Investing Warren Buffett style: Leyland Asset Management

This week's fund manager interview is with Charles Leyland, the Managing Director of Leyland Asset Management. Charles runs a series of individually managed accounts for people who mandate him to run the money. He doesn't run funds so much as run people's money, or manage people's money for them.

Charles is a Warren Buffett style value investor, and has been for a long time. He's a devotee of Warren Buffett, has habitually gone to their annual meetings, and tries to invest in the way that Warren Buffett does. He's got a lot of really interesting ideas about how to invest, but obviously it's been a hard couple of years for value investors generally, and Charles has found it tougher in the last couple of years than he has for the previous 15. It's interesting to listen to him as to how he's dealt with it, and how he sees things going forward from here.

The other thing to note about Charles, and Leyland Asset Management, is that they are the largest shareholders in InvestSMART. They own 18% of the company, so at the end of the interview, I ask him to talk about InvestSMART, and why he has invested in it, and why he likes it, which I think you might find interesting as a subscriber to InvestSMART, to hear what the largest investor likes about the company. 

Here's Charles Leyland, the Managing Director of Leyland Asset Management. 

Listen to the podcast or read the full transcript below:

Well, Charles, the last time I spoke to you I think was two years ago, January 2017.  And obviously since then, the market's been up and down but it's been a difficult couple of years I think for value investors like yourself.  Well, it's been a difficult 2018 for all investors, I guess.  How have you fared as a Warren Buffett style value investor in the market over the past couple of years?

You probably summarised that quite well Alan because we've been going for 15 years and we had 13 really good years.  On average we outperformed the accumulation by about 3-3.5%.  The last two years have been tougher and really, unless you've been in the resource companies which is really hard to buy for value investors unless they're dirt cheap, or riskier businesses for instance Afterpay or Bellamy's or those sort of businesses that are higher up the risk chain, it's been really, really hard to make money.  We sort of made the observation also that in the last four or five years almost every blue chip or top 50 company has had a 50% variance from their top price to their bottom price.  There's lots of ways in which you could have lost half your money in the last few years.  Whether it was buying BHP at $50 and seeing them fall to $15.  Or buy Telstra at $6 and seeing them fall to $3, or the banks. It's been hard to avoid those sort of movements because it doesn't matter which stock you're invested in.

The other thing that I've noticed in the last couple of years is there has been very little value placed on price, it's all on the excitement of the stock.  So that has made it tough again for value investors.  It sort of reminds me in some way of the dot com boom where all the good businesses at good prices were actually being left behind.  The investors seemed to feel like they were boring old businesses, they never move.  Whereas really what made them boring was that they actually make money and the exciting new businesses were the ones capturing all the attention.  I don't think that will last forever.

But have you found that the most difficult thing, or is the most difficult thing for a value investor faced with that situation to not capitulate, to kind of change the way you approach companies to think oh well I'll rethink what value is.  In fact, looking at say Afterpay or some of those companies, and you go well actually may be that is value given the way it's growing.  Is that the great temptation?

For someone like myself it's not a temptation because I've been doing this for so long and I think I've got the temperament to not go into stocks that I don't really believe in or don't have a strong view that they're going to perform for the long term.  But for our investors, we operate under discretion model where clients give us their money, they are under a limited power of attorney and a set mandate, we invest on their behalf.  It's teaching those investors to stay the course with quality stocks and again that's what reminds of the dot com boom.  Same sort of thing where clients wanted to jump out of good companies making good money into companies that weren't making money but whose share price was simply going up for whatever reason and they were seeing their neighbours make lots of money, whether it's an Afterpay, whether it's a cryptocurrency or any other number of things.

But you do make an interesting point because even value investing, you can think about it in different ways.  Charlie Munger once said at a Berkshire AGM he said, "Look, all investing should be value investing.  You're buying a business.  You're buying a business that you understand and you're buying a business you've got faith in in the future."  He said there is an argument that if you are very, very close to a company that is a start-up or doesn't make any money and you know the management well, you know the potential market well and you're willing to take that risk, there is an argument that you could have some of that stock in your portfolio but I think that's where it’s probably more appropriate for people who are actually involved in the start-ups or are early seed investors.  Once they hit the share market it's often too late to get the leverage upside you'd get in a start-up.

In fact, in your most recent monthly newsletter, you wrote approvingly of CSL which is on a PE of 33 for 2019 and wouldn't normally you'd think be a part of a value investor’s portfolio, but I take it it's part of your portfolio, is it?

Well, actually I probably should have elaborated more on the previous point about the different styles of value investing.  This is where Buffett gives credit to Munger.  Buffett in the early days considered value to be cheap, cheap stocks.  It didn't really matter what you buy as long as you bought it cheap and whether it was cheap on an asset basis or cheap on an earnings basis.  Munger then came and made the argument that you can pay more for a quality business and the definition of quality really is a two-pronged definition.  First is, quality of earnings so the sustainability of earnings and I think that CSL ticks that box over and above most other companies in Australia.  The earnings are very, very self-sustaining.  Then the quality of growth and earnings.  Munger makes the point that if you pay 40% higher price for a stock that's got sustainable long-term earnings rather than a lower price for a stock who's got static earnings, that PE premium disappears very, very quickly as the earnings move up you end up on a historic basis paying the same price and then you're getting all the future.  His argument is you can pay a slightly higher price for a high-quality business and still consider it a value investment.

Were you buying in December?

We were.  We certainly weren't selling.  We're normally quite fully invested.  Our mandates are to be in the share market so we don't buy and sell the market here.  We don't try and predict where the market is going.  For what capital we had available we certainly were doing some buying.  Then quite often our investors make their own capital allocation decisions.  We were contacting our investors saying these are the types...  and obviously you read our newsletter.  We would have said we can't predict where the market's going to be and we've always said that but if we can buy the same businesses at 20%, 30%, 40% discounts to what we've bought them three or four months earlier it's a very, very strong argument that you should be allocating additional capital to those businesses because really when you invest in the share market that's all you're doing.  We look for investing through the lens of you’re buying a business.  For any business, if you love a business at $100, why wouldn't you love it more at $60 all things being equal.

Yes, and you've said it in the newsletter you're going to approach the market in 2019 the same as you always have, looking for quality companies to invest at attractive prices.  You won't be able to forecast the market movements or short-term share price movements but will be able to discuss each of the businesses they own.  Can you run us through some of the businesses you currently own?

Yeah sure.  A really good example is one of our biggest holdings is Challenger.  Challenger Financial is in my opinion… my opinion there are 10 great businesses in Australia and whether you buy them or not comes down to price and portfolio construction, but Challenger is right up…

Only 10 great businesses?

Well, if you think about businesses that have got very low debt that own their market, so that's your moat, and a moat that is really, really difficult to break.  You have to think of the free online behemoths realestate.com, carsales.com and realestate.com and you'd probably throw Nine in there, Domain.   Then you've got ASX, another company that's very low debt that own their market, Computershare, Challenger, CSL, Cochlear.  They are wonderful and Sydney Airport, if you seize the chance.  If you get a portfolio of those sorts of businesses and it's hard to see you losing money over through the cycle, through the stock market cycle.  Out of those our pick as far as the one we happen to have the most of, I guess.  This is one that's given us more opportunities to buy at a cheap price.  The others have sort of held up quite well through market cycles, but Challenger's one that we happen to own.  We bought it at $3, we bought it at $7.  It went up to $14 and it's now back at $7 but really, it's a very similar business to the same business that people are paying $14 for a year ago.  You are probably aware they offer annuities is their primary source of income.

And that's what you're saying is the business that they've got a moat around?

That's their moat, yeah.  No-one else is in the market.  No-one else is likely to get into that market in the near term.

Why not?

Because of capital constraints.  The banks have got enough problems at the moment with non-core businesses and with capital.  The new capital requirements for banks make it very difficult for them to find the capital to go into annuity businesses.  We've actually seen that Challenger are selling their annuities now through BT and therefore Westpac.  I think that they'll get more traction through the banks.  They're also selling offshore now through into Japan at the moment, so that's another nice angle for them.  The annuity market even in Australia is quite small compared to the US and UK.  We think the pie will grow and if they can even maintain the same slice of the pie it's natural growth.  In addition, it's almost government mandated growth because of the encouragement by the government for superannuants to include annuities in their pension funds.  So that side of the business to me has a great moat and if you're buying it at $7 compared to $14 obviously, the cheaper you buy it the greater your chance of making money and a lower chance of losing money in the short term.

The other side of the business which has less of a moat and is more volatile is the incubation.  They incubate managed funds and of course when that's going well and performance fees are coming in and fund management fees are coming, but of course when the market falls that side of the business is a little more volatile.  That's the reason they had the recent big fall from $10 to $7 and it was not a huge fall in earnings, it was really just I think it's 2-4% fall in earnings.  It's really just the fact that the market doesn't like any negative news at the moment.

Yeah.  It's been a shocker in the past 12 months, no doubt about it.

Yeah.

You must have looked at it and thought what the hell am I doing? But no, you've got nerves of steel Charles.

Well, the biggest risk I think is not understanding the business you own.  Then what of course what happens is you start thinking the market's telling you something and then when the share price falls you sell it because you're not sure of what you're doing and that to me is the biggest risk.  There's been lots of things.  Like Challenger actually fell, I can't remember it must have been six or seven years ago, it fell from $10 to $3 and people were scared and worrying about the stock but it's the same business.  No, we don't worry about that sort of thing too much.  Our job is to educate our investors to have the same sort of temperament to see through these fluctuations because it can be upsetting for people to see stocks fall 50% but again Munger makes the point that they've seen Berkshire fall 50% from top to bottom three times in the last 40 years.  You've just got to be prepared to go through that, to get the excess returns achievable on the market.

Well Berkshire Hathaway in fact has had a rare flat period itself, hasn't it, in the last 12 months or so?

Yeah, it has.

Both the As and the Bs have done nothing.

Well, that's right.  The Bs track the As, of course.  It just happens, I think it's probably symptomatic of what's happening in the market here.  The value stocks really haven't been doing much.  The FANNG stocks that have been causing all the excitement over there.  Of course, they've got an investment in Apple.  Arguably that goes against their usual thinking but gee you wouldn't bet against them after their long-term track record.  I think their investment in Apple probably comes back to what we were discussing earlier when you're buying a quality stock and paying a little bit more than they usually would have in the old days.  Things have changed too with technology, the valuations of stocks are available at the stroke of a key on the InvestSMART website.  Whereas in the old days Buffett used to pore through the pink pages looking, so it was harder work but the rewards were there, getting the dirt cheap stocks now is a lot more difficult.

The other problem they have of course is they're so big which means that they need to make very, very big investments in order to move the dial such as Apple.

Yeah, that's right.  They've said that all along but I think what happened they started saying that in the early '90s and of course the outperformance still occurred throughout the '90s and perhaps the first decade of the 2000s so people stopped believing them when they said, "Oh look once we get too big it will be really hard to get outperformance." I think you're right, that does come home to roost eventually.

Are you investing outside of these 10 great companies that you talk about in Australia? And if so, which stocks?

Yeah, of course.  We have different mandates for different clients but some of the value stocks that we've got outside that, one I know we've spoken about in the past and I’ll touch on because I know you had a question about it in your last interview was on FlexiGroup.  They're a stock that's fallen from $5 to $1 in the last 2-2.5 years.  The nature of their business has adjusted but it hasn't adjusted to the extent that in my opinion deserves an 80% fall in share price.  They were historically known as being the point of sale financier for Harvey Norman and a lot of similar companies.  But that started to wane a few years ago.  I think they were getting a bit of blow back from the government, alternative purchasing sources came in.  They diversified their earnings quite well through acquisitions.  Now one of their large sources of income is through vendor financing.

Let's say solar panels as an example, if someone comes to install solar panels and they fund the purchase, a bit like a big Afterpay.  They fund the purchase, you pay it back over a few years, FlexiGroup is often behind that vendor financing.  Their earnings have been relatively stable around that $75-$80 million mark for the last couple of years.  They came out at their results announcement late last year and said that they expected 8-13% earnings per share growth and last week they said that they don't expect that sort of growth and they announced a write-off.  The shares are around $1.15 I think which puts them on about five times earnings which in anyone's books is very, very cheap but they probably won't go up to any great extent until the company can actually show some earnings in growth.  If they do, it's not hard to imagine a place where they're at 10 times earnings and they achieve sustainable growth and they'll probably be 15 times earnings.  It's one of those ones where you're buying cheaply with a bit of patience and I think that there's a chance there of getting a three or four bagger with them.  Completely at the opposite end of that risk return scale to those 10 sort of staple type stocks that you might think about in a portfolio.

Channel Nine's one that we own because we owned Fairfax shares and that was really and still is a sum of the parts argument when you look at the value of Stan, it’s going very well.  Domain of course is a high-quality asset.  Then they've obviously got the newspapers, they've got the free to air TV.  Free to air TV is dying as quickly as perhaps the newspapers did when disruption came.  They've got radio stations; radio stations are a quality asset.

If you think of the two advertising vehicles which are difficult to disrupt, they are radio and billboards because most frequently they're listened to or looked at when people are driving and that's the one time you can't be looking at your phone or your computer.  Billboards and radio are less likely to be disrupted so they've got exposure through those radio assets.  We had a valuation, I think it equates to around about $2.20 on the sum of the parts and they’re trading I think around $1.45 at the moment.  That's one that we own and we quite like at the moment.

Can I get you to talk about InvestSMART which is obviously one of the stocks you own and you're in fact the largest shareholder in InvestSMART with 18% of the company.

Yeah, sure.

I presume InvestSMART is one of the 10 great companies in Australia? Just kidding.  But tell us why you like InvestSMART?

We've owned it for quite a while and a couple of iterations but there's a few things that we really do like about InvestSMART.  They're kind of the good guys in finance.  They are the people that have the ‘Your Share’ asset, the grandfathering of commissions.  InvestSMART's been trying to give grandfather commissions back to investors for years.  Part of the business is Your Share where if someone's got a fund let's say an AMP fund the commission was 2% per annum back to the planner who put them into it, well they traditionally move that across to Your Share and Your Share gave them back most of that and took out a fee for doing so.  Now that business has been very good and they've also got the subscription businesses.  They own the best quality newsletters in Australia.  They've got the Intelligent Investor of course and Eureka Report and the InvestSMART newsletters.  They are quite good assets.  They're helping people to become better investors and it's a fairer way of doing business.  From a company perspective though, the Your Share business is likely to be dismantled.  Ironically the good guys are losing out here in the Royal Commission.  Over the next three years once grandfathering goes that Your Share income dries up.

But the great thing that Intelligent Investor are doing is, as we were discussing earlier, the normal lifespan of a subscriber to a newsletter is that an investor gets a lump sum of money, whether it be from an inheritance, whether it be they've taken their money out of managed fund or something else and they get very excited about investing their own funds so they subscribe to newsletters and they'll start investing on their own.  But then of course what happens they either realise it's a lot harder than it seems, or they lose enthusiasm for it, or they just get sick of it and they decide to get someone say like us to do it for them. 

The great thing for InvestSMART is that we've been talking to Ron about this for years as a concept is to retain those people that you traditionally lose is to then have an offering whereby these trusted houses, the people who are writing the research can then do the investing on the client's behalf.  So now the great thing InvestSMART's doing is bringing that offering to the market.  That's a way of retaining any lost clients from the newsletters.  But in addition, InvestSMART has brought on board Alan Kohler, yourself, and Paul Clitheroe, two of the doyens of the investment industry in Australia.  Really, I know Alan yourself and Paul have been pushing for fairer fees for a long, long time.  InvestSMART is offering capped active and passive ETFs.  That conceptually is a huge potential market for them.

I was watching, Alan, your camera sort of podcast on Friday and I know you were talking, someone had a question they've got $1.7 million they were going to put it into an industry superfund.  In an industry superfund they're probably going to get market returns at best minus their fees.  The fees are about $30,000 a year.  If that person was put the money into a capped ETF they would pay I think $451 a year.  Their saving is $29,500 a year.  Over 10 years that's $295,000 and then you think of the returns they could have got on that but saved money.  It doesn't take much to work out say a $500,000 saving there and so then $1.7 becomes $2.2.  It's not an insignificant amount of money in relation to that person's net wealth.  I think there's a huge market for this particularly for people who are just happy to get market type returns, i.e. particularly those perhaps who are in industry funds where they don't want to try and achieve that outperformance.  I think there's a huge potential market there.

Of course, with any investment you have to have a lot of faith in the people involved and Ron Hodge is as honest and as hard working as anyone else in the investment industry.  Of course, they've got yourself and Paul.  I think you've got the good people, you've got a good product and you're doing the right thing by investors.  I think over the long term that has to work out well.

I couldn't agree more, thanks very much Charles.

That's okay.

Thanks a lot Charles.

Alright Alan, no problem.

That was Charles Leyland, the Managing Director of Leyland Asset Management.