Riding Out The Storm With Quality Stocks

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This summer's rumble on Wall Street doesn't faze Larry Coats, portfolio manager of the Durham [N.C.] Oak Value Fund (OAKVX). He has seen his share of ups and downs, and has learned to avoid companies heavily reliant on the credit markets.



Sticking to the investing principles taught by Benjamin Graham and Warren Buffett, Coats buys companies that he can understand and put a price tag on. "This is a great time to be able to say: I know what this business is worth," he says. "It makes it a lot easier to sleep at night."



Coats also likes to find companies that aren't being appreciated in the market. "Our goal is not to eliminate risk," he explains. "It's to identify and understand the pricing, and take advantage of the mispricing whenever we see it."



Coats, who has been running the $140 million fund with David Carr since 2003, holds just 24 names. Buffett's Berkshire Hathaway (BRKA, BRKB) is the fund's largest holding. Other top holdings include Apollo Group (APOL), Fidelity National Information Services (FIS), E.W. Scripps (SSP), and Praxair (PX). Oak Value also owns well-known tech names Oracle (ORCL), Microsoft (MSFT), and eBay (EBAY).



So far this year through July 31, Oak Value was up 5.6%, beating the Standard & Poor's 500-stock index and the average performance of large blend funds as tracked by Morningstar. For 2006, the portfolio's 14.2% gain matched its peers, but was slightly below the S&P 500's rise.



BusinessWeek's Karyn McCormack met with Coats in New York on Aug. 14, and they talked about how he's navigating the market storm. Edited excerpts of their conversation follow.



How do you manage your portfolio in these volatile times?



No differently from any other time. Interestingly, one of the companies that we bought in recent periods is a company that we talked with you about in 1996: American Express (AXP). That's a classic case of, though market conditions seem to be different this time, it really is more similar than people are willing to acknowledge.



How is it similar?



Risk always gets mispriced. It becomes mispriced on the positive side, and then somewhere along the way it gets mispriced on the negative side. And therein lies the opportunity for people who are willing to take a long-term view.



David [Carr] and I recently discussed, in a joking manner, all the good noise around the credit markets today. Various people tried to convince us over the last year that we really should be involved in companies that are more exposed to it. We've avoided that temptation. Our response has been, we've lost that money twice in the last 12 to 13 years -- we don't need to do it again. We've lived through credit cycles -- we know what happens when capital is free. At some point in time, capital becomes more expensive. That movement from free to expensive creates a lot of dislocation.



How has your fund held up so well?



Our focus on high-quality, good businesses that are not dependent on the capital markets for their day-to-day operations has served us extremely well. Our financials exposure, which is 20% to 25% of the fund, consists of Berkshire Hathaway, Aon (AOC), and Willis Group (WSH). We own one depository, Capital One (COF), and American Express.



You made three changes to the fund last quarter [ended June]. Why?



If you look back over the last 12 months, we've had two to three new names each quarter. We sell for one of three reasons. Either a stock reaches our price target, we have a change in the fundamentals -- which is a nice way of saying our investment thesis was wrong -- or we have a better opportunity.



We always want attractive ideas competing to get into the portfolio, so as a business reaches 90% of its intrinsic value we can take some of that capital and put it back into a stock trading for 65% on the dollar. Since the end of the quarter, the market has given us some additional opportunities.



So you've been buying?



Yes, we have bought some new names. I can't give you the names. The reason is our portfolio has done very well -- we have some businesses that are approaching their intrinsic value. We have added a couple of new names since the end of the second quarter, and we've also made meaningful increases to select positions.



Why did you add Medtronic to the fund?



We bought an initial position in the second quarter. In some ways it complements our position in Johnson & Johnson (JNJ). We own four names in health care -- J&J, Medtronic (MDT), Omnicare (OCR), which we bought in the second quarter, and IMS Health (RX). Importantly, there's very little exposure to Big Pharma. J&J is as big of a consumer-products and medical-device company as it is a pharmaceutical company.



Medtronic gives us an opportunity to participate in a company focused on chronic illness. Given the demographics we have -- whether it's on the diabetic side, heart disease, or spinal and nerve -- we believe the segment has organic growth for the foreseeable future.



Once known as the pacemaker company, Medtronic has very high operating margins, pristine balance sheet, and a management transition that has made people a little uncomfortable. The noise in the marketplace has created an interesting opportunity. On the ICD [implantable cardioverter-defibrillator] side, both Boston Scientific (BSX) and St. Jude (STJ) have said the market is firming up. Medtronic reports earnings later this month, and we'll see what happens.



What about Omnicare?



We also bought Omnicare in the second quarter. It's the institutional pharmacy to nursing homes and skilled nursing facilities, and is also a play on chronic care. Omnicare is, in essence, a high value-added distribution company. Their margins are much higher than a typical distribution company. They have 9% to 10% operating margin, and we think they can take them higher as they take out overhead and rationalize their business.



What kind of discount do you look for when buying a stock?



We're attempting to buy a stock at 65% or 70% on the dollar, so a 30% to 35% discount. We use a discounted cash-flow model, using an 8% discount rate. The magic in that sauce is not around the discount rate, it's around the terminal multiple that you put in the valuation equation. Because at the end of year five, you have to assign something as the present value of the future cash flow.



We end up with a portfolio that has, on average, operating margins in excess of 20%, return on equity above 20%, and debt-to-total enterprise value less than 20%. So I've got highly profitable businesses generating returns on equity and doing it without significant leverage on the balance sheet.



From a growth perspective, we believe revenue over the next five years for this collection will rise just short of 10%, on average; and earnings growth will be in the mid-teens, or 13% to 15%. We have stocks with higher quality, better growth, less risk in terms of balance sheet, and trade at a market multiple.



Are you optimistic about the market?



Yes. We're where we should be. Look at the three basic principles that Benjamin Graham taught over a half-century ago. One is if you're going to own equities, you should own them as businesses, recognize that they're not pieces of paper, and understand the business. Two, always require a margin of safety. And know what the business is worth -- the valuation discipline is important.



If you're viewing them as businesses, buy ones that you would want to own -- growing businesses, clean balance sheet, high return on capital, international growth and opportunities. Nearly 50% of revenues in our collection come from outside the U.S., so we have the opportunity to grow beyond what happens in the housing market in Florida. People are selling things because they don't know what they're worth. This is a great time to be able to say: I know what this business is worth. It makes it a lot easier to sleep at night.



Are you getting a lot of calls from worried investors these days?



Worry is a wonderful thing. One of the interesting challenges is people become so overwhelmed by the emotion, and by the fear [of what, they don't know]. It's one thing to know what you don't know, but it's another thing when you realize how much you don't know. We communicate with investors very openly, directly, and frequently. But at the end of the day, I can't protect people from themselves.