09 Sep 2012 Clipper - Semi Annual Commentary ( Portfolio )
More than past results, our optimism about the future is based on our Portfolio today. In other words, while history presents a positive statistical picture, the most important basis for our optimism is the strong fundamentals and attractive valuations of the individual companies that make up Clipper Fund now.

As equity investors, we never forget that stocks represent ownership interests in real businesses like Costco, American Express, CVS Caremark, and Berkshire Hathaway.5 Over the long term, the growing value of these businesses will determine our success, not the fluctuating prices of their stocks. As a result, while we recognize that the prices of the stocks we own have been disappointing in recent years, the revenue, earnings, cash flow, and dividends of the vast majority of the companies we own have continued to make progress during this difficult period. Furthermore, virtually all of these companies have strengthened their balance sheets by reducing debt and, in the case of all of our financial holdings, also increased capital and reserves.

While we are always glad to own companies with such durability, resiliency and growth, the cornerstone of our optimism is that these companies in aggregate currently trade at a discount to the averages. The combination of above-average businesses at below-average prices is not one that investors often see.

In recent manager commentaries, we have outlined the investment rationale for many of our most important holdings. As these holdings remain in our Portfolio and as their valuations remain comparable, we would recommend these commentaries for anyone who would like greater detail about specific companies. However, there is one important characteristic many companies in the Portfolio share that we have not previously discussed that we believe is a critical differentiator. This characteristic is one of the reasons we are so confident about the Portfolio going forward.

To understand this characteristic, it may be helpful to consider a typical company in our Portfolio trading at a price-earnings multiple of 13 times earnings.6 Now suppose that this company (like many in our Portfolio) dedicates a third of its earnings to dividends, retains a third to fund its business and spends the remaining third to repurchase its own shares. Finally, assume over the next five years that this company is only able to grow its earnings 3% per year and that its price-earnings multiple remains the same at 13 times earnings. Here is the question: What return will shareholders of this company earn over this five year period?

At first glance, the obvious answer would seem to be 3% per year. After all, earnings only grew 3% per year and the price-earnings ratio stayed at the same 13 times earnings. Although this seems obvious, it is wrong. The correct answer is that shareholders of this company would have earned more than 8% per year over this five year period. The secret to this surprising result is one of the most important and underappreciated characteristics of our Portfolio, namely that we put great emphasis on how the earnings generated by the companies we own are allocated. In this example, the one-third of earnings allocated to dividends added about 2.5% per year to the stock return. The one-third of earnings allocated to share repurchases added another 2.5% per year to the return since earnings and dividends were then spread over fewer shares outstanding. As a result, the combination of a reasonable dividend yield and disciplined share repurchase turned a 3% growth in earnings into a more than 8% return to shareholders.

Our investment focus on capital allocation is one of the primary reasons we think Portfolio returns can be satisfactory even in an anemic economic environment. For those who would suggest that our expectation for even 3% profit growth is too optimistic, we would note that during the last 12 years, our country absorbed the bursting of the Internet bubble, two recessions, September 11th, the invasion of Afghanistan and Iraq, the housing bust, the financial crisis, and a 12 year bear market. Yet despite all of these enormous and in some cases unprecedented headwinds, earnings still grew roughly 6% per year for the S&P 500® companies overall. As a result, while not a worst case, 3% seems a realistic and sober expectation.

Perhaps more important, disciplined share repurchase means that should stock prices fall farther, reported returns might look disappointing but growth in intrinsic value per share would accelerate, increasing our eventual returns. In Berkshire Hathaway’s 2011 annual report, Warren Buffett explains this counterintuitive dynamic by noting when Berkshire buys “stock in a company that is repurchasing shares, we hope for two events: First, we have the normal hope that earnings of the business will increase at a good clip for a long time to come; and second, we also hope that the stock underperforms in the market for a long time as well. . . . The logic is simple: If you (own) . . . a company that is repurchasing shares, you are hurt when stocks rise. You benefit when stocks swoon.”

This logic becomes clear if you imagine that you own a business with only one other partner. If you plan to gradually buy out your partner’s interest in the business, then you would want the business to do well and your partner to sell you shares at a lower price rather than higher price. What is true when there is only one other shareholder is equally true when there are thousands of other shareholders. Buying at lower prices increases future returns.

The fact that so many of our companies are repurchasing shares at low prices is an important silver lining to the weak market performance of recent years. In addition, because this topic is so poorly understood and rarely discussed by market commentators, it is a source of differentiation for our Portfolio that should help relative returns in the years ahead. Amazingly, almost 70% of the total Portfolio and 80% of our top 20 holdings repurchased shares last year. Because share repurchases and dividends should be such important contributors to our future returns, we are able to be more dispassionate about both stock price volatility and our sober economic outlook. Put differently, with disciplined capital allocation many of our Portfolio companies should be able to build shareholder value in the face of an anemic economy while actually benefiting from the market volatility that worries so many investors.

Mistakes

As stewards of our clients’ savings, we firmly believe in the discipline of providing a review of our most significant mistakes. Before beginning, however, we should emphasize we do not consider an investment a mistake simply because its stock price has declined below our purchase price. Given the truth of the old saying that the only people who buy at the bottom and sell at the top are liars, every company we buy will likely trade below our purchase price at some point. Similarly, we do not consider an investment a mistake simply because it is controversial or the subject of negative articles in the press.

However, the fact that we do not define a mistake in terms of critical press reports and declining stock prices does not mean that we ignore them. Such negative events often reflect or contain new information that must be considered when assessing value. Successful investing requires balancing the patience and discipline needed to maintain conviction when our work is correct with the open-mindedness and humility required to admit mistakes when new information proves it wrong.

As a result, we label an investment a mistake when we meaningfully reduce our estimate of a company’s intrinsic value. In the worst cases, usually caused by some combination of leverage (e.g., Lehman Brothers, Fannie Mae, Freddie Mac), low-cost competition (e.g., General Motors, Kmart), obsolescence (e.g., Polaroid, Kodak), or fraud (e.g., WorldCom, Enron), the company is unable to ever return to profitability and equity investors are essentially wiped out. While we avoided all of the examples mentioned above, we estimate that the intrinsic value of our costliest mistake, AIG, declined more than 80% on a per share basis. No other mistake has been remotely as costly. More important, we strongly believe that the extraordinary circumstances of the financial crisis combined with the lessons we learned during that process make the possibility of another such loss far less likely.

Over the last three years, the biggest detractors from our results were RHJ (Ripplewood Holdings Japan), Bank of New York Mellon and Hewlett-Packard. In our last report, we wrote at some length about Bank of New York Mellon, concluding: “At today’s price. . . . the fact that the shares now trade at a low multiple on depressed earnings leaves us optimistic that Bank of New York Mellon will add to our future returns and that we will earn back some of this loss in the years ahead.” Our view has not changed since and for those wanting more background we would commend our earlier commentary, which is available in the commentaries section on clipperfund.com.

Although certainly not a well-known company, RHJ is a public investment company formed by the very successful private equity firm Ripplewood and incorporated in 2005 in Belgium due to that country’s favorable tax structure. Ripplewood’s founder Timothy Collins is RHJ’s largest shareholder. For the position of chief executive officer, RHJ recruited Leonhard Fischer, a well-regarded executive with extensive experience in financial services. RHJ’s portfolio was initially focused on Japan and included several electronics and auto component manufacturers, which we appraised above their net asset value or book value. We invested for two important reasons. First, the company was led by a team of executives who owned a meaningful percentage of the shares and had a long-term record of value creation. Second, the shares traded at a discount to their net asset value. In short, we judged that the shares represented a good combination of growth potential at a value price.

We were wrong. Since 2006, RHJ’s net asset value (NAV) has declined a staggering 59%, from about €20 per share to €8 per share. The biggest loss came from the company’s investment in the auto parts company Honsel whose 2008-2009 collapse eliminated €3.35 of NAV, though there were other losses as well. Given this record, it is reasonable to ask why we continue to own RHJ. The answer is that at €4, RHJ trades at just one half of NAV, and only marginally above the €3 of net cash the company has on its balance sheet. Moreover, unlike 2006, the majority of the remaining portion of NAV is made up of the company’s investment in storied private bank and asset manager Kleinwort Benson, which RHJ purchased during the depths of the financial crisis in 2009. RHJ has divested all but an insignificant residual of Kleinwort’s legacy investments, is working to restore Kleinwort to attractive returns and is opportunistically searching throughout Europe for assets that distressed European banks may be forced to sell. While this strategy is promising, we are chastened by RHJ’s record and our own mistaken analysis. Furthermore, because of management’s record of value destruction, some discount to NAV is warranted. However, with the shares trading at 50% of a fairly clean NAV and only slightly above net cash on the balance sheet, we have decided to hold them for the time being.

Unlike RHJ, the largest detractor from our three-year returns is a household name whose troubles have been well reported. We first purchased Hewlett-Packard for Clipper Fund at $48 per share in 2008, a year in which the company earned $3.38 per share. Since then, the earnings have grown nicely, particularly considering the economic backdrop, and should top $4.00 per share this year, an increase of almost 20%. Unfortunately, during this same period, Hewlett-Packard’s share price has fallen approximately 60%. What happened?

The short answer is that while earnings per share have grown and Hewlett-Packard’s core businesses have done well, the company went on a buying spree that has wiped out tens of billions of dollars of value and saddled the company with more than $20 billion of debt. On top of this, over the last 13 years, the company has had a staggering seven CEOs, four of whom were forced out and two of whom were interim.

While all of this turmoil has had a substantial cost, we continue to own the shares because we believe that the company’s underlying businesses have remained far more stable than the chaos on the company’s board and in its executive suite would indicate. Furthermore, the combination of debt and a loss of credibility make it nearly certain that the company will not make another major acquisition for a long, long time. In short, while we would not suggest that Hewlett-Packard is a wonderful company with great prospects, we would argue that at less than five times current year earnings (which despite everything are only slightly lower than last year’s), the company is priced as if its businesses are collapsing. The investment opportunity lies in the fact that there is no evidence of this. On the contrary, the majority of the company’s earnings come from fairly stable businesses such as printer supplies, services, software, and large enterprise solutions. If we are right, then just like Philip Morris in the 1990s or the pharmaceutical companies more recently, Hewlett-Packard’s stock could prove a satisfactory investment simply if the business does not collapse. Given that the company is priced with more than a 20% earnings yield, we think this is a reasonable expectation and, in fact, have added to the position as the shares fell.

At a recent shareholder meeting, one longtime shareholder asked why we spend so much more time discussing our mistakes than our successes. After all, he said, during the same three-year period in which Bank of New York Mellon, RHJ and Hewlett-Packard subtracted from results, American Express, Costco and Berkshire Hathaway more than made up the lost ground. The most eloquent answer to this question came from Microsoft’s founder Bill Gates who said, “Success is a lousy teacher.” All investors make mistakes. In reviewing them so thoroughly, it is our hope to extract future value from past losses. As my grandfather Shelby Cullom Davis said, “The value of a mistake lies in the lesson learned.”

Conclusion

Poor stock market returns and disappointing relative results have made the last decade difficult for our investors. In this report, we have outlined our rationale for holding fast to our investment discipline and for expecting improved returns in the decade ahead. We do so not to be promotional but instead to help ensure that investors who have come through these difficult times with us will be with us for the brighter days that we believe lie ahead.

This positive view of the future may sound out of place in a present so characterized by nervousness, pessimism and uncertainty. After more than a dozen years of sluggish economic growth and poor stock market returns, investors are giving up on stocks and flocking to the perceived safety of cash and bonds. USA Today captured the mood perfectly with a front-page headline declaring, “Invest in Stocks? Forget About It!” The article went on to disparage stock investing, saying that the “long-running story about how stocks are the best way to build wealth seems tired, dated and less believable…the (new) mentality (is) . . . get-me-out, wait-and-see, bonds-are-safer. . . .”

This article is as much a product of its time as the articles in 1999 and 2000 trumpeting Internet stocks and predicting that the Dow Jones would be at 40,000 by now. What these articles have in common is that they ignore valuation. Back when the press and pundits loved equities, the market was at an all-time high, valued at 30 times earnings, or a 3% earnings yield, while a government bond yielded 7%. Today, when the same publications are advising investors to “forget” about equities, the market trades at 14 times earnings or a 7% earnings yield and pays annual dividends in excess of government bonds, which now yield a paltry 2.4%.

In the face of such negative articles and press reports, the desire to sell stocks 12 years into a bear market in order to buy bonds at their all-time high or hold cash with a zero percent interest rate is perfectly understandable from a psychological point of view. However, it is likely to be significantly wrong from an economic point of view. Nervousness, pessimism and uncertainty have driven down prices and the golden rule of investing is that low prices increase future returns.

As a result, while it is our general tendency to moderate expectations, we want to be emphatic about our conviction that stocks at today’s prices are the most undervalued large asset class available to investors. What’s more, because we accept Warren Buffett’s definition of risk as “the reasoned probability of . . . (an) investment causing its owner a loss of purchasing power over his contemplated holding period,” we also consider stocks among the lowest risk asset class for long-term investors, especially compared with cash and government bonds. The idea that cash and low yielding government bonds are “risk free” is one of the most dangerous fictions there is. After all, a dollar hidden under a mattress 50 years ago has lost more than 80% of its purchasing power and now can only buy what 20 cents used to buy. It is hard to understand how an asset that has declined 80% in value over 50 years can be considered risk free. Yet despite an 80% decline in purchasing power over 50 years, investors continue to describe holding cash as “risk free.”

Our positive outlook for stock returns is not based on a rosy economic outlook. The deflationary trends from global deleveraging continue, Europe is a mess, Washington dysfunctional, and Asia slowing. But today’s low valuations discount a great deal of bad news. Furthermore, because our companies tend to pay dividends and repurchase shares, they should be able to generate satisfactory investor returns even with relatively anemic earnings growth. In short, by remembering that stocks represent actual ownership in real operating businesses, investors can focus on the quality, durability and profitability of these businesses and tune out the blaring headlines, day-to-day noise and rampant pessimism. While no one can know for sure what the future holds, we do know that our Portfolio is made up of strong companies generating an earnings yield of close to 8%, much of which they are returning to shareholders. These facts are what make us look to the future with optimism.

As we said at the beginning of this report, we are deeply disappointed at the unsatisfactory results of Clipper Fund in its years under our management. We know we have ground to make up and, for the reasons outlined in this report, we have confidence that we are moving in the right direction. But if actions speak louder than words, then maybe a better indicator of our confidence is the fact that during the last five years, your portfolio managers, our firm and our families have increased the number of shares of the Clipper Fund we own from roughly 724,000 to 1.2 million today. Although we cannot promise better results, we have at least put our money where our mouth is.