Preserving substance while downsizing in dysfunctional markets

CIO Insights 1Q2009

Our main objective in investment selection as deep value analysts is to be able to distinguish between (1) temporary problems companies are inevitably faced with from time to time and (2) permanent impairment of value. We seek out investment situations falling into the former area when we believe, contrary to market opinion, that a particular problem issue does not cut substantially into the real substance of a company or may in fact make it even stronger down the line. The latter we want to avoid at all cost because substance is lost forever.

Brutal downturns like the one we are witnessing at the moment are the perfect test cases to judge whether we are truly skilled at separating one from the other. So far the evidence has been very encouraging. With one exception we are not yet seeing any of the following actions which we would consider to be permanent impairment of value: selling off core strategic business units, PP&E or marketable securities at ultra depressed prices; cutting essential capital expenditures; and letting go key personnel in crucial R&D, production and client service functions.

Inevitably our businesses need to adjust to the downturn as well, but their strengths allow them to make more subtle, even beneficial changes which don’t impair asset value or threaten their future competitiveness. For example, a number of companies in the Fund have cut or temporarily eliminated their dividend to preserve cash. Contrary to many other equity investors we commend such moves as now is the time to engage in value creating activities such as buying back debt at a big discount to par or looking around for acquisition opportunities at depressed prices.

Another healthy example of how many of our companies have adjusted to the difficult times is the rigorous reassessment of capital expenditure programs and the consequent cutback in non-essential investments. A downturn reinforces the need for prudent project budgeting, which ultimately rewards shareholders in that it tends to enhance both profitability and capital efficiency when evaluated over the course of a normal business cycle.

A third significant way a number of our companies make ends meet in a constructive fashion is in the area of staff management. Instead of resorting to across-the board layoffs in which a firm would lose valuable know-how, they offer schemes such as short hours and furloughs. In this way our companies are able to improve their operating leverage by means of adjusting the cost structure while retaining the ability to gear up production rapidly when demand returns. In fact, this could be one of the advantages of investing in the mid- to small-cap space: because oftentimes such companies are majority owned by a family or other long-term-minded controlling shareholder, perhaps they tend to be more considerate of this issue than many large, widely-owned corporations.

It goes without saying that the degree to which our companies are able to preserve their substance will quite heavily depend on the severity and length of the downturn. At some point even the strongest companies have to sell core assets at too low a price, forego profitability-enhancing investment opportunities or massively lay off key staff. Fortunately, considering the substance of our investment portfolio, we are far away from such a bleak scenario.

Sincerely,