thrilled to learn that not only did the company have high quality, high caliber people, but its philosophy was similar to ours. IT Asset Management is global in its approach, working to identify themes and then find the best companies worldwide to benefit from these growth trends.

IT Asset Management had a strong brand but lacked scale. Equities tend to be cyclical and investing only in one sector meant we were even more cyclical. We were interested in smoothing out the cycle and gaining scale, both of which we were able to achieve by pairing with a larger, more diversified asset manager."

Where will FOURPOINTS be positioned in the Paris investment management community?

"We are a stock-picking, long-only, conviction-based fund manager. We are very focused on our investment process, which we think is key to producing favorable long-term returns. We have a long track record with the same team, which is important and rare, as investment staff tend to rotate quite often. We focus heavily on primary research to know our companies inside out."

What is your investment approach/style?

"Experience tells us that to make money, we need to identify companies able to develop themselves better than their peers in order to develop and maintain competitive advantages as well as grow and generate free cash flow. These outstanding, successful companies must be positioned in growing sectors because structural headwinds can negate the skill of even the best managers. We want tailwinds for the companies we own, and we select only those companies with very high competitive advantages. This allows us to have conviction that these companies will be able to develop and succeed.

The second part of our strategy is that we must be very careful to buy stocks at the right price. It's easy to say that the L'Oreals, FANUCS, Yum! Brands, and Nestlés of this world are outstanding companies, but if you pay too much for them, portfolio performance will be disappointing. We are here to deliver performance for our clients, so we put a lot of emphasis on valuation. Our rule for investment is 'margin of safety,' which in practice means buying $1 of value for less than that, say 70 cents. In other words, we look to buy outstanding companies below what they're worth. We can do this if we are patient and if we don't run the same race as the rest of the market. Many other managers are only focused on their performance on a three-month, six-month, or 12-month basis and as soon as companies within their portfolio don't deliver on these time horizons, they punish them and sell. This presents us with an opportunity, as we have a longer term horizon. We have the luxury of practicing what we call 'time arbitrage,' where we buy a stock at a discount to its intrinsic value, but that intrinsic value may not be evident to the market for longer than other managers' time horizon. For us this is a big competitive advantage.

In our view, risk is not volatility. Risk is a permanent loss. If we make a bad selection or a mistake evaluating the future cash flow of a company, we are going to lose money. If we make a good bet on cash flow but we bought at too high a price, we are going to underperform. If we have conviction on future cash flow and we have a good entry price, we have the stomach to live through short-term volatility as we know the market will sooner or later recognize the intrinsic value of the company.

For IT our approach is a little bit different - partly because technology stocks tend to have higher valuation ratios - but we also first identify investment themes. It is not random stock picking. We share a long-term vision. We look for the best managed companies. We look at valuation. These are key values we share. But in tech, the real value creation comes from disruption. If you look at the best times for Microsoft, Intel, Cisco, Oracle, and more recently Google, they happened because these companies had technologies that were at the forefront of huge disruption. You need to sort out what is a true disruption and what is not. In technology, people get over-excited far too early but underestimate the impact of disruption. We have a background in technology, so we understand technology, what it does, and what it does not do. We also look at the value delivered to the consumer or the corporation. Just buying a company because a broker recommends it or because you want to be exposed to the latest buzz you don't really understand is not what we do. It's easy to buy the wrong thing. For example, right now everyone is talking about "Big Data" but it's easy to buy the wrong company at the wrong price as this is a real trend but ill-defined and poorly understood.

Also you need to go beyond the benchmark. For example, more and more disruption is outside what's considered traditional technology. Overall information technology corporate spending is growing at a compound rate of 3% so if you want to find real growth you need to go beyond technology and look at companies that re-engineer the supply chain or disrupt other business. For instance, a company like LinkedIn competes against recruitment companies, so it's not a pure tech company. A company like Netflix is not a traditional technology company, but a hybrid video distribution company. Look at Amazon, which is killing retail in the US for many of the traditional 'brick and mortar' players like RadioShack and Barnes & Noble. So we pick interesting companies, but the key theme is disruption, because in Tech, disruption brings tremendous growth."

Does the team split sectors or geographies?

"No we don't care about geography - we look at the best companies around the world. With barriers to trade steadily falling competition comes from everywhere. You have to identify the best players in the US, Europe and Asia. Currently we invest in only the developed markets – the US, Europe, Japan, Australia and Singapore, as well as Taiwan and Korea for technology. Because of their importance we cover some Chinese companies, though we don't invest directly in Chinese stock markets. We don't invest in emerging markets like Brazil yet."

Do you use screens? If so, what sort of screens?

"No – valuation comes at the end in our process. We first want high quality companies, companies with competitive advantages, companies aligned with long-term growth trends. We also look at the industry to understand what the competitive environment is and whether economic profits will be competed away. These are all very fundamental things that need to be scrutinized before investing. Then we look at valuation.

If we did it the other way around and screened on free cash flow yield or P/E, we could have dozens and dozens of companies, and how could we choose? We need to look under the hood, do fundamental analysis, and really understand the company first. Two companies can have the same P/E but one might be generating returns on invested capital far above its cost of capital while the other might be destroying shareholder value. Or the companies' growth profiles may be completely different. The only true yardstick that fairly values a company is discounted cash flow (DCF) modeling, but to produce a DCF you must have conviction, and to have this conviction you must do fundamental analysis. In the end if we don't know the fair price for a company we can't say if the stock price is an opportunity or a risk. After determining our opinion of fair value, we compare it to the share price. Only then do we look at P/E and EBIT and price-to-book."

Average holding period?

"Our average holding period is two to three years. However, if a company continues to create value faster than the market prices it in and remains undervalued, we are happy to hold stocks for much longer."

Average market cap size of US holdings?

"We tend to focus on mid-cap stocks. We happily buy large cap companies if there is more than 30% upside as larger companies tend to be less risky. If I can make a nice return on McDonalds I should put it on the portfolio. However, most of the time these blue chips tend to be closer to fair value, so we find that stocks in the $2 – $5 billion market cap range usually have more potential. Those companies have already been successful against competitors, they have carved out niches, and can often grow for another 5 – 10 years and see good share price performance. Consequently, we tend to focus on mid-cap stocks."

Which benchmark do you use?

"We use whatever benchmark is most relevant for the portfolio. While we compare our portfolio to the benchmark we don't construct our portfolio to hug the benchmark – we are comfortable taking sizeable bets relative to a benchmark. In most of our strategies, we currently have an overweight position in the energy, InfoTech, industrials (where we find some outstanding companies) and healthcare sectors. We like healthcare stocks because not only do they have the potential of the developed markets because of ageing populations, but also because of the huge opportunities in the emerging world. We currently have underweight positions in the financials, telecom and utilities."

Core Holdings – discuss why you bought them?

"E-commerce disruption is a key theme for us, and Amazon is one of the big elephants in the room. We also like eBay as it has dramatically changed its business model especially with the further development of PayPal. PayPal is growing rapidly and its revenues are now roughly 40% of Visa's. Mobile payments overall are growing and PayPal is a significant player. We came to eBay through disruption in e-commerce.

Another key investment theme is the ageing of the world population. We focus on companies that are relatively insulated from regulatory and competitive issues mostly in upstream niche markets. In the pharmaceutical sector, for instance, we are shareholders of Gerresheimer, a mid cap German company specializing in glass and plastic packaging for both generic and patent-protected drugs. There are high barriers to entry in this business, demonstrated by the fact that no new entrant has come to the market for the last 15 years. Gerresheimer is increasingly focusing on high-value added (and high margin) products, in particular ready-to-fill syringes and insulin pens that will account for 60% of the company's profit growth through 2015. Gerresheimer also has a solid pipeline of new products in the high-growth segments of diabetes and oncology and is expanding its geographical presence to Brazil, India and China, targeted to account for 20% of sales by 2014.

We also like oil & gas exploration and production (E&P) and services companies as maintaining and growing the oil supply is a real problem for the world. Growth in demand is only 1% but if you stop investing in existing oilfields, you lose 5% of production per year. The oilfield services and capital equipment sector is controlled by a handful of US and European companies such as Schlumberger, Technip, Subsea 7, and Cameron, all of whom are very sophisticated. They are long term winners. Competition tends to be rational. After the BP/Macondo incident in 2010, the industry has even better barriers to entry, as the major oil companies will not sub-contract to providers who haven't built up a solid reputation. Also, high margin recurring services revenues should become even more important for many of these companies, like Cameron."

Recent sales?

"It is difficult to sell as valuations are very compelling right now. We recently bought LVMH and Swatch as we sold Ryohin Keikaku, a Japanese consumer stock. Ryohin's share price had performed well and we sold as we had a better idea. We sold EMC to swap into NetApp, which we prefer. We are not afraid to be contrarian and bought NetApp after the negative pre-announcement last quarter punished the stock more than what we thought was reasonable, presenting an attractive entry point."

What about Canadian stocks? Can you own them and do you?

"Yes, we can and do invest in Canada. Canada's economy is heavily tilted towards natural resources and financials. We've been able to find attractive energy and mining companies in Canada, so our investments have tended to be in those areas."

Do you have a buy trigger?

"Valuation is part of the equation when making an investment, but not the whole equation. We want to have a margin of safety when we invest, so this generally means a 30% or greater discount to what we consider to be intrinsic value, meaning we want to pay 70 cents on the dollar. We will often find an interesting company with solid competitive advantages that is attractively positioned in a growing industry, but there isn't a margin of safety. When this happens, we put the stock in our investable universe and wait for a better entry point. This may mean we never get a chance to buy the stock, but we believe sticking to our discipline will help avoid costly mistakes, and we're comfortable with that trade-off."

Does a stock have to be profitable?

"Generally yes – we think we have a better chance of understanding potential future outcomes for companies that are already in reasonably good shape and have developed a profitable business. Brokers like to recommend high operating leverage cyclicals like the auto OEMs and airlines of the world for a quick rebound, but our philosophy is to avoid making cyclical calls in industries that have problems with oversupply."

What about companies with very high valuations?

"We don't buy companies with very high valuations except in the IT sector. We sold Essilor and Novozymes when we thought their valuation – and thus market expectations – were too high. IT is the exception because when there is disruptive technology, valuations can appear high. For instance, if you categorically avoid high multiple tech stocks you would have sold Microsoft way too early in the 1990s and missed a huge opportunity. However, we need to triple check to make sure we are right about the disruption, because these kinds of companies can be a double-edged sword. We own Red Hat for example, which is a good company and all about open source. Trustable open source companies are making a dent in existing platforms because corporations want to replace their old bulky proprietary costly software with Internet-centric scalable modern solutions, respecting standards."

Do you vote your proxy?

"We vote proxies for French companies. We vote proxies for non-French companies when possible, particularly when we believe management's proxy recommendations are not aligned with the long-term interest of minority shareholders. This is rarely the case, though, because we tend to invest in companies in whose managements we have faith and confidence."

How do you know if you want to meet a company?

"An hour spent meeting with a company that can clearly articulate its strategy and prospects and the competitive situation of the industry is the most productive hour of the day. We love to meet any company that fits in one of our investment themes, but will often meet with companies outside our themes to better understand an industry or to get a better picture of the competitive landscape. However, though we may go into a meeting with a company thinking it's unlikely we would invest, it's not unusual for a meeting with management to persuade us to do more work on a company and ultimately add it to a portfolio."

Who do you prefer to meet (e.g. CEO, CFO, IR)?

"We prefer to meet the CEO but we find it valuable to meet with any member of senior management. We also like to meet with division heads, particularly European division heads. Meeting management face to face is really important as you get a much better sense of the people making key decisions than you can from a conference call or large presentation in an auditorium."

Best companies at IR?

"There are many excellent IRs, and IR quality has risen over time. I like Lockheed Martin. I don't have the stock in my portfolio but I used to have it. I meet with Jerry Kircher, the IR, every time he comes to Paris and I've met him in New York. He's very professional. It's always a consistent presentation and he always anticipates questions. Also, we recently met with Patricia Murphy of IBM, who is very knowledgeable and has a deep understanding of not only IBM but also all of the industries in which it competes. Patricia was travelling with an independent IR consultant, not a broker, a habit we'd like to see more companies adopt."

Any companies you'd like to see visit Paris?

"Some larger companies we'd like to see include GE, Siemens, Merck, and Glaxo, especially given their ability to share insight on many different market segments. In general, we like to see companies in the $2 to $5 billion range that have carved out niches and have strong competitive positions."

Outlook for stock markets for the remainder of 2012?

"We cannot forecast the market but we think the world is facing three main risks: a US double dip or further recession; a China double dip or further recession; and the situation in Europe and what becomes of the euro. The disruption of the euro is something no one can forecast. Should the problem be solved – the undervaluation of stocks would be quickly corrected. I'm not sure when the bubble in government bonds will burst, but lending money to the US government at 1.5% for 10 years is not sustainable. Interest rates will go up one day. It might get worse before it gets better but already there is significant upside in equities long term. Equities are the only asset class that creates value. You buy government bonds and you create nothing."

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