Vindication Amid Turmoil

During the four months from July to October 2002, value stocks got caught in the indiscriminate sell-off that often characterizes the final phases of major bear markets. Such phases tend to hurt value stocks as much as others, if not more, because after extended financial pain, human nature leads panicked investors to sell first those stocks on which they have the smallest losses.

As a result of that four-month whirlpool, and despite a good start, our accounts finished the full year 2002 moderately in the red. Nevertheless, through the bear market as a whole, the performance of Tocqueville’s accounts generally vindicated the contrarian value discipline followed by our team.

The figures presented below are for the same account we have been using as a proxy for our long-term performance (explanations and disclaimers are available in Investment Style And Market Cycles). Briefly, we use this account because, throughout the last twenty-six years, it has represented a significant, though thankfully declining, percentage of the assets under our management, and also because it is our only account for which audited performance figures have been available without interruption since 1976. We also believe that it fairly reflects our firm wide investment style.

NB : Account returns are presented after deduction of our fees, and S&P 500 returns include the re-investment of dividends. Figures for 2002 are still unaudited but should be very close to final results.

I take these figures as a vindication of our discipline, which aims to preserve and enhance our clients’ wealth after taxes and inflation by taking a contrarian value approach to investment selection. To preserve wealth, it is first important to avoid large losses.

But what do we mean by contrarian value?

Ben Graham was the first professional and academic to fully articulate the value investing approach, first in his Security Analysis (1934) and then in The Intelligent Investor (1949). The later provides an excellent summary of Graham’s principles and lists the value ratios he recommended. It is unfortunate that the former, less easy to read, has generally not remained as popular. It taught how to thoroughly and critically analyze financial statements, and stressed the need to constantly check the quality of earnings and other corporate data. Some of the greatest investors of the last fifty years (the few who have remained superior for more than just one market cycle) have been disciples of Graham, including Warren Buffet. On the other hand, it is now clear that many hotshot analysts of the 1990s could have hugely benefited from Graham’s indoctrination – even though his Security Analysis surely would have required some updating to match the new creativity of corporate accountants.

But there is another problem with traditional value investing: the widespread availability, today, of databases and computing power. I remember, in the early 1970s, skimming line by line through the couple of thousand companies in the Standard & Poor’s stock guide (now an obsolete tool), to find companies with price/earnings ratios of less than 11 and, on the surface, decent balance sheets and financial liquidity. The serious analyses, of course, remained to be done. But, even if a few hundred investors went through the same painstaking exercise, enough inefficiency was left in the market so that true values could be identified.

Today, with thousands of value ratios available at the click of a mouse, the kind of opportunities that used to be found within the broad market are only available among very small companies, with market capitalizations well below the radar screens of even medium-sized institutional investors and most research departments.

Beyond this, the pressure on corporate managers to use capital more efficiently has increased steadily over the past two decades. Indeed, some economists have credited America’s success in this area for the country’s spectacular productivity boom of the 1990s. As a result, there are few remaining “hidden” assets on American corporate balance sheets -- in the form of cash or cheaply bought real estate, for example.Countless academic studies have confirmed that, over time, stocks with low price/earnings or low price/cash-flow ratios outperform both stocks with higher ratios and the market overall. But there is a catch.

Most of these studies cover broad universes of stocks -- usually, several thousands. Thus, the lowest price/earnings ratio categories (usually deciles) still contain several hundred names and presumably include many companies that have low ratios for good reasons. These reasons are sometimes life-threatening ones (asbestos-related lawsuits, off-balance-sheet problems, overcome technologies, for instance.)The practical problem with the batting-average approach is that the very broad diversification and implied death rate required to achieve superior and safe results are often unacceptable to individual clients – and sometimes even to ourselves.

When we present investment results to clients after a successful year when their portfolio has performed well, they will almost always pick the couple of investments that did not work out as expected and question them. This is not an “attitude” problem: many of our largest clients have been with our team for twenty years or more. Their loyalty is not questionable and they are quite familiar with our investment style. But, consciously or not, they are checking whether we are still “in control”; whether we are still as good as they had assumed we were, or whether our judgment is slipping. So, I hate to think how they would react if their portfolio, while showing good results overall, contained even ten percent of “casualties”.

The very broad diversification implied by a pure batting average approach also presents a problem for the experienced financial analysts we are. This is not due only to the difficulty of seriously analyzing and monitoring several hundred companies in a “value” screen. More paradoxically, it is likely that our research discipline would eliminate many of the companies in the sample that would likely provide the most spectacular returns if they eventually turned around their operations.

There are risks that, as managers of private fortunes, we cannot accept to assume on behalf of our clients, even if these risks are far-fetched and elusive.

In a fascinating book (“Fooled By Randomness”), Nassim Nicholas Taleb, a hedge fund manager and professor at New York University, points out The studies documenting the validity of “blind” statistical investing in low price/earnings ratio companies are compelling. But they are history and what we see of history cannot always be taken as an absolute guide. We simply cannot afford to bet families’ livelihoods on the assumption that a “rare event” will not occur, with devastating consequences.

Value investing long rested on limited historical data and “static” analysis of various current ratios. The technological tools available today to investors put the identical results of this once painstaking discipline on the desks of tens of thousands of financial analysts around the world. Not surprisingly, information so readily obtained and so widely shared has dulled the edge of traditional value investing.

Time has come to recognize that, at its heart, value investing always has been a contrarian discipline, since it aims to identify companies that the market values at fifty cents while informed analysis shows them to really be worth one dollar.

Jean-Pierre Conreur, the highly successful manager of the Tocqueville Small Cap Value Fund, likes to invest in what he appealingly calls “road kills”. To that purpose, he routinely looks for ideas of companies to investigate among those whose stocks are making new lows on the New York Stock Exchange and the NASDAQ. Other Tocqueville managers go through the same exercise.

Of course, being on the new-low list does not guarantee that a stock is cheap or that its company will start performing better. But it does offer a fairly good indication that investors’ expectations for the company are lower than they have been. If, in addition, the stock price is significantly below its high of recent years and the decline has been long enough to allow most disenchanted investors to bail out (usually at least 18 to 24 months), then the stock is worth a look as a contrarian investment.

If, on top of that, the company’s balance sheet is strong enough to allow it ample staying power even in a difficult operating environment, the odds of a good buy are increasing. Then, the reasons for the decline might be of a positive nature: earnings temporarily depressed by a surge in research and development or the establishment of new marketing and sales organizations in anticipation of new products with large potential, for example. When this is the case, true value often has been unearthed.

From experience, I have become very suspicious of so-called turnaround situations. I define these as companies that have suffered from serious, self-inflicted hard times and that promise new management actions to re-invent themselves. The results, beyond the short-term recapture of excessive “one-time” write-offs and provisions, are usually elusive. I have had better luck with slow-but-steady growers that other investors consider boring but where better prospects might be in store. I also had success with medium-growers that are subject to strong cycles related to the economic environment. Usually, the better-managed ones emerge from the down cycle in trim fighting shape, with considerable operating leverage once the economic environment improves.

This is when the contrarian component of value investing comes fully into play – more through an analysis of the macroeconomic or industry-specific environment than today’s financial analysis, which tends to focus mainly on forecasting a company’s earnings per share for the coming year based on the experience of … the last several quarters.

Typically, toward the end of long periods when the economic environment has hurt some companies, analysts tend to forget how well these same companies can do in better times. Often, even corporate managers, busy as they are surviving the tough times, are also reluctant to dream of how well they could do if the environment improved. Yet, industries that have gone through a long down cycle have experienced consolidation (with the elimination of weaker players and marginal facilities), intense cost cutting, and the survivors are not only as strong as before – they actually are stronger.

Typically, as investors relying on the bottom-up fundamental analysis of individual companies, we pay relatively less attention to the macroeconomic environment, except as a backdrop to identifying our stock picking ideas. But today, after a long economic cycle that left behind many companies in traditional industries, we may be entering one of the rare episodes when the macro backdrop is key to identifying good contrarian values.

The returns listed in this article are based upon the combined actual annual returns for each of the last ten years for a large account which has been managed by François Sicart, founder and Chairman of Tocqueville Asset Management. The account predates the formation of Tocqueville on January 1, 1990 , and was managed by Mr. Sicart initially as an executive of Tucker Anthony, R.L. Day, Inc., beginning in 1977 through the formation of Tocqueville. While representing a significant portion of the total assets under management, the results shown do not represent a separate composite of Tocqueville, and their publication is not intended to infer Tocqueville\'s compliance with AIMR-PPS standards. This account is included in the firm\'s current equity composites, along with other similarly managed accounts. Other accounts were managed by Mr. Sicart during the same period, and may have had different investment objectives and achieved different results. All results are the actual performance of the U.S. stocks in the account only, and nothing contained herein is intended to imply or guarantee that a new account with the same investment objectives and style will achieve similar results in the future.

François Sicart
February 10, 2003

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