RAFAEL RESENDES is the Co-Founder of The Applied Finance Group, LTD., a Founding Managing Director of Toreador Research and Trading, and a Founding Managing Member of AFGI. Founded in 1995, The Applied Finance Group — AFG — specializes in understanding the expectations embedded in market prices and constructing portfolios from that information to outperform stock market indices around the world. Founded in 2006, Toreador Research and Trading applies AFG’s research through its domestic and international funds. Mr. Resendes is the Co-Portfolio Manager of Toreador’s Domestic Large Cap Core, Explorer Fund and International Large Cap Core Fund. Founded in 2014, AFGI provides portfolio management services to RIAs and bank trust departments focused on custom portfolio model delivery. Mr. Resendes graduated Phi Beta Kappa from The University of California at Berkeley, with a B.S. degree in finance and economic analysis, and he obtained his MBA from the University of Chicago. Mr. Resendes routinely provides educational seminars on the topics of portfolio construction, valuation and market expectations, speaking to over 35 Financial Analyst Societies in 14 countries.
Having an Analytical Advantage to Stock Picking
TWST: Today we’re talking about the Core Fund. How do you feel about the performance at this point?
Mr. Resendes: What has been really gratifying for us about this product is that we beat all the benchmarks, whether you are talking about growth or value or core. If you compare us across the Morningstar universe, we beat their core blend universe, their growth blend universe, their value universe over the one, three, five, 10 years since inception period.
TWST: In your opinion, what has been responsible for that success?
Mr. Resendes: I think I read not too long ago that someone said your sources of outperformance can come from three places: One is an informational advantage, the second is an analytic advantage, and the third is a sense of time arbitrage, where you just hold longer than other people and wait for things to turn around. And I think we really do well with number two.
I think we have an extraordinary analytic advantage over probably 99.9% of market participants with the way we break down data, convert as-reported accounting data to an economic framework to properly measure how are companies performing and then incorporate our valuation approach that we’ve been using for 23 years, which solves a lot of problems with traditional valuation approaches. So I think the analytic advantage is a huge plus for us, and that then translates into what I agree is then a time arbitrage advantage, which because we understand what we’re buying and what we’re paying for, it’s easy for us to ride through highs and lows because we have this specific absolute estimate of what we think a company is worth, and we’re not scared to purchase more if it holds.
Recently, in the last 24 months, we’ve been on quite a roller coaster with the stock Micron (NASDAQ:MU). We initiated the position I think at about $16. Unfortunately it was a nightmare situation that it immediately dropped to about $9, but we bought more. Yesterday Micron closed around $43. We think the stock still has a lot of room for improvement in terms of price; it’s still a very inexpensive stock. So it’s situations such as these that we’ve consistently exploited through time.
When Bank of America (NYSE:BAC) was down trading in the $5s, we were buyers of the stock. It’s trading today at $28. We’ve consistently been able to identify mispricings and understand the risk in the return of the opportunity and establish positions with strong conviction. These are what I’d call special situations in the portfolio, but the broad portfolio in general owns about 100-plus names. So we’re consistently buying stocks that fall into kind of our philosophical strike zone for what we want to own in a stock.
And we have the same team that we started with when we first began Toreador back in 2006, and it’s the exact same team that’s been in place since the early 2000. So we have a very deep bench of seasoned financial analysts and portfolio managers that love our work and are excited about the future. We started off with the Toreador Core Fund; we added an international fund that’s beating its benchmarks; we added a SMID fund which is beating its benchmarks; and then earlier this year we added a very low turnover large-cap value product, also beating its benchmarks. So it’s really a strong testament to the process that we put in place, the process focusing on what’s the underlying economics are for a company, what’s the value of the company, what’s the quality of management, what’s the quality of the financials, and then does it have proper economic momentum in its place to trigger the catalyst to realize the value that the stock has at a point in time.
TWST: What you just described is a bottom-up approach to stock selection. Do you look at larger global trends when selecting individual names?
Mr. Resendes: We are, first and foremost, we’re stock pickers, and that’s our bread and butter. That’s where we derive the vast majority of our performance. Our process is used to value 22,000 stocks on a systematic basis, that gives us access to a rich data set that very few firms in the industry have access to or could even dream of having access to. And the result of that is over time we’ve identified certain inflection points that, while we’re not macro-type allocators, we’ve been able to identify certain inflection points that tell us this market is extraordinarily cheap or this market is extraordinarily expensive. And beyond those points, that’s when we would actively think about should we be moving more into cash, should we be having a more aggressive portfolio position, should we be defensive, should we be aggressive.
For example, I recall in 2008, I was on the CNBC, people thought the world was falling apart, no one wanted to invest in stocks, and we were on the air telling people buy. We told people, this truly is a generational opportunity to buy stocks because the implied expectations in the market were so low that the market was essentially saying S&P 500 stocks would be 50% smaller by 2013, and while anything can happen, in the world of investing what we really want to focus on is what’s likely to happen, and that was not likely to happen. So you were getting a great discount on amazing businesses back then.
The flipside of that is we actually, in our research company, The Applied Finance Group, we issued a research report on Cisco Systems (NASDAQ:CSCO) back in 2000; the stock was trading around $65, and we just selected this one as representative of the tech boom problem as a whole, and we said the stock is worth no more than $17, and essentially over the next few years Cisco systematically traded down into the very low teens, and it took until maybe 2010 for Cisco to really significantly break out above $17. So we don’t really emphasize macro analysis for the stock markets around the world; on occasion signals become so strong that we develop plans to account for extreme markets.
TWST: Can you talk about your views of valuation?
Mr. Resendes: I think the art and science of valuation has been lost for a while now. So many people in the industry and even what you would think of as accomplished professionals really have no idea how to value a stock. They might look at p/e ratios or various multiple or things of that sort, and even people that sit down and do a lot of work on valuation, they grind out a pro-forma DCF statement and they make explicit five-year projections only to value by applying a terminal value perpetuity multiple which is as detached from reality as my believing I can beat Tiger Woods.
As a result, most analysts just don’t have confidence in their answer because they know the assumptions from which they derived their answers are mostly foolish. So many firms will pay lip service to value; few actually have it in their DNA to act on the information they produce in that regard. That is ultimately bad for their investors.
We have a 23-year history of making valuation estimates and measuring our estimates against market movements, so if we say a stock is worth $25 and it’s trading at $15, odds are that’s a great investment. We’ve been doing this for almost a quarter of a century, and what allows us to be different from other people is our rich database of actual estimated intrinsic values against traded price, not some theoretical back-test database that people are always creating, looking backward. We create things looking forward and then time stamping them and then over time measuring how well things are working out, not just through the fund but also in our research.
And so for us what we found of all the variables that can affect the future returns of a stock, identifying companies that are trading below their intrinsic value is the most important one, and so that’s why we’ve built our entire approach around valuation, not necessarily “value stocks,” as an investing category, because you can have a cheap stock that gets cheaper because it’s a lousy investment, but we’ve built our entire foundation around valuation, and for us a “growth stock” or a “value stock” is irrelevant. What we want to focus on are stocks where the embedded expectations in the price are reasonable to achieve relative to what the company’s able to do, and we build a portfolio of those, and we like to think of it as being the house not the gambler.
There’s a reason why some of the most amazing buildings in the world are in Vegas and Macau, right. You have the greatest shows, the greatest interiors, the greatest suites, the greatest swimming pools, the greatest infrastructure. So if you are the house, and you can constantly get people to sit at the blackjack table, you might lose today, you might lose tomorrow, but over time you tend to grind out wins, and that’s the way we look at building portfolios. The house wins, and that’s the way we look at it. We don’t really care that one stock is underperforming today, tomorrow or next week. We want to put together our portfolio of a broad list of 100 names. We feel comfortable from those 100 names, 60 are going to do well, 40 won’t, but that 20% spread is what pays for the casino.
TWST: You invest both U.S. and foreign markets?
Mr. Resendes: That’s correct.
TWST: What are your parameters for investing internationally?
Mr. Resendes: Similar to our large-cap core product — U.S. investment product — that is sector-neutral, we do the same thing globally. Again, we don’t hold ourselves out to be macro allocators. So what we’re looking to do is we have a country-neutral, sector-neutral portfolio. We’re looking to buy the best chemical company investment, whether it’s in Germany or Japan, or the best automaker investment, whether it’s Germany, Japan or Korea, doesn’t matter. At the end of the day we’re going to construct a portfolio that’s equally exposed to German companies as the underlying benchmark, which is the MSCI EAFE, and have the same exposure to the sector weights of the MSCI EAFE, and all alpha essentially will derive from our stock picking, which has worked out very well for us.
TWST: Why are you sector-neutral?
Mr. Resendes: Our approach tends to work regardless of sector or country, and so what we really want to do is find the cheapest exposure to what we believe are important proprietary factors. We search around the world and find those factors at the cheapest price. And so that’s why we don’t make sector bets and we don’t make country bets. What we’re doing is we’re focusing on what we know well, as these factors lead to success and outperformance for stocks over time.
We want to accumulate these factors as cheaply as possible. We have no problem with people that are out making sector and/or country bets and all that macro stuff — God bless them. We just stick to our time-tested approach and look to increase the wealth of our investors consistently, albeit without the sizzle and drama of big country or sector calls.
TWST: Tell us why Micron is a name you like?
Mr. Resendes: When we bought the stock we really thought it was attractive; based on its valuation, it was trading around $16. We thought back then it was probably worth around $30. So the conditions for it to be a good investment were in place, and then as we kicked the tires more, we became convinced that Micron was just in a very under-appreciated situation. At the time, everyone still thought of the memory business as being dominated by wild cycles and a Wild Wild West style of competition.
That was understandable, as there used to be 13 or 14 DRAM manufacturers in the world; however, by 2016 that number had dropped to three. So the DRAM business used to be kind of a classic competitive economic market where firms were constantly underbidding themselves to gain market share. When you are down to three producers, now you are in more of an oligopolistic market. And there is a fair amount of coordination that takes place among these producers if you listened to their conference calls. They don’t speak directly, but they speak in indirect tones about the fact that the industry really doesn’t need any more capacity additions.
That might be Micron CEO speaking; then you listen to the Samsung (KRX:005930) CEO and he’ll say, we believe supply and demand conditions are very well-balanced, even though in the background in the industry what’s taking place is that there is a shortage of manufacturing of DRAM and the price has been going through the roof. Everybody is signaling to one another, this is great, we’re basically printing money with these products. We don’t want to kill the golden goose and add more factories. So the entire premise of that industry has changed, and I think people are just now starting to understand that.
The other aspect of the business that really intrigued us was the world is going toward memory. The model of computing used to be very processor-centric. You buy a computer, you get a faster processor, everything worked great. The problem now is so much data is being created, the processor is important, but it’s reaching very fundamental limits as to how much faster the processor technology is going to go. But data is expanding exponentially. So the demand for storage is just going through the roof whether it’s short-term storage, as immediately accessible DRAM, or whether it’s permanent storage through NAND. Storage requirements are exploding, and as a whole, the industry conditions for this stock were just extraordinary. And they continue to be extraordinary.
This industry works such that every year their cost of production tends to drop 20% to 30%. So even if prices fell 30% over the next year, their costs have dropped by 30% as well, but their overall output has gone up, and that will be a massive profit driver for these companies going forward. Not to mention, there is a embedded call option on Micron with new technology they created jointly with Intel (NASDAQ:INTC) called 3D XPoint, which could be a revolutionary business, but at the time, the market was putting zero value to that, just valuing the existing business very cheaply given how the industry had changed. Today, Micron is probably poised to generate $8 a share in 2018, and the stock is trading in the low 40s. On a multiple basis, this is still an extraordinarily cheap stock compared to the marketplace.
TWST: Give us another name you like and tell us why you like it.
Mr. Resendes: Another name that we’ve held for quite a while — since it’s close to Christmas, I’ll give you two. One is Intel and the other is Bank of America. The story on Bank of America I think is really simple. It’s a stock that will do very well as interest rates continue to rise in the economy. We owned Bank of America back in 2008. We held it through its continuing declines through 2011, down to $5, I think we probably sold it around $20 in maybe 2014. We’ve reinitiated the position on Bank of America I think in 2016 in the low 20s. I think now it’s $28. We took a little heat in 2016 at the beginning of the year; it dropped quite a bit. But the underlying thesis was we thought back in 2016, three, four, five years out, interest rates are going to be increasing, and the stock even in a low interest rate environment was attractively priced. We felt very comfortable putting the position on.
With Intel, we bought the stock a number of years ago back in the low 20s. I think now it’s at $48. And the underlying story, as is often the case, we find stocks that are to some degree orphaned because of “the prevailing story.” For Bank of America, it was the low interest rate environment. For Intel, it’s they weren’t in mobile. The whole world was just thinking mobile.
The funny thing about Intel is, yes, the PC market was declining, but they had built a business and were in the process of building a business almost as large as their PC business in the server space. They basically dominate 90% to 95% of the server dollar share for processors. They built an extraordinary business there with great barriers to entry. And we just thought that this was a crazy mispricing that time will take care of because the company was doing the right things. And sure enough, this stock has just marched steadily upward. And at the price at which we bought it, our basis I think we’re getting maybe 4% dividend from the stock every year, which is another nice little benefit for our investors.
TWST: How often do you rebalance?
Mr. Resendes: Our fundamental rebalancing takes place quarterly. If we have an extraordinary inflow or outflow at a point in time during the quarter, we would consider doing a rebalancing then. The main philosophy again is we’re not necessarily looking to make a bet on any one particularly company in the absence of a very special situation. So we’re looking again to diversify our exposure to these success factors in the U.S. across industry and across companies.
So each quarter, we want everything just to be reset back to more or less an equal weight across the portfolio. And that’s just been a very successful recipe for us. It’s good from the perspective of mitigating risk for the clients because generally it’s rare for us to have any particularly large positions. Further, it takes all the emotion out of short-term price movements that typically have investors selling low and buying high.
TWST: You have about 100 names in the portfolio. In general, if you buy something, do you have to sell something?
Mr. Resendes: Let’s just say we found 10 more stocks that we liked at a rebalancing and all the stocks that we own we continue to like, what we would do is we would just either take a bit off the table of the existing 100 we continued to like. However, usually there are some names that haven’t worked out or have worked out so well and they’re no longer attractive from a valuation perspective to us, so like any bad relationship, we part ways and move on, though we are quite happy to say “it’s you not us” to the stocks we sell.
TWST: And new ideas? Where do they come from?
Mr. Resendes: In our large-cap universe, we have approximately 1,200 stocks that we pick from. In our SMID universe, we have about 2,500. And in our global universe, we have about 2,000. Again, we process our metrics on these stocks every day. And so when it’s time to rebalance, what we’re looking to do is we evaluate every stock that we own against the entire universe of what we can own. We have the existing portfolio. We’re comparing it against the attractiveness of all the other stocks out there.
In general, over the course of the year, our turnover tends to run about 80%. So if we started with 100 stocks in January, by December 31, we’d probably have in portfolio, 80 of the stocks are new. But the ideas come from the relative comparisons we’re always making of stocks that we own against stocks that we could buy. Very unemotional. It avoids a lot of the behavioral biases that you constantly see in portfolio management. And we have a very rigorous way in which we score each stock that we’re looking to buy.
So we tend to avoid many of the problems inherent to portfolio management, such as when an analyst falls in love with a stock and will do anything to justify keeping in the portfolio or adding it to the portfolio. Or worse, many organizations that don’t even have a process for managing their portfolio. We were at a conference the other day and we were talking to somebody, and they said how do you guys pick stocks, and I said, well first, tell me how you do it. He says, I read a lot. I’m thinking well, that’s interesting, I do too, but that’s not necessarily how we put together a portfolio. He’s continued, I’m always reading to see if I can get an idea from The Wall Street Journal or Forbes that I can buy.
So then I started to explain our process, which admittedly is very boring. And I think he fell asleep into his drink, which made me happy, one less portfolio to worry about competing against. We’re happy to be the most boring firm around as long as we’re able to consistently deliver superior results to our clients.
TWST: Is valuation, or a change in valuation, the reason you would sell something?
Mr. Resendes: While valuation weighs heavy into our process, the other factors that come into play are management quality. We really don’t want to be investing in managements that do not understand how to create value. Earnings quality, so a company’s financial results are sustainable — in other words, we don’t want to be buying companies that are channel stuffing and things of that sort.
We also are looking for economic momentum so that the trends a company has in its operations are likely to continue going forward. So valuation is a big part of it, but each of these factors gets a score and weight in our approach. And so what we end up with is a combined overall score that we give every company from A down to F. We simply buy As and avoid Fs. And then the rebalancing is a function of looking if what we own has either valuation, quality or momentum deterioration that no longer makes them attractive to continue owning, or have other stocks just risen so much that they make a more compelling case that we should be adding them to the portfolio.
TWST: Are you still adding new strategies?
Mr. Resendes: I think we’ve basically reached the portfolio family that we want with a large enough core, SMID core and international core, and then there is the special large-cap value product. I don’t anticipate us adding many more products within the fund family. I think it’s pretty complete, and now it’s more just waiting for each of these funds to kind of marinate and mature like the core fund has.
TWST: For your clients or any retail investor buying your fund, what advice would you give them?
Mr. Resendes: For the average retail investor, if you are buying the Toreador products, I would suggest to them they should develop a long-term mentality. I think the biggest mistakes people make are along the classic behavioral problems of panicking when things go down, selling when they’ve lost money, and not being invested when markets moves up, which often come suddenly.
TWST: Thank you.