Manager Views

McElvaine: Finding value in troubled companies

“You have to kiss a lot of frogs to find a prince.”

Tim McElvaine, President of McElvaine Investment Management Ltd., has been a value investor for more than 20 years. As a value investor, he looks for companies trading at a steep discount to what he estimates they are really worth. He honed his value-oriented approach during his tenure with the Cundill organization, and last year Mackenzie appointed McElvaine Investment Management Ltd. as sub-advisor to Mackenzie Universal Canadian Value Class. In the accompanying article, McElvaine describes his investment philosophy and how he has to “kiss a lot of frogs” before he finds an unloved company that turns into “a prince.”

From frogs into princes

One of the first things you notice about Tim McElvaine (besides the orange jacket) is his company logo – a strange-looking frog with collagen lips. But once McElvaine starts talking about value investing and finding beat-up companies that he believes may rebound, you understand the meaning behind the frog. “It’s not quite like a castle as far as a corporate emblem,” explains McElvaine, “but the idea is that as a value investor you have to kiss a lot of frogs to find a prince. I’m dealing with a lot of things with warts on them and I’m just trying to figure out which one we want to kiss.”

So far, McElvaine’s search for companies covered in warts has paid off for Mackenzie Universal Canadian Value Class since he took over the portfolio February 23 of last year. The fund, which currently consists of 31 stocks and is 26% in cash, has also changed significantly.

But that’s not surprising given his long track record as a value investor. In fact, McElvaine re-established ties with Mackenzie in February 2009 as a sub-advisor on Mackenzie Universal Canadian Value Class. But from 1992 to 1999, he was the lead manager of Cundill Canadian Security Fund and co-manager on the Cundill Value Fund from 1998 to 2003, as well as CIO at Cundill from 1998 to 2003.

How did you become a value investor?

I think it may have started with the chickens when I was about 12. We lived on a farm and my dad thought, instead of paying me an allowance, I could raise chickens and sell the eggs, so that was my little business venture. I ended up getting 20 chickens and I thought I would be the chicken king of Kingston, Ontario. Well, the eggs would break in winter because the coop wasn’t heated. Or the chickens didn’t have what they needed to make the eggs harder. Sometimes my mom would use the eggs without telling me. So, I didn’t have a good accounting system, and I went bankrupt.

I had to get the farmer across the road to come over, and he basically executed the chickens and made them into chicken pot pie. And that was the liquidation value, and it was certainly less than what I paid to set everything up. After that, I decided if I’m going to do something, I need to protect the downside. I need a margin of safety. In this case, if I’m going to have to turn these things into chicken pot pie, how much do I have at risk?

Can you describe your investment process?

I’ve tried to describe my investment process and people’s eyes would gloss over. So I needed a snappy way of doing it and I came up with ABBA. The first (A) that I look for is an Accident. As John Templeton said, “If you’re going to buy the best bargains, you have to buy the things that other people are selling.” Why do people sell? Something’s gone wrong or something’s happened that people didn’t expect. It could be a natural or man-made disaster. It could be something as simple as missing the earnings. Or a company is downgraded or taken out of an index. Something has happened for the seller not to care about the price. For example, with Chubb Corp., it was more a general sell-off of the insurers, while with Corus Entertainment, the accident was very specific to the company.

The first B – Bird in the hand – what I want to know is whether the stock I’m buying today is worth more than the price it’s trading at. Do I have a margin of safety? In March 2009, I bought Sotheby’s and their assets were worth about $850 million. But the value of Sotheby’s at the time we were buying was about $470 million, so I had a margin of safety.

The second B – the Brick house – comes from the story of the Three Little Pigs. It’s the pig with the brick house that survives the wolf. But I want a cheap brick house. I’m looking at one that has a leaky roof, a rusted car sitting on the front lawn, the grass is too long, and the door’s hanging off. But you go into this cheap brick house, and you say, ‘this thing has good bones.’

The last A is Avoid Surprises. How does this apply to stock selection? When you buy a company, you want to understand where the board is coming from: What are the motivation and interests of the Board and management? And you do not want to find this out after you buy the stock.

With Sotheby’s, it hit a low of $6; you had bought around $7, and sold the entire position by $15. As of March 2010, it was trading in the $25 - $30 range. Did you sell too soon?

We often sell early. Maybe there are a couple of circumstances where we’ve caught the whole run, but usually as a value investor, you buy early and you sell early. When the stocks I buy get into the kind of range of what I think they’re worth, I’m happy to sell them, even if it’s little bit early, and hold onto the cash.

Your cash position was around 40% last September and about 26% at the end of 2009. Is that typical for you?

I think our cash position has typically been between 15% and 30%. It’s a bit above average but not particularly high. It’s always easier to sell something than buy something.

When you sell something, it might take a month before you get that cash back down.

How long do you usually hold a stock for?

Three years. I joke about this – but the first year after you buy it, you regret buying it because it keeps going down. The second year, you forget you bought it because nothing happens. And then the third year, you’re usually happy you bought it because it starts to go up.

How do you short-list the universe of stocks that you end up buying?

We’re working on improving the screening side. But right now, the ideas either come through something I’ve read or in talking with other investors I know.

You’ve recently increased your exposure to Japan and the US.

Yes, the biggest change in the portfolio over the last quarter [Q4 2009] was Japan. That always makes people a bit apprehensive because they don’t like Japan, but to be honest, like John Templeton says, to get the best bargains, you have to go where people are selling. The key thing is, we were able to buy brand-type companies at below asset value, and they just happen to be located in Japan. And certainly in the fall [of 2009], Japan was still weak.

What do you foresee for 2010?

I don’t think the world is coming to an end but I would anticipate volatility. That’s good for a value guy because it gives us the opportunity to buy and sell as prices fluctuate. So I’ll just stick to my knitting and wait for ABBA opportunities!