Clarkston Capital Partners was founded in 2004 by Jeffrey and Jerry Hakala and is based in Bloomfield Hills, Michigan. The firm is a dedicated research boutique with a focus on domestic long-only equity strategies. Clarkston seeks to invest in high-quality companies operated by strong management teams at market prices that are below its assessment of their intrinsic value.
InvestorView recently sat down with Jeff to discuss founding Clarkston Capital Partners, the firm’s “quality value” investment philosophy and how it views opportunities in small- and mid-cap investing, among other topics.
InvestorView: Thanks for taking the time to speak with us. First, can you provide a background on yourself and your co-portfolio manager and brother, Jerry Hakala?
Jeff Hakala: In 2004, Jerry and I began our serious talks about starting Clarkston Capital Partners. I was trained as a CPA in public accounting and therefore am well versed in the language of accounting. Jerry spent several years in corporate finance at Ford Motor Co. We like to say that I spent my time looking at businesses from the “outside in,” and Jerry spent his time looking at businesses from the “inside out.” Our different but complementary backgrounds provided the foundation for performing sound research and analysis.
My experience working with many different types of businesses prepared me to become the firm’s architect, whereas Jerry’s experience facilitated a more hands-on approach to implementing our ideas. This meant that I always focused on “what” to do, while Jerry focused on “how” to do it.
The common thread across both our backgrounds is that we were trained to analyze businesses – not buy and sell stocks. As you may expect, it didn’t take much time for us to embrace Benjamin Graham’s axiom that “investment is most intelligent when it is most business-like.” We founded Clarkston on the belief that the best way to create and protect wealth is by owning great and sustainable businesses. That is the central theme on which the business was built and to this day governs the investment philosophy.
IV: As you just described, you and your brother do not have traditional value investing pedigrees. What drew you to value investing, and what motivated you to build your own firm?
JH: I will answer that question in two parts. First, why value investing? We believe that you don’t choose value investing – it chooses you. Value investing fits our experiences and personalities so well that there was no other methodology in which we could be successful. Initially, we were drawn to the most obvious principle of value investing: buying something for less than it is worth. How do you make an investment if you don’t know what it is worth? And, when you value a business, you have to know your way around financial statements. Our accounting and finance experience made it much easier for us to head down the value path. We knew very little about markets or how to read charts and had no interest in learning how to, so we were initially drawn to this simple and essential concept of valuing businesses and buying at a discount.
While our background and experiences drew us to value investing, it was our temperament and personality traits that enabled us to execute successfully. These traits include the ability to think long term, have patience, act courageously and demonstrate a healthy dose of contrarianism. We have come to believe that these traits are inherited; they can be enhanced, but one cannot develop them from scratch. Depending on your view, we were either lucky or cursed. We inherited many of these “value-enabling” characteristics that made it easy for us to understand and subscribe to value investing.
To address the second part of your question: why build our own firm? We believe that our entrepreneurial spirit was inherited from our grandfather, Anthony Filippis, who founded Wright & Filippis, a privately held orthotics and prosthetics company. I can remember watching him build his business through drive, passion and a bit of stubbornness. We like to think that some of that rubbed off on us. As a result, Jerry and I always wanted to build our own money management business; we were just waiting for the right time.
IV: I’ve heard you describe yourself as the “quality guy” and Jerry as the “value guy.” Can you explain your investment philosophy at a high level, what you mean by “quality” and “value” and how these two characteristics interact in your portfolio companies?
JH: We consider ourselves “quality value” investors. We start with quality and patiently wait for value.
A quality business, which we refer to as “Clarkston Grade,” is one that generates consistently high levels of profitability, possesses the competitive advantages necessary to protect those returns and is operated by a capable management team. We developed a proprietary profitability metric – cash return on net operating assets, or CRONOA – which helps us more efficiently identify highly profitable businesses by minimizing accounting complexities. Specifically, a consistently high CRONOA indicates three things: a likely competitive advantage, the ability to compound capital and a high percentage of net income that is converted into free cash.
Once we identify a business that meets our quality standards, we estimate the value of its future free cash flows and wait for it to go on sale. As absolute investors, we will not commit capital until the company’s normalized free cash flow yield plus future growth exceeds our hurdle rate of 10%. Over our 11-year history, we have become intimate with a list of companies that meet our quality standards. We are simply waiting for short-term challenges to impair their market value before committing to a long-term investment with the benefit of a margin of safety.
IV: Compared with large-cap investing, small- and mid-cap (SMID-cap) investing is typically associated with greater price volatility and a higher risk of permanent capital impairment. Clarkston’s strategy seeks to protect capital in down markets, and returns are less volatile than those of your SMID-cap peers. Can you identify how the firm’s investment approach leads to a differentiated return profile?
JH: Our quality value investment philosophy seeks to mitigate the risk of permanent capital impairment regardless of a company’s market cap. Quality provides two things: a much lower probability of business extinction and the ability to compound capital. Thus, the investment horizon is less relevant. However, a high-quality business is not worth an infinite amount, so we require a discount to intrinsic value – or said differently, a margin of safety to further insulate against error. At the intersection of quality and value is where we find asymmetrical return outcomes. Less volatile returns are a byproduct of our investment approach.
IV: Similarly, why invest in small- and mid-cap domestic companies rather than large-cap or international businesses? How do you view the long-term opportunity set for SMID-cap investors?
JH: From a valuation perspective, we believe the small- and mid-cap space is underfollowed and therefore less efficient than the large-cap space. Some of our small-cap companies may be followed by few analysts, whereas the larger companies can be followed by more than 40 analysts. Because there are fewer minds evaluating smaller firms, the share prices can deviate much further from the value of the underlying business and for a longer time period.
Clarkston focuses on SMID-cap companies that are more likely to benefit from micro-niche characteristics. We define a micro-niche as a moderately growing, small industry that is typically isolated from large pools of capital. The industry is too small to attract investment from larger companies or venture capital and is not growing fast enough for an entrant to garner enough share to earn an attractive return. Although not impossible, taking market share from a dominant incumbent is a difficult task, resulting in a built-in “structural” barrier. Large-cap companies typically compete in larger, more competitive markets that may interest sophisticated, large pools of capital.
Not many businesses can be classified as Clarkston Grade. However, we have spent the past decade identifying and studying them and are patiently waiting for the opportunity to buy them at an attractive value with a margin of safety.
IV: Can you provide an example of a Clarkston Grade business and the criteria on which the investment decision was based?
JH: Actuant Corporation is a great example of a Clarkston Grade business that exhibits the micro-niche characteristics addressed earlier. Actuant is a small diversified industrial company that sells hydraulic tools, specialized products and highly engineered motion control systems to infrastructure, energy, transportation and agricultural end markets. The company operates under three segments: industrial, energy and engineered solutions.
Initially, Actuant stood out from other industrial businesses with its exceptional normalized companywide CRONOA around 50%. Further analysis revealed that the CRONOA of Actuant’s industrial segment was double that of the company as a whole. The company’s industrial segment is known for its high force hydraulic and mechanical tools marketed under several brand names. In fact, Actuant’s Enerpac brand is so well recognized throughout the industry that it has been characterized as the Kleenex of high force hydraulics. The brand’s value enables Enerpac to charge up to 15% more than competitors for comparable tools and equipment. As a result, the industrial segment has produced earnings before interest, taxes and amortization (EBITA) margins of 30%. These high margins coupled with Actuant’s flexible, asset-light assembly model facilitate the attractive CRONOA and provide for resilient operating results despite cyclical end markets.
The high force hydraulic tools and equipment industry is a $1 billion micro-niche. Actuant is the market leader, with 40% share, vs. a 15% share for its closest competitor. These industry dynamics create the structural barrier to entry that deters both large-cap and startup entrants. Can you imagine GE committing capital and time to chase after a total market opportunity that represents 1% of its total revenues?
Over the past couple years, Actuant’s share price has been unfairly punished due to its energy exposure. We believe other investors misunderstand the company’s energy segment, which comprises just one-third of its total revenues. Many investors believe that this segment’s revenues are directly linked to oil prices; however, the majority of Actuant’s energy exposure is downstream and maintenance-related, which tends to be less cyclical than upstream exploration and production activities. Within Actuant’s energy segment is its Hydratight business, which manufactures and markets hydraulic torque wrenches and bolt tensioners for maintenance and service on oil rigs, refineries and pipelines. Hydratight’s revenues tend to be more resilient in difficult commodity environments because of the nature of its services. Regardless of oil prices, energy infrastructure still needs to be serviced to avoid costly downtime and expensive environmental remediation. As a result, an asset owner can delay maintenance but cannot suspend it indefinitely.
We believe Actuant’s future is brighter than ever. The company has tailored its portfolio of businesses to capitalize on long-term macro trends in energy demand, global infrastructure development, farm productivity and natural resources. At current prices, we are enjoying an attractive valuation and a healthy margin of safety on a high-quality business.
Interview conducted and article written by Caroline Thomas.
All statements made regarding companies, securities or other financial information are strictly beliefs and points of view held by Clarkston Capital Partners, LLC and are subject to change without notice. The information is for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. An investor should consult a financial or other professional regarding the investor’s specific situation.
Past performance is no guarantee of future results.
For more complete information on the Clarkston Partners Fund, contact your investment professional for a prospectus or summary prospectus or visit www.clarkstonfunds.com. An investor should consider the fund's investment objectives, risks, charges and expenses carefully before investing. This and other information is in the fund's prospectus, which should be read carefully before investing.
The Clarkston Partners Fund’s investment objective is to achieve long-term capital appreciation. There is no guarantee that the fund’s objective will be achieved. The fund is new and has a limited operating history. Clarkston Capital Partners is the investment advisor to the fund and has a limited history of managing mutual funds for investors to evaluate. As with any mutual fund, there are risks to investing. The fund is “non-diversified,” which means that it may invest a significant portion of its assets in a relatively small number of issuers and could experience greater price volatility. The fund invests in equity securities, which are generally volatile and more risky than some other forms of investment. The fund invests in small-capitalization and mid-capitalization company stocks, which are more volatile and less liquid than larger, more established company securities. It is possible to lose money on an investment in the fund.
Portfolio holdings will change and should not be considered as investment advice or a recommendation to buy, sell or hold any particular security. As of December 31, 2015, the fund’s top 10 holdings were: The Western Union Co. (5.84%); Brown & Brown, Inc. (5.08%); Willis Group Holdings PLC (4.88%); Hillenbrand, Inc. (3.95%); Broadridge Financial Solutions, Inc. (3.93%); Federated Investors, Inc., Class B (3.93%); Matthews International Corp., Class A (3.84%); John Wiley & Sons, Inc., Class A (3.57%); Landstar System, Inc. (3.22%); and Actuant Corp., Class A (3.14%).
The Clarkston Partners Fund is distributed by ALPS Distributors, Inc. ALPS is not affiliated with Clarkston Capital Partners.
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