To patiently wait or to pounce

By George Cipolloni

Successful investing “requires this crazy combination of gumption and patience, and then being ready to pounce when the opportunity presents itself…" 

-  Charlie Munger

Our goal is to make money for our clients over the long term without taking excessive risk.  We contend that contrarian investing is the best way to do that.

Investors should expect the Nedgroup Investments Global Cautious Fund to eschew the crowd. After a long rally where the market set fresh records, we will tend to shrink our allocation to stocks and vice versa.  The same will be true of bonds. We will tend to sell bonds when prices are high, credit spreads are tight and yields are low. If we think both markets are overvalued, the fund's cash stash will swell while we wait for a better time to invest. All of these moves reflect the fund’s bottom-up investment process. 

As managers, we are just as interested to see the broad shifts in allocation (cash, stock and bond weightings) from a historical perspective as our investors are.  Over time these allocation shifts, while not intentional from a top-down perspective, have demonstrated an ability to avoid downside risk.  This approach requires that we pass up short-term, temporary gains in order to avoid long-term, permanent losses. 

Our tried and tested investment approach

The Killen Group’s contrarian, bottom-up investment process has been tested in different market cycles over time.  Consistently adding value when investing in the equity and fixed-income markets is not an easy task.  It requires a set of intellectual and emotional skills that at times can conflict with each other. Scrutinising objective metrics, such as financial ratios and other statistics, and subjective factors, such as changes in management and strategy, is a critical part of the Killen Group's research process.  Being willing to ignore conventional wisdom is another key trait.  Ultimately, knowing when to take or avoid risk is the goal of this endeavour. 

A solid investment philosophy and process enables a manager to balance risk and reward in each investment decision.  It has helped us identify attractive investment candidates in areas of the market that are out of favour. Its flexibility lets us ‘pounce’ when we see opportunity while allowing us to wait when there is a dearth of interesting candidates.

With both stock and bond prices at elevated levels, the Nedgroup Investments Global Cautious Fund’s current positioning is relatively cautious with a higher than usual cash allocation.  This fact, however, has not prevented its managers from taking positions in some very attractive, out-of-favour investments.  During times when the markets are generally expensive, the individual holdings in the fund will tend to exhibit some phase of a turnaround effort.  Two recent common stock investments illustrate ‘The Killen Way’.

  • Sony Corporation (SNE)

The venerable consumer electronics manufacturer had seen better days.  The company had been in a downward spiral in popularity, profitability and stock price for over a decade. 

Conventional wisdom held that Sony would or could never evolve into a viable consumer electronics force in a post-Apple world.  Japanese management teams have generally earned their reputation of being slow to respond to anything.  Why would Sony be any different? Year after year, it watched Apple and other Asian consumer electronics companies eat away at its profits and market share.

Objective Analysis
What most investors forget is that Sony is hardly a one-trick pony. In addition to consumer electronics, the company has a highly profitable financial services division.  It is also a media content heavyweight with dominant, profitable positions in movies and music.  Excluding consumer electronics, Sony could earn roughly $2 per share.  Also, Sony was building a higher growth / high margin business in image sensors used by competitors, like Apple.  The Killen Group spotted an under-appreciated value in SNE.  One major question remained: did Sony have the gumption to do what was necessary to return their consumer electronics business to break even, much less profitability?  Could Sony be a turnaround candidate even though nobody thought they could turn their business around?

Subjective Analysis
After identifying value from an objective perspective, Killen set its sights on the subjective: Sony’s management team.  Were there any changes in the past few years?  If changes were made, were they effective?  Could they drive a successful shift in strategy?  Sony's financial statements did not provide answers.  However, a review of comments made during earning conference calls, in the media, and the company's annual reports did hold clues about what was really going on with Sony.

Sony made some critical management picks even though neither executive was a true outsider.  Kazuo “Kaz” Hirai was named CEO in 2012.  Hirai initiated some restructuring efforts immediately.  However, the changes were not bold enough to halt the decline in the company’s profits.  Then, in late 2013, Kenichiro Yoshida was named Chief Strategy Officer.  Yoshida’s management style was a sharp, but welcome, contrast to Sony’s predecessors.  Straight-talking Yoshida instilled a culture of accountability throughout each of Sony’s operating units and was quickly promoted to Chief Financial Officer where he got right to work

Sony sold its ailing Vaio PC division, spun off its TV business, and invested heavily in its image sensors used in smartphones and security cameras.  Each of these moves should go a long way towards helping Sony’s consumer electronics business return to profitability.  The stock has responded so far and the future is looking brighter for Sony.

  • Carnival Corp (CCL)

The embattled cruise ship operator suffered from a series of setbacks that created a perfect storm of a public relations nightmare.  Over the years, the company had grown with an eye towards sales and not profitability.  Each of its subsidiaries were run independently with very little operating leverage or synergies.

Conventional wisdom labeled Carnival a poor excuse for a party boat operator. The company’s namesake brand – Carnival Cruise Lines – was the pariah of the industry after facing a number of highly public disasters. These ranged from the tragic loss of dozens of lives when the Costa Concordia beached off the coast of Italy to passengers being stranded for days with no working toilets. Why would anyone want to travel on a Carnival Cruise or invest in its stock?

Objective Analysis
The company had a spotty history in growing their revenue when Killen bought the stock. Financial statements reported falling margins and profits.  Why couldn't they achieve a better margin when they held the largest market share of the cruise industry worldwide? Ten years prior they had industry leading margins.  What had happened?  Was management simply inept?

Subjective Analysis
Carnival was a family business, started by Ted Arison in the early 1970s.  His son, Mickey, was CEO of the company for over 20 years.  During Mickey’s tenure, the company grew at the expense of profitability.  In 2013, long-term board member Arnold Donald, an accomplished manager in his own right, was named successor to Mickey, marking the end of over 40 years of family management, a significant event in our view.

Two major points about the company captured our attention.  First, new management was changing the organization’s culture. The company’s individual cruise brands operated as independent businesses.  In this decentralised model; brands shared little commonality and had major inefficiencies on both the revenue and costs sides of the business.  With ten brands under the Carnival Corporation umbrella, often times individual brands (Carnival vs. Princess, etc.) would compete fiercely with one another on price.  Removing the silos and integrating the brands created large opportunities to grow sales (optimise pricing models, package airfare/cruise/activities) and reduce costs (inventory management, book discounted airfare in bulk).

The second point involved burnishing Carnival’s image and rebuilding customer confidence in the company.  CCL launched its first national advertising campaign in a decade.  It began repairing relationships with travel agents and introduced programmes offering money back to cruisers who were not fully satisfied with their vacation. This increased marketing and advertising costs in the short term, but if efforts are successful in improving the brand, they will realise the benefits in the years ahead.  

We bought the stock when oil prices were hovering around $100 per barrel knowing full well that fuel is one of Carnival's largest expenses. While we did not know that oil would decline about 50% since our initial purchase, we did know that a decline in fuel costs could benefit the company’s earnings in a positive way.


On the lookout for opportunities

In times like this, when we are exhibiting a high degree of restraint and patience, we are always ready for an opportunity to pounce.  As bottom-up, contrarian investors, the Killen Group’s research team spends a considerable amount of time and energy on individual company research.  This research process does not cease when the equity and fixed income markets are broadly expensive.  We continue to attempt to ferret out individual situations that are exhibiting fundamental change and presenting under-appreciated value.  The Killen Group’s success depends upon making more good decisions than bad; and minimising mistakes when they do occur.  Over the long term, we believe this is the best way to invest for our clients and shareholders.