Chad Clark and Brian Vollmer, co-portfolio managers at Select Equity Group, L.P. (SEG), use a term to describe the stocks of companies that meet their investment criteria: “SEG Pedigree” businesses.1 For the past 27 years, SEG has sought to generate attractive long-term returns for clients by identifying and rigorously researching high-quality businesses that meet the SEG Pedigree standard and by adhering to strict valuation criteria. InvestorView recently sat down with Clark and Vollmer to discuss their investment backgrounds, what it takes to be an SEG Pedigree business and the current opportunity set in international equities.
Tell us about your investing backgrounds, how your philosophies have evolved over time and why SEG is a good home to practice your craft.
Chad Clark: I have spent virtually my entire 20-plus-year career investing in publicly traded international equities. After 15 years at Harris Associates, which is known for value investing, I arrived at SEG with a well-honed, disciplined process for analyzing a company’s cash flow-based intrinsic value and buying stocks only when they trade at an attractive discount. Over time, however, I found myself gravitating toward higher-quality businesses. A discounted cash flow model is ultimately path dependent, and the more predictable a company’s future cash flows, the more likely an estimate of fair value is to be accurate at any point in time. SEG has proved to be a perfect match in that respect. The firm only invests in high-quality businesses and, in fact, we have no interest in owning the vast majority of publicly traded companies at any price.
Brian Vollmer: After spending several years investing in private equity, I joined SEG in 2005 directly from business school. Having arrived at SEG when the firm’s activities were primarily focused on U.S. small- to mid-cap companies, I have spent my entire career here broadening the scope of the firm’s universe of SEG Pedigree companies to include larger-cap companies globally and international companies across the market cap spectrum.
CC: Our team applies the same investing discipline to international and larger-cap companies that our founder, George Loening, originally established as the cornerstone of the firm’s investment philosophy. We focus on rigorous bottom-up fundamental research on a select universe of unusually high-quality businesses. The team maintains strict independence; we read virtually no sell-side research for the long book and do not actively reach out to other managers, enabling us to identify unique investment opportunities relative to the broader Wall Street herd and to take a contrarian long-term view of those companies at what we believe are opportune moments. The firm provides us with an unlimited research travel budget; we spend a great deal of time overseas visiting companies. We don’t limit our research travel to countries where equity market prices are depressed – we typically speak with nearly every company in our universe annually regardless of the current stock price – but sometimes these trips provide very timely, immediately actionable insights. Last June, we spent eight days in the U.K. meeting with 20 companies that were on our shopping list ahead of the forthcoming Brexit vote, and we purchased several of those stocks at sharply lower prices just a few weeks later.
We also benefit from our qualitative field research professionals, an in-house group of former financial journalists and sourcing specialists who conduct deep-dive studies on companies, value chains and management teams in support of timely investment opportunities. Overall, our approach marries deep qualitative research on outstanding companies with rigorous financial analysis of what we believe those businesses are worth and could possibly be worth in the future. The entire investment team operates in a think tank culture that promotes active, ongoing debate in pursuit of identifying the most attractive investment opportunities.
What is an SEG Pedigree business, and what allows you to buy such high-quality businesses at attractive valuations?
BV: Very simply, we are trying to find businesses that exhibit three characteristics: predictable long-term growth, high returns on invested capital and well-established, sustainable barriers to competition. We like to own businesses that we believe can grow their cash earnings per share at least 10% annually over time. Unlike the typical growth company that consumes cash, an SEG Pedigree business generates strong cash flow while growing. Our companies generally enjoy high profit margins and relatively low capital intensity and tend to be managed by executives who reinvest that cash flow at high rates of return. As research analysts, we spend most of our time understanding the competitive moat – we need confidence that those growing cash flows will not be competed away over time. We want to own businesses with pricing power vis-à-vis their customers and suppliers – those that sell unique, highly valued products or services to customers who have little desire to switch to a competitor. We often say our businesses have most or all of the “four Ps”: pricing power, predictability, a growing pie (or market) and a growing piece (or share) of that market. We also spend a lot of time on people – the fifth “P” – and most of our companies are managed by extraordinarily talented, shareholder-minded executives.
CC: To add to that, it is worth noting that our SEG Pedigree universe is relatively small: In more than 25 years of investment research, we have identified roughly 500 businesses that meet our criteria out of the tens of thousands of publicly traded companies worldwide. Once we’ve identified a business that appears to fit our criteria, we study it continually over a multiyear timeframe and develop a proprietary opinion on its intrinsic “fair value.” Given their quality, these businesses generally trade at premiums to our estimates of their intrinsic values – and to the market as a whole. We wait patiently for opportunities to buy those stocks at attractive discounts to their intrinsic values. Sometimes those opportunities present themselves in a broader market sell-off, in which great businesses go on sale as investors flee equities. As long-term investors, we more often find valuation opportunities when these companies have the occasional near-term stumble or encounter an unusually murky six- to 12-month outlook. In these moments, momentum-driven growth investors and buy-side firms with a time horizon of just a few quarters typically move aside until they see demonstrable evidence that the clouds have lifted. We find stock prices often move far more than our fair value estimates; during these periods, we can take a contrarian long-term view, confident of being rewarded when the long-term tailwinds reassert themselves.
International equities have lagged U.S. equities by 9.3%, 6.9% and 5.9% over the past three, five and 10 years, respectively.2 While it is always dangerous to extrapolate past to the present in investing, why should U.S. dollar-based investors consider owning assets outside of the U.S.? Describe the opportunity set you are facing and how it compares with what is available in the U.S. in terms of business quality and valuation.
CC: It’s important to remember that the U.S. represents less than 40% of the world’s equity market capitalization, less than 25% of global GDP and less than 5% of the world’s population. The past 20 years have seen worldwide markets and supply chains globalize; very few of the international companies we study and admire derive their revenues and profits from a single country. Today, businesses with differentiated products and services find a willing audience of customers around the globe. On a purchasing power parity, or PPP, basis, over the past 10 years, 74% of global growth has come from emerging market economies, and the International Monetary Fund forecasts those same economies to generate 73% of global growth over the next five years. Whereas our U.S. investment team has identified many great businesses that derive the vast majority of their sales and profits in the large U.S. domestic market, we find that European and Japanese companies have in many cases been quicker to pursue the long-term opportunity to serve emerging markets customers – possibly because their own home markets are smaller and slower growing than the U.S., forcing ambitious entrepreneurs to look elsewhere for growth. Our favorite international companies are run by executives who employ a shareholder-friendly, capitalist-minded approach to growing their businesses; many of them were educated in the U.S. or worked in U.S. companies earlier in their careers. Today, we are finding valuations for high-quality, cash flow-generative growth companies to be far more reasonable in Europe and Japan relative to their U.S. peers. The U.S. bull market and economic recovery are now in their eighth year, a timeframe that has included a double-dip recession in Europe and a slowdown in almost every major emerging market economy. With favorable macroeconomic data out of both Europe and many emerging markets, as well as more attractive foreign currency valuations (relative to five years ago), we are particularly excited about the relative attractiveness of non-U.S. equities.
The strength of the dollar has been a large headwind to international returns over the past five years. How do you approach currencies in your strategy?
BV: We actively analyze whether we should hedge our clients’ currency exposures in order to protect against the risk of a strengthening U.S. dollar. Our clients are U.S. dollar-based investors, so foreign currency moves vs. the dollar are extremely important to our ability to generate returns for our clients by investing internationally. We select our stock portfolios on a bottom-up basis, driven by the attractiveness of single-stock opportunities, regardless of domicile or currency. As a general rule, we do not try to predict near-term currency moves and never invest in a stock simply because we have a view that its currency is going to appreciate. We do, however, have a view on long-term intrinsic value for each currency in which we invest – informed primarily by PPP – and try to be mindful of near-term risks to a given currency from geopolitical or macroeconomic forces. If we find that our bottom-up portfolio is overweight in one or more currencies we would rather not own outright, we will hedge that currency if it is cost-effective. Over the past five to six years, we have been as much as 100% hedged to the Japanese yen, euro, Swiss franc and British pound sterling at various points in time. As an aside, emerging market currencies are often not cost-effective to hedge, so if an attractive emerging market stock opportunity arises in a currency we deem risky, we would likely either invest with a lower target weight or avoid the opportunity altogether.
Anecdotally, our portfolio currently is unhedged today for the first time in many years. The U.S. dollar has appreciated by more than 40% since 2011 against a trade-weighted basket of currencies and today is arguably between 10% and 20% overvalued vs. the yen, pound and euro based on PPP. We are cautiously optimistic that after a multiyear period of dollar strength, we could be entering an environment where the currencies in which we invest strengthen against the dollar. This would be a welcome tailwind for our investors.
SEG focuses on select value chains. Can you provide an example of a value chain that you are attracted to, as well as a business within that value chain in the portfolio and the investment thesis behind it?
CC: A classic example of an SEG Pedigree value chain is the optical products industry: makers and retailers of eyeglasses. An aging population globally has led to a tailwind in unit demand for corrective vision products, while rising disposable incomes have encouraged consumers to “trade up” for higher-value products that offer better technological benefits and higher fashion offerings. When purchasing eyeglasses, consumers generally do not base decisions on price; an eyeglass wearer consults a healthcare professional, often including a lengthy eye exam, before purchasing new glasses and typically buys the lenses and frames that same day onsite. Consumers wear eyeglasses daily, making the several-hundred-dollar price point for a pair of glasses relatively insignificant relative to the quality of life benefits they afford. Additionally, eyeglass insurance is becoming more prevalent, making consumers even less price-sensitive in making their purchases. The companies we admire that sell into this value chain have evolved into global leaders, benefiting from significant economies of scale, strong consumer brands and entrenched service relationships with retail customers.
We currently own two optical suppliers in our portfolio. Luxottica is the dominant global eyeglass frame maker and the partner of choice for luxury brand companies looking to extend their presence into the eyeglass category. Luxottica has also vertically integrated into eyeglass retail, including global leadership in sunglass retail. Essilor is the dominant global eyeglass lenses maker, investing significantly more than its much smaller competitors in research and development and technology as well as customer service to independent eyeglass retailers worldwide. Both companies saw valuations compress due to a slowdown in the U.S. market over the past year, which we view as transitory given rising consumer confidence and accelerating employment and wages. Interestingly, after we purchased them, the two companies announced a merger that should enable them to realize significant cost synergies while further widening their competitive moat. Taken together, our combined Luxottica and Essilor positions would represent one of the five largest holdings in our portfolio.
Interview conducted and article written by Carson Christus.