We take an owner's mentality to an investment process. We're looking at the long-term ownership of businesses that we could buy outright if we wanted to.
Blake Moore:
Welcome to Distinctively Active Investing: Profiles and Perspectives, presented by Touchstone Investments. I'm Blake Moore, President and Chief Executive Officer of Touchstone. On this show, you'll find out what makes Touchstone, and its portfolio managers distinctive. We share in-depth interviews with people who are actively engaged in leading and managing the Touchstone funds and you will hear from other industry professionals, as well.
Tim Bray:
Hi. I'm Tim Bray. The divisional vice-president here at Touchstone Investments. Today we're talking with Steve Goddard and Brian Campbell of The London Company. Steve is the founder of The London Company and heads the firm's investment and management teams. Steven and Brian are portfolio managers of the Touchstone Mid Cap Fund, as well as the Touchstone Large Cap Fund, and the Touchstone Small Cap Fund. The London Company serves as a sub-advisor to the funds. They'll be discussing The London Company's investment strategy, as well as their personal backgrounds and career trajectories. First we'll hear from Steve and then Brian, about how they got into the investment business.
Steve Goddard:
Back in college, I was a part of the Student Investment Club, before there were student investment clubs. We decided to start a small investment club with five, six students and with our own capital. That was back in the early 80s when the markets were not the popular place to be. When I got out of school, had a taste of that, but I was working for an accounting firm and going towards my CPA and I found myself on my off hours, tend to gravitating towards looking at value lines and investment reports, just as a hobby.
The more I did it, the more I realized that if I enjoy doing this so much, I should go into it for my profession. So I dropped the accounting route and started as a sell-side analyst for a small regional firm. From there it moved step by step, and finally got on the buy-side five years later, it evolved from there. The buy- side, because I was working for a bank, regional bank in Virginia, and we had responsibility for certain sectors. So I was getting my background with financial services, I was given the banks, which at that time were not very popular with the investment community. So I was following 10 to 15 different financial service firms. I always had, ever since I got out of college, my ultimate goal was to start an investment firm and it took me 15, 16 years to get to that point.
But you know, it, I waited for the right opportunity and that came along in 1994, when the insurance company gave me the flexibility to bring in other accounts and being as risk averse as I am, that was the perfect opportunity for me because I had the first company, I mean the insurance company for my main account, but didn't have all the startup risks that you normally would have.
Tim Bray:
Steve, do you remember your first investment?
Steve Goddard:
The first one taught me a very good lesson because I bought it was, back then, it was a startup airline. No thrills airline called People's Express and it was fully employee owned. It didn't work out. So it taught me in the beginning, what not to buy. And I think my second investment was Nike, which was at that time was a startup shoe company. And there've been a lot of casualties in that industry prior to that, with Reebok and Stride Rite. Other companies, but that’s what really got me into focusing on high return on capital franchises with high margins. And from then on, I was sold on that, on that process.
Brian Campbell:
Well, similar to Steve, I was exposed to this business, my second half of undergrad, I think it was late junior year, the Tennessee Valley authority, large government backed entity offered, I think eight of the SCC schools, the Southeastern conference schools, some capital to start a student managed investment fund. And this is late nineties, probably 97, 98. And each university picked what they thought six finance students that would be interested in doing this. And of course I was raising my hand immediately and kind of get exposed early to what this really was about. And you kind of goes through the whole process, looking at industries and companies and vetting them and valuing them. And this was all green to me. I had no idea I mean that this world really existed and I really became fascinated by it.
And it, it was definitely calling that, okay, this is what I want to do for my career. You know, previously, majoring in finance and business and thinking about law school, was never what I wanted to do. And when I discovered it was a good personality match for me. And so I spent the first couple of years post-graduation knocking on a lot of doors and trying to get in. I was often the bridesmaid. They usually hired the guy or gal with six years of experience and MBA, but I did get my foot in the door a couple of years later. You know, in the meantime I worked as an analyst for a casino, which is actually interesting in its own right. And, and a lot of valuable experience, but there was a firm in Louisville, Kentucky, where I'm from that took a chance and hired me as an equity analyst despite not having my MBA yet.
I think I was the first one there to join without that, but that was my entry. And I joined right at the peak of the NASDAQ March, 2000, which is also an interesting time to start a career in this business. And it really got my feet wet, first couple of years of my career there. I really am a strong believer of the first couple of years of your career mark and sort of create a path on how you think and behave. And that really molded me throughout my career and that learning experience of watching businesses to continue to depreciate was long lasting in my mind. And so you focus on companies that you feel have their own control over their destiny.
And there was a lot of lessons learned and a lot of industries that were being disrupted and valuations that were just absurd. The beginning of that point, in 2000, so those lessons carried with me for a long time and, and really led me 10 years ago to join The London Company.
Brian Campbell:
I spent seven years at a firm post-grad school I did in between my first job as an analyst at National Asset Management, which was later bought by Invesco. And then my previous iteration at Hilliard Lyons Asset Management, post-graduate school. I was managing mid cap and large cap strategies and incubated a mid cap fund in 2004 in a very similar approach, focusing on long-term ownership of highly profitable companies with great returns on capital and with management teams that you found had the integrity and aptitude to really create great wealth with the long-term ownership of those businesses.
And we had a lot of potential red flags and other sort of hindrances to really grow that business. Being owned at one point by a broker dealer and by a large bank, at one point were owned by PNC Bank.
There were a lot of the institutional consultants and intermediaries that just did not want to work with you. You really wanted to find boutique managers that were independently owned and employee owned. And so even though we had good people, good performance, good process, we really couldn't grow our business in a meaningful way. And I had been keeping my ears open for other opportunities and it was probably mid-2010 and it was pretty serendipitous.
I got a phone call from a recruiter about a job in Richmond, Virginia, and I had just taken the family on our first vacation to the Outer Banks, which is in North Carolina. And we were driving through Virginia two weeks prior and stopped in Charlottesville and made some comments like this is a really beautiful state, this is pretty nice. And I got that call two weeks later and I was like, well, that's kind of random. I was just in Virginia and drove through Richmond and drove to Charlottesville.
And once I learned about the opportunity and learned the philosophy, it checked a lot of the boxes. It was, oh yeah, I'm doing that. I think that way, I think that's actually very, very interesting. And at the time it was Steve and John Moody and they were experiencing hyper-growth post-the great financial, the great recession in 2008 and 2009. And I think needed some help with bandwidth and getting folks on board to really carry some weight on the investment side and do other things. So it was a fairly quick process. Fortunately, Steve had some, shared contacts with people and folks in my history. I actually shared the same third party marketing firm. And so was able to vet me, I think, fairly quickly, and then joined September, 2010, almost 10 years ago now.
Tim Bray:
Brian, for those people that are not familiar with The London Company, can you tell us about the firm's approach to investing?
Brian Campbell:
Sure. You know, we take an owner's mentality to an investment process. We're looking at the long-term ownership of businesses that we could buy outright if we wanted to. You know, we think managing money, there's a couple core beliefs that make The London Company a little bit different. First, we feel the market is less efficient at assessing the risk side of the equation versus the reward. And we spend a good portion of our time, if not most of our time looking at what can go wrong over what could go, right? So when you take an owner's mentality and you find businesses that you think are trading at substantial discounts, that risk component is the focus of our process. We do everything in our power to try to mitigate mistakes. We really do spend the entire process, discussions trying to get that equation right. And I think that's a little bit different than other firms that are looking to be right where we're looking not to be wrong, more or less. So when you, take that risk approach and then you filter it through the companies that fit what we're looking for and how we get there, it's really focusing on things that we can control. Companies that have very strong balance sheets, that don't need to access capital markets in times of stress, companies that generate good cash flow that have high returns on capital and incrementally improving returns on capital.
We think that metric is probably the most important metric of any company because it, it really does define the cash return you get from the cash invested. And if they're able to generate really good returns and spreads on the capital committed, it's implying that they have an advantage over their peers, if it's not easily duplicated and that return on capital, the balance sheet approach and the way we get our valuation is really the three key tenets of our process. But again, the holistic approaches of being different, focusing on the long-term, focusing on not being wrong.
Tim Bray:
Steve, what makes your firm different from its competitors?
Steve Goddard:
Well, I think there's two important aspects of our firm that makes it different. One is that we take a much more longer-term orientation, So we're looking way beyond, in fact most of our models are using ten-year forecasts. We try not to speculate on what the growth rate might be. We tend to use very modest growth rates, if any, we're looking more for sustainability of the cash flow. And the balance sheet optimization process is very different from what I've seen, any other firm use. Where we're basing our investment thesis on things that management can control to create value versus trying to speculate on a future growth rates of any company. So I think those two things are the main edge that we have over our competitors. At least what makes us different.
Brian Campbell:
I think when you, when you analyze a business and we're looking at companies in a universe that have historically earned really good returns on capital and strong free cash flow, that allows us to have a valuation approach that is different. When you talk to other portfolio managers, analysts, and they're describing how they get a valuation of the business more often than not, it's through some discounted cash flow analysis. And if you think about every input and assumption that's made in that analysis, extrapolating error risk each step along the way. And we don't think we're able to outguess anyone else better than the next person in the street, because we can't forecast our own business very well. We have no idea when fund flows are going to come in and what the market's going to do. And we don't think manager teams in most companies are, are any better at that either.
So forecasting is full of risk and we try to reduce as much speculation in our process. So I think what makes our process a little bit more unique and novel is our valuation approach is different. And we actually do a more akin to a private equity valuation, where we are looking at the capital structure of the business. And the only assumption we're going to make is, is that capital structure static, or could it be adjusted? And what we mean by that is most firms are funded with debt and equity, and there is an optimal balance depending on your industry, depending on your returns on capital, and your cash flow. More firms have historically carried too much equity on that capital structure versus debt. And we go through a hypothetical process like private equity investor would and say, could you optimize that balance sheet and lower your cost of capital?
Now the cost of debt, is historically and will always be cheaper than the cost of equity. Could you increase your debt burden very conservatively? No more than 40% in debt to cap or four times interest coverage. And if you could, and you could retire your higher cost equity, could you lower that discount rate and thus implying a higher enterprise value for the business? So hypothetically we go through this model, this balance sheet optimization is what we call it internally. And we're looking for discounts of 30 to 40%. And what we're assuming is cash flows are flat revenues are flat. We're not making any assumptions to margins. Pretty much status quo, very little growth, and zero to less than inflation. Could you get a large discount just by adjusting the capital structure? So that's a very, I think concrete way without forecasting or speculating on what the world's going to do going forward, or how much revenue is going to grow or margins are going to expand.
And that's allowed us to really have businesses that hold up well, particularly in times of stress, because when capital gets constrained, spreads widen out and these companies have this flexibility and that's really what we're looking for. That flexibility that allows them to fund their own projects or withstand a bad down-market better than their peers. So if you think about our process, every step of the way is designed to reduce risk. And we define risk as loss of capital, in the permanent impairment of capital, not just volatility, but if you think about it, when you think about the return on capital focus, that really is designed to reduce a lot of inherent business risk. You're focused on companies that are much more stable, have much more visibility on their cash flows, who takes an inherent business risk out of the equation immediately.
We spend an enormous amount of time trying to get the management equation right. The culture of the firm equation right. Which is very, very challenging. It's a softer intangible asset, but it really pays dividends over the long haul and companies that have superb managers and think like shareholders tend to add the most value overtime. And so we spend hours talking to people that have history and knowledge of how the culture is internally. We look at the proxy statement and look at incentives and see how they have... How the management pays themselves. We, we find them very, very valuable. How they exercise their own options and are they buying stock personally with their own capital? So if you get that management equation, right, you're reducing some of the company-specific risk. And then our evaluation approach, the balance sheet optimization model, our price risk is reduced because we're not speculating. We're not forecasting on growth or margins.
So all that leaves a reduction of risk. And then you get to our risk controls and sell discipline. We actually have a 1% soft, stop-loss, a quantitative method that reduces risk when we are wrong. And then this business is very humbling and you're going to be wrong, but we try to mitigate our mistakes. So if we have a position that hits a 1% reduction in its own size, by its own merits, meaning if the 3% position trade itself to a two that triggers a soft stop loss review, we’ll go back, review our thesis. We'll think about what we missed. And more importantly, we're not going to compound them that error by adding to the position. It actually is either a hold or sell. So we don't want to turn a small mistake into a big mistake. And, and historically that's added a lot of value for our process.
So each step along the way is a risk reduction step. And what we're trying to do is if you think about a normal distribution curve mitigate that left tail, and if you can eliminate that second, third standard deviation on the left side, then your median return will be skewed right. And unfortunately we're not very good at predicting which ones do best year in, year out, but we know overtime, if we don't have the left tail, that our results will be above mean and skewed right. And that's what we've proved to do for the last 25 years.
Tim Bray:
Brian, how does The London Company incorporate ESG into its investment process?
Brian Campbell:
Well, it's becoming an ever-increasing factor for all money managers and for us, we've historically been very in tune with the governance aspect of ESG. The last number of years, we have incorporated the other elements as well. And it really is for us about sustainability. Our approach is the long-term ownership of businesses, and we want our businesses and partners to do what's best, not only for the firm, but for their community and environment to make it as sustainable and long lasting as possible. We've actually implemented third-party software Sustainalytics that helps evaluate all the ESG categories, scores them. And if there are issues or if there are flags for us to consider, we reach out to the companies and have conversations, but we think it's best practices to think about it from a long- term standpoint, because that's our hope with the ownership of these businesses.
Tim Bray:
So Steve, what advice would you give to someone getting into the investment business today?
Steve Goddard:
I think the key is being patient, everyone who wants to get into the business wants to do so right away. And sometimes you've got to take a lot of sidesteps, career paths that might indirectly get you there, but it always takes longer than you expect, so you have to be patient and disciplined and also focus on areas that other people are not focusing on. That's hard to do, but you don't want to be one of many using traditional investment vehicles. So whether it’s an asset class or just a product that's slightly different from other investment vehicles. And if you're willing to be patient and disciplined, the markets will eventually come your way, but just asset classes or a combination of asset classes that maybe somebody else or most of the market participants aren't really focused on. And that's hard to do because it's not going to be very popular in the beginning.
By giving an example, when we first started with the income equity product, we had a combination of some preferreds in there, along with common. And dividends were not popular back in the eighties and nineties. In fact, that was a sign of weakness. And we had a theme that the decade of the dividend was coming. And for years it didn't materialize. And then third, fourth year it did, we were sitting right in the perfect spot to benefit from the popularity of dividend type product. Sometimes you have to stretch and start early and the product wasn't that much different than other equity income products, but because of those preferreds at the time, and they ended up being a very excellent product that took off.
Brian Campbell:
I think Steve's being even a little modest there. I mean, it was very contrarian to start a dividend oriented strategy in 1999. Again, that was the height of the tech bubble. And there weren't any investors looking to start a conservative low-beta dividend oriented strategy at that time. I think his comments of being different is very true. And I think if you can find opportunities to exploit when others are not focusing on it. It could end up being a great decision for the firm.
Tim Bray:
So, Brian, why do you think active management matters going forward?
Brian Campbell:
I think investors should know what they own and what they invest in. Unfortunately, there's a lack of education in the larger pockets of society where investors generally don't know what they own. And when you are passively invested and you have all the companies in the index, you have a hundred percent of the downside exposure, active managers offset that. We can control what we own, we can avoid the positions we think are most at risk and position our portfolios and holdings that, through market cycles, will hold up better. And I think that's obviously been lost when you go through a nine to 10 year bull market, active managers have been ridiculed and passed over because of fee compression and ease in use of passive indices. But when you go through volatile periods and you go through times where you have significant draw downs, you hope your exposure has some active managers in there because those will allow you to do hold up much better.
Tim Bray:
Brian and Steve, I'd love to hear from each of you, who is your investment mentor and why?
Brian Campbell:
I've been lucky to work for three great investors, and I picked up pieces from each one, but I think you have to really develop your own style and know what works for you. But now, I mean, I started very young, low, early twenties, and there was a PM at my first firm that was an engineer by trade from Dartmouth who was very methodical, very independent thinking. And that was the one element that I thought was very value added and different. To Steve's comment about being one-on-one being different and independent thoughts. He really ingrained that in me.
Post-business school, I worked with a portfolio manager that was incredibly patient, incredibly disciplined. Turnover in the fund was maybe 10%, and he kept things very simple. He would, the first question in business you know like what makes this business special? And that simplicity, that patience, that discipline was always allowing me to stay within my circle of competence and try to reduce complexity. And when I joined The London Company, Steve Goddard was very influential and looking at incentives, looking at actions, looking at behavior. I've been a big believer in behavioral finance, student of people. I think that explains a lot of things that are tough to explain. And early when I started here 10 years ago looking at what motivates people and how they pay themselves, those statements and elements drive a lot of value overtime and can keep you from making a lot of mistakes.
Steve Goddard:
Yeah, well, I like many value investors, Warren buffet, and this is going back in their early mid-eighties for anybody really knew who, who he was. And that kind of came about in a roundabout way, in terms
of, I noticed you my first five years in the business, that high return on capital free cash flow generation, sustainable businesses were stocks that tend to do much better than the other stocks I was looking at. And I started, I came about accidentally some Berkshire Hathaway annual reports, and I've been following his principles ever since.
Tim Bray:
Brian and Steve, would you each give us some book recommendations for investing, as well as life in general.
Brian Campbell:
Yeah. I think there are different answers for that, depending on the content of the material. From an investment perspective, I've found the most value from the behavioral finance guys, you know, Daniel Kahneman and Amos Tversky, his latest “Thinking Fast and Slow” was probably the accumulation of a lot of the stuff that you've read over the years and really helps to understand people, you know, markets aren't rational. There are people like us that aren't always thinking clearly. So if you understand human behavior and understand why people are rational, it helps explain the greed and fear paradigm that you experience in the bull and bear markets. So from an invest perspective, I think that that has been very helpful.
There's been other great books to help understand yourself. I think to be a great investor, to be long- term focused, you really have to understand yourself really well. You have to understand your pain points when you're going to make decisions based on rash decision-making versus emotions. And so there's been different elements and different books I've read over the years that really helps with that, with that side of the equation.
Steve Goddard:
Investment wise, Seth Karlman, “A Margin of Safety” was probably the best book that I could really relate to because his whole thing was to avoid mistakes more than picking winners and always put very modest assumptions into your valuation analysis, being long term, it just really registered with me when I read that book. More recently, Shoe Dog, which is a memoir of Phil Knight of Nike, chairman of Nike. And he was just a very, gave a very honest story on how Nike evolved. And I never really realized all the trials and tribulations that he went through for at least a decade and the near failures. He was very honest about the mistakes they made. And you know, when you start a firm, everyone thinks it just kind of, you get lucky and things happen. No one really appreciates all the trials and the risks he took and how many failures it took to get to that point. And it was just very refreshing to hear someone so honest give a very independent perspective of how that company evolved into one of the great global brands.
Tim Bray:
Lots of leaders have daily routines to keep them at their best and to stay focused. Do you two have anything like that? And your daily routines.
Brian Campbell:
I do, I try to make sure I get some form of exercise in every single day. I think it's, for me, it's a way to de-stress. So I've always fit that in throughout the day. You know, one of the things that I love about this business is it's not routine. It's not mundane every day is going to be different news flow happens all the time and dictates a lot of your day to day stuff. But I'm more of a night owl. I spend a lot of my time thinking and reading late at night, and it allows me to kind of process and absorb information when markets aren't open and emails aren't flying and try to think pretty coherently about what the best decisions could be. So both the good run and maybe one glass of bourbon. I do a lot of good thinking later at night.
Steve Goddard:
Yeah, I need structure. So I try to write down the main things I need to do the next day. Certainly try to get the things that, the more important things, or tasks that I don't like. I try to get them out of the way first. So it keeps me on a pretty disciplined routine daily.
Tim Bray:
What is the most interesting place in the world that each of you has visited?
Brian Campbell:
That's a really tough question. Fortunately we've traveled to quite a few places. I've actually been to all but two of the States in this country. And when I think about that, and I think about all the places that I've been and seen, I'm always, probably most inspired in the places out West that are just so vast and provides perspective. And I think the last trip, this was state 47 marked off last summer was in New Mexico and going up to Georgia, O'Keeffe’s ranch, North of Santa Fe and just the vastness of the land and a different, you know, the whole landscape is so awe inspiring. I thought that was just really, really grounding. It gives you perspective and, and puts things in order a little bit. So, you know that and like Yellowstone National Park, all the national parks are just so majestic. It's hard to find places that are more interesting than those.
Steve Goddard:
By far Kenya. We went on an African Safari family trip five, six years ago. In addition to just the beauty and the amazing wildlife, you also got to see how the tribes. And they basically have nothing, but they're very proud people, lead a very simple life, very content. It just puts things in perspective in this rat race you run through in our American lives. It was very refreshing to see.
Tim Bray:
Thanks to Steve and Brian for sharing their insights today into The London Company's investment process, as well as their personal interests and background until next time. I'm Tim Bray.
Blake Moore:
Thank you for listening to Distinctively Active Investing. You can find the resources mentioned in the episode, and learn all about Touchstone at www.touchstoneinvestments.com/podcast. If you like the show, please share it with someone you know. We appreciate when you subscribe to the show and take the time to leave us a rating and review. Find our podcast on Apple Podcasts, Spotify, or your favorite podcast app. I'm Blake Moore and from all of us at Touchstone Investments, thank you for listening.
The companies mentioned in this interview are not held in the Touchstone Mid Cap Fund
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