26 Feb 2011 Clipper Fund - Q4 2010 Commentary ( Portfolio )
By far the most important reason we believe the next five years should be better than the last lies in the economic characteristics and valuations of the companies that make up Clipper Fund.10 Bearing in the mind the risk of overgeneralizing, especially given John Train’s observation that “investing is the art of the specific,” the Portfolio today can roughly be divided into three categories. The first is made up of companies that are under a cloud whose reputations and valuations have suffered because of management missteps, lackluster execution or worse than expected results. Although subjective, this category would include companies such as Harley-Davidson, Bank of New York Mellon, Hewlett-Packard, CVS Caremark, and ConocoPhillips. Because these companies are currently unpopular, their shares can be purchased at low valuations. Moreover, in each case, we have reason to believe the fundamentals will improve and the companies will regain some of their lost luster. If this happens, shareholders can benefit from both improved earnings and an improved multiple of earnings, a compounding effect my grandfather referred to as “the double play.”

A second category is made up of companies whose relatively small size, complexity or illiquidity means their stocks are poorly understood or followed by relatively few. In this subjective category, we would include companies like Oaktree Capital, RHJ International, SKBHC Holdings, and even Loews Corporation. Although each of these companies is run by owner operators with proven records of success, they tend to be relatively illiquid or not well known and thus not attractive to many large investors. In the years ahead, we hope to show that one of the advantages of Clipper Fund’s relatively small size is the opportunity to take meaningful positions in such companies.

The third category makes up the majority of Fund assets. Companies in this largest and most important category might well be characterized as world leaders. This category includes some of the highest quality companies we have ever owned. We believe a significant percentage of them are best-of-breed across a range of different industries. Think of American Express, Wells Fargo and Goldman Sachs in financial services; Costco in retailing; Procter & Gamble in consumer products; Merck and Roche in health care; Diageo and Coca-Cola in beverages; Canadian Natural Resources in energy; Berkshire Hathaway in insurance (and many other industries); and Microsoft and Texas Instruments in technology. These companies tend to have deeper moats, stronger balance sheets and often more pricing power or lower costs than their competitors. Many also have broad product portfolios and wide geographic diversity that gives them exposure to higher growth economies around the world. These attributes helped many of these companies deliver strong business results straight through the worst economic downturn since the Great Depression. A number of our holdings, including Merck, Coca-Cola, Wells Fargo, and Berkshire Hathaway, actually took advantage of the financial crisis by making opportunistic acquisitions and others such as Texas Instruments and Microsoft repurchased a meaningful amount of their outstanding shares at distressed prices.

However, the economic characteristics of these leading companies are only half the reason we are so optimistic about future returns. The other half of the equation is valuation. Because the stock market works like a pari-mutuel system, businesses with such wonderful characteristics will tend to trade at high valuations, which in turn can make them poor investments. While above average valuations may be appropriate for above average businesses, they decrease the likelihood investors will earn an excess return. As expected, during most periods, investors who wanted the safety and security of owning some of the world’s most durable businesses had to give up some return by paying higher than average valuations. Such valuations reached bubble levels in the Nifty Fifty era of the early 1970s and again in the late 1990s when many such global leaders had dividend yields of less than 1% and traded at more than 30 times earnings.

However, since then, there has been a dramatic reversal. An interesting way to look at this reversal is to use the top 100 companies in the S&P 500® Index as a proxy for the sorts of companies we own. In a recent report, our friend Robert Hagstrom of Legg Mason highlighted the fact that over the last 11 years, while the S&P 100® Index declined 11.2%, the S&P SmallCap 600® Index and the S&P MidCap 400® Index actually gained an astonishing 134%.11 He concludes, “By almost any historical measurement, the drubbing big-cap stocks have endured in both duration and magnitude is unprecedented.” The huge difference in trailing returns has led to big changes in valuations. According to Robert, the MidCap and SmallCap Indexes trade at 22 times and 28 times trailing earnings while the S&P 100® Index trades at approximately 15 times trailing earnings.

While the valuation of the index of very large companies is attractive, the valuation of the individually selected companies that make up this portion of Clipper Fund is even more attractive as these holdings are currently priced around 12 times our estimate of this year’s owner earnings. Owner earnings is a measure of earnings that differs somewhat from generally accepted accounting principles (GAAP) in ways that we believe make it a more accurate measure of economic versus accounting reality. For example, in determining owner earnings, we normalize tax rates and credit costs, add back historic depreciation while deducting maintenance capital spending, deduct the costs of adequately funding pension liabilities, and so on.

With low valuation as the final piece of the puzzle, we would conclude this largest portion of Clipper Fund’s portfolio currently exhibits a rare combination of (1) lower than average risk, as measured by our companies’ balance sheet strength, competitive position and low risk of obsolescence;12 (2) durable, long-term growth prospects as indicated by their product portfolios, geographic diversity and attractive returns on retained equity; and (3) low valuations as indicated by the fact they are priced at a substantial discount to our estimated range of fair value. In our view, this is the perfect combination in an uncertain environment that may include anything from a robust economic recovery to another economic or financial crisis.