June 30, 2016 www.valueinvestorinsight.com Value Investor Insight

Opinions vary among value inves-tors over the extent to which portfolio cash is a valuable risk

mitigator, or even a strategic asset. The “fully-invested” camp likens letting cash build in the absence of table-pounding in-vestment options as thinly veiled market timing. As Carlo Cannell of Cannell Capi-tal puts it: “By having a high cash balance, one is suggesting that he has some wisdom or knowledge about timing the market for which he should be compensated. I have none of that.”

Others say they can typically find stocks that offer at least adequate returns, especially compared to cash that earns next to nothing. Vulcan Value Partners’ C.T. Fitzpatrick put it this way in an in-terview: “People we greatly respect think about this differently, but if even in 2007

we could buy a company like Wrigley at 80 cents on the dollar, we think that’s a lot more attractive than holding cash. Even at 80 cents on the dollar, we’d expect a rate of return in the mid-teens annually. And that was available in, across the board, the priciest market I’ve ever seen.”

On the other hand, many equally ac-complished investors are willing to let cash grow as a residual effect of not find-ing enough to buy. A high-profile propo-nent of this approach, Baupost Group’s Seth Klarman, considers it a valuable way to mitigate downside risk: “Our willing-ness to hold cash during fallow periods has enabled us to maintain a strict sell dis-cipline [and] has also enabled us to avoid the gun-to-the head mentality that pres-sures many investors to own less-than-stellar investments. The world doesn’t end when we pass on a borderline investment that later works out; the danger we seek to avoid is the temptation or pressure to make too many borderline investments that later turn out badly.” Bruce Berkow-itz of Fairholme Capital trumpets a fur-ther beneficial aspect of having cash on hand: “The older I get, the more I see cash as a strategic asset. It allows us to take advantage of those great opportuni-ties that come up from time to time. We’re just behaving like the companies we like to invest in.”

Seeking guidance from four of the best “defense-is-the-best-offense” inves-tors in the business, we recently spoke with Charles de Vaulx of International Value Advisers, Zeke Ashton of Centaur Capital, First Eagle Investment’s Kimball Brooker and Intrepid Capital’s Jayme Wiggins about how they’re positioning their portfolios today and why.

Your IVA Worldwide Fund has a broad global mandate but is sitting today with around 40% in cash. Describe what’s be-hind such a defensive positioning.

Charles de Vaulx: Our style of value in-vesting is to buy only when a stock trades at a sufficient discount to what a knowl-edgeable buyer would pay in cash to own 100% of the business, and to sell when that discount is gone or intrinsic value isn’t sufficiently compounding, redirecting the proceeds to new bargains. When we can’t find new bargains trading at enough of a discount, cash will grow.

Holding cash today is awful – in real terms you lose money. That leads some people to argue that with interest rates so low, you should use higher multiples to value businesses. Or maybe don’t insist on a 30% discount to intrinsic value, and take 15% instead. We say no to both.

Why?

ValueInvestorINSIGHT

June 30, 2016

The Leading Authority on Value Investing

On The DefensiveFour highly successful investors explain why they’re sitting on so much cash, where they expect to use it when the time comes, and where – even in what they consider a pricey market – they see bargains of particular note.

I N V E S T O R I N S I G H T

Charles de Vaulx International Value Advisers

“Often when the outlook is bleak, valua-tions are attractive enough to offer a mar-gin of safety. That isn’t the case today.”

June 30, 2016 www.valueinvestorinsight.com Value Investor Insight

I N V E S T O R I N S I G H T : On the Defensive

CdV: Implicit in lowering your valuation standards is a willingness to accept a low-er equity risk premium in the stocks you own. But when we look at the world to-day, at the market manipulation by central banks, the financial imbalances and exces-sive debt, the morose economic outlook and the disruption going on in industries that reduces visibility almost across the board, we’d argue for requiring a higher equity risk premium rather than lower.

Often when the outlook is bleak, valua-tions are attractive enough to offer a good margin of safety. But that isn’t the case to-day. We can go anywhere, developed and emerging markets alike, and we’re just struggling to find genuine bargains.

Let’s look briefly around the world. In Europe, broad valuations may look more attractive, but the biggest companies in the index typically deserve to be cheap. European banks are still undercapitalized. Insurance companies are squeezed by the yield curve. Telecom companies, utilities … they have poor outlooks and should have low valuations. But when you look at companies with wonderful business models – which is our focus – the valua-tions are as high or higher than on compa-rable U.S. companies. In freight-forward-ing, for example, Kuehne + Nagel, which is based in Switzerland, trades at 17x EV/EBIT, while Expeditors International in the U.S. trades at 13x. Look at Lindt & Spruengli, the chocolate manufacturer, or Givaudan, the flavors and fragrances company, or testing and inspection com-panies like Bureau Veritas and SGS – they all trade at least as expensively as similar U.S. companies.

In Japan, Abenomics has resulted in a significant weakening of the yen in recent years, which has helped many companies, but the market has gone up quite a bit al-ready. Corporate governance is better, but debt in the system is unsustainable and there’s still virtually no mergers and acqui-sitions activity. In our Worldwide Fund, Japan now makes up about 7% of the portfolio, down from 14% five years ago.

In China, the credit excesses there are among our biggest global worries. Other emerging equity markets have come down

a lot more in U.S. dollar terms than in local-currency terms, and there’s much of the same dispersion in valuation that I spoke about in Europe. Petrobras in Bra-zil deserves to be cheap, but good banks like Banco Itau or Bradesco, while they’ve come down in price, still trade at around 1.4x tangible book value. They may de-serve that because they earn good returns on equity, but these are not the bargains of the century. The market in India has done reasonably well, but now trades at something like 2.4x book and 17x after-tax cash flow. That’s nosebleed.

Is the outlook better in the U.S.? Yes. But I’m not sure that’s as bullish for stocks as valuations imply. If the U.S. economy slowly progresses while the rest of the world struggles, odds are high that the dollar goes up another 15-20%. With close to 40% of the earnings of S&P 500 companies coming from overseas, that’s not good. If wages go up, that threatens historically high corporate profit margins. If the economy keeps improving, the Fed has to raise interest rates at some point. None of this would be great for U.S. stocks.

Is your discipline focused on what an in-dependent buyer would pay allowing you any leeway on valuation?

CdV: We are aware that buyers are pay-ing higher multiples than they were a few years ago. But when we believe the prices paid are not sustainable because they’re facilitated by ultra-low interest rates and a too-compliant high-yield financing envi-ronment, we’re not willing to take some of the multiples being paid now at face value.

You’ve said you don’t consider cash just a buffer against stocks falling, but also something that has “huge optionality val-ue.” What do you mean?

CdV: It simply means cash is the dry pow-der we have to have in order to buy low when genuine bargains surface again. We’ve always divided the world along in-dustry lines, and each of our analysts has a list of names for which we have tentative

intrinsic-value estimates and that we’ll pounce on to look at more closely when a stock reaches 70% of that value.

The watch list is often populated with stocks we’ve owned in the past. Today it includes wonderful companies in Japan, like [bicycle-component maker] Shimano [7309:JP], [power-tool manufacturer] Makita [6586:JP] and [industrial-automa-tion company] Keyence [6861:JP]. In Eu-rope, we have a stake in L’Oreal [OR:FP] through our position in Nestle, but at the right price we’d love to own it outright. In the U.S. some wonderful industrial com-panies actually came off the watch list and made it into the portfolio, including Unit-ed Technologies [UTX], Emerson Electric [EMR] and Flowserve [FLS].

Japan’s Astellas Pharma [4503:JP] is a stock we’ve spoken with you about before [VII, August 31, 2012]. Describe why you still find it so interesting today.

CdV: I looked back to see how the stock had done since we spoke, and accounting for a 5:1 split in 2014, the shares have roughly doubled. So it might be strange for me to suggest this as something we really like today, but we still scratch our heads at the valuation relative to intrinsic value.

This is Japan’s second-largest pharma-ceutical company by sales, with a market cap of more than $30 billion. It’s a world-class player – five years ago it generated 42% of its revenues outside Japan and that number today is almost 65%. Nearly 85% of earnings come from overseas.

The product diversity is also better than ever. In 2010 two drugs, the immu-nosuppressant Prograf and the urinary-infection treatment Harnal (called Flomax in the U.S.), accounted for 64% of EBIT. Now that’s less than 25%. One blockbust-er today is Xtandi, which is a top-selling prostate-cancer drug they own 50% of with Medivation, which is now the object of a hostile takeover offer by Sanofi. Astel-las’ success in expanding the product line is testament to the strength of its R&D operation and to its ability to identify at-tractive drugs to partner with others on.

June 30, 2016 www.valueinvestorinsight.com Value Investor Insight

I N V E S T O R I N S I G H T : On the Defensive

Have they been big acquirers?

CdV: They have done select deals, but not the giant ones that have gotten some others into trouble. This year, for exam-ple, they paid $380 million to buy Ocata Therapeutics, a U.S. biotechnology firm focused on therapies in the field of regen-erative medicine, primarily for ophthal-mology patients.

We consider Astellas to be kind of the anti-Valeant. It doesn’t engage in the price gouging you’ve seen at other firms. It also spends a lot on research and development, around 17% of annual revenues. The new-product pipeline remains strong, with highly promising drugs recently launched or soon to be launched – often with part-ners – in such treatment areas such as fun-

gal infections, cholesterol reduction, kid-ney disease and osteoporosis.

We also believe the company has con-servative accounting. One reason I think the stock is undervalued is because Japa-nese investors focus too much on the com-pany’s earnings before interest and taxes, when the better earnings measure also in-cludes amortization of acquisition-related goodwill, which we consider a genuine non-cash charge. There’s a 15% gap here between the EBIT and the EBITA.

The shares, now at ¥1,615, are down 20% from their highs last summer. How are you looking at valuation today?

CdV: At a time when comparable U.S. and European pharma companies trade

between 12x and 22x forward EV/EBITA, Astellas shares trade at less than 8x.

Based on the prices at which deals have been done, and there are plenty of relevant comps, we use 13x EV/EBITA for our intrinsic-value estimate. That results in an intrinsic share value for Astellas of ¥2,270, so today’s price is a 30% discount.

We think we’re protected on the down-side. As a worst case we’re using the cur-rent 8x March 2017 EV/EBITA, which we believe is absurdly cheap. It’s also worth noting that at the price Sanofi has offered for Medivation – which the market is bet-ting will be increased, by the way – Astel-las’ stake in Xtandi alone, plus net cash, gives you the current market value of the company’s shares. That means we’re get-ting the rest of the drug portfolio, which provides 60% of total earnings, and the pipeline for free.

I should add that the company is very un-Japanese in terms of its capital alloca-tion. It pays more than 35% of free cash flow out as dividends, which today offers a 2.1% dividend yield. Since 2001 it has bought back 37% of its shares outstand-ing, usually most aggressively when its net cash exceeds 20% of the market capital-ization. Today net cash is 14% of market cap, so they may replenish cash before they buy more, but as long as the shares remain undervalued that would be a good use of capital.

Last time we spoke you said the follow-ing: “One thing that’s difficult about be-ing a value investor like us is that over a full economic cycle, roughly two-thirds of the time we look bad because we lag our benchmarks. Only one-third of the time do we shine, and we hope to end up shining over the whole period. You need clients who get that, which we have, but your ego has to be prepared for that as well.” Any advice on keeping your ego prepared?

CdV: It’s really not that difficult. If you believe in value investing and your process and have experience that shows it works, why would you question it all during pe-riods when you lag your benchmark? VII

Astellas Pharma (Tokyo: 4503:JP)

Business: Global research, development, manufacture and sale of pharmaceuticals; key treatment areas include urology, oncology, neuroscience, immunology and nephrology.

Share Information(@6/29/16, Exchange Rate: $1 = ¥102.93):

Price ¥1,61552-Week Range ¥1,358 – ¥2,009Dividend Yield 2.1%Market Cap ¥3.48 trillion

Financials (FY2016 Forecast): Revenue ¥1.35 trillionReturn on Assets 20.0%Return on Equity 14.7%

Valuation Metrics(@6/29/16):

4503:JP S&P 500P/E (TTM) 18.0 24.2 Forward P/E (Est.) 15.7 17.9

I N V E S T M E N T S N A P S H O T

ASTELLAS PRICE HISTORY

THE BOTTOM LINECharles de Vaulx considers the company “the anti-Valeant,” with an increasingly diverse existing-product portfolio, a good pipeline of new and pending drug launches and a favorable, “un-Japanese” approach to capital allocation. Using a 13x EV/EBITA multiple from what he considers relevant comps, the shares would trade at 40% above today’s price.

Sources: Company reports, other publicly available information

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Important Information Concerning the Attached June 30, 2016 Value Investor Insight Article Reprint

This reprinted article should not be construed as an offer to sell or a solicitation of an offer to buy securities or any product mentioned in this article. This article does not constitute investment advice and should not be viewed as a recommendation to adopt any investment strategy. All data in this article was provided by Value Investor Insight and has not been independently verified by IVA. As of June 30, 2018, the IVA Worldwide Fund’s top 10 holdings were: Gold bullion (5.5%); Berkshire Hathaway, Inc. Class A; Class B (4.6%); Bureau Veritas SA (2.5%); Astellas Pharma Inc. (2.4%); Oracle Corporation (2.1%); Cimarex Energy Co. (2.1%); Nestle SA (2.1%); Mastercard Incorporated Class A (2.0%); Sodexo SA (2.0%); Acuity Brands, Inc. (1.8%). As of June 30, 2018, the IVA International Fund’s top 10 holdings were: Gold bullion (6.8%); Bureau Veritas SA (3.8%); Sodexo SA (2.9%); Astellas Pharma Inc. (2.8%); Nestle SA (2.4%); Airbus Group SE (2.4%); Samsung Electronics Co., Ltd. (2.3%); Kangwon Land, Inc. (1.8%); Alten SA (1.8%); Haw Par Corporation Limited (1.7%). The views expressed in this document reflect those of the portfolio managers and analysts only through the end of the period as stated on the cover and do not necessarily represent the views of IVA or any other person in the IVA organization. Any such views are subject to change at any time based upon market or other conditions and IVA disclaims any responsibility to update such views. These views may not be relied on as investment advice and, because investment decisions for an IVA fund are based on numerous factors, may not be relied on as an indication of trading intent on behalf of any IVA fund. The securities mentioned are not necessarily holdings invested in by the portfolio managers or IVA. References to specific company securities should not be construed as recommendations or investment advice.

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