Understanding Large-Cap Stocks Beyond GAAP Valuation with Portfolio Manager Rafael Resendes of Toreador Research and Trading: One of the Best Investment Strategy Interviews of 2012



67 WALL STREET, New York - December 18, 2012 - The Wall Street Transcript has just published its Best Investment Strategy Interviews of 2012. The full issue is available by calling (212) 952-7433 or via The Wall Street Transcript Online.

Topics covered: Investment Strategies - Large Cap Investing - Investing in Emerging Markets - Investing in Energy - Value Investing - Downside Protection With Upside Participation - Macroeconomic Trends

Companies include: Apple Inc. (AAPL), Automatic Data Processing, Inc (ADP), Chevron Corp. (CVX), Ecolab Inc. (ECL), International Business Machine (IBM), McDonald's Corp. (MCD), Southern Company (SO), Exxon Mobil Corp. (XOM), Yum! Brands Inc. (YUM)

In the following excerpt from the Best Investment Strategy Interviews of 2012, an experienced portfolio manager discusses his investment methodology for large cap stocks:

We capture this through a proprietary concept we call Economic Margin Decay. If you study decay rates over time, and globally, it quickly becomes apparent that valuations based on multiples are just silly, and explains why so few firms and individuals consistently assign reasonable values to companies, and instead use coarse generalizations - such as growth firms or value firms - when in fact growth is required to understand value.

In the same way that Google has the best search algorithms, understanding intrinsic value is a unique advantage Toreador has over its competitors. This allows us to understand the future performance we are paying for a firm at any point in time.

For example in 2000, quality firms traded with very low future expectations embedded in their price relative to risky firms, and as the market became unstable and overvalued. We witnessed something similar in 2007, as Toreador moved to buy safety and held that position through much of 2011. In late 2011, our fund made a very explicit decision to trade out of safety. Going into 2011, we owned names like MCD (MCD), IBM (IBM), Clorox (CLX), Coca-Cola (KO), P&G (PG), and others that served us well through 2010. Essentially, you could go down the list, and we focused on firms that were considered to be safe - very stable cash flows, low leverage, big firms, multinational presences.

However, with the euro crises unfolding in 2011, these firms were consistently being overbought as everyone reached for safety, yields and low volatility. If you look at what happened last year, the top-performing firms versus the bottom-performing firms, the top-quartile firms returned about 26%, whereas the bottom-quartile performer returned a negative 30%. The top firms were roughly two to four times larger than the bottom-performing firms market-cap wise. Again, there was a clear reach for safety. The top firms were half as levered as the bottom-performing firms. Top firms' dividend yield was almost twice as much as the bottom-performing firms and the Economic Margin of the top firms exceeded the bottom ones by a factor of three, with a third of the volatility.

At the end of 2011, however, when we sat down and we spotted the value, we found that, on average, the typical firm in the safe group had to grow its sales for the next five years at about 14% a year to justify their valuation, and the question we asked is whether such performance is reasonable or not. If you look at these firms, on average, over the previous five years, they have only been able to grow at about 6.8% a year. In other words, right now, because of the reach for safety, these firms would have to grow at about more than double what they have been able to do historically, and to us, while these are great firms, they were just too expensive.

After the crash in August, we explicitly started investing in riskier cash flows as the market had unreasonably punished firms with these characteristics. For example, risky cash flow firms were priced to grow their top line at about 4% a year whereas, historically, they have been able to grow at about 10% a year. When stocks can beat their expectations built into their price, they tend to do very well, and when they can't, they tend to underperform. That's what we saw back in 2000 with the tech bubble, expectations exceeded reality and we witnessed the tech crash. We believe we were in a bubble for quality, and investors were significantly overreaching, and as a result, we restructured our portfolio to take advantage of this.

Some of the names that we own that I think are interesting are Bank of America (BAC). We made a big push into owning financials over Q4 of 2011. Bank of America is, I think, a really unique name in the sense of it probably has normalized earnings in the neighborhood of $2 a share. We expect that for 2012 it should earn maybe $1 a share. So in simple terms, has a p/e of 7.5 - after appreciating more than 30% this year - holding that constant with $2 of earnings, we believe investors will push its value to the low teens. Our estimate of its intrinsic value is approximately $15 a share, making it a wonderful buy-and-hold opportunity. We estimate the downside risk to Bank of America somewhere in the neighborhood of $6 if the market gets really jittery again. We see the upside at $15 plus. For us, 100% potential return with 20% downside even assuming 50/50 odds is a great investment vehicle. We actively search for those types of risk return opportunities, and as a consequence, we've made Bank of America the largest holding in our fund.

By the way, the financial sector is where we have the greatest percent of our funds allocated at the moment. We have about 28% of our fund allocated to financials, versus a market weight of 14%, primary focused on the global banks and life insurers such as MetLife (MET).

We believe the environment for financials is unique in the sense of offering what I call upside regulatory surprise. I think for the last three years, we've had a regulatory environment very hostile to financials from headlines to Washington's desire to capitalize on such sentiments. I think that environment will change. It is obvious an economic recovery will not reach its full potential with government at war with banks...

For more of this interview and many others visit the Wall Street Transcript - a unique service for investors and industry researchers - providing fresh commentary and insight through verbatim interviews with CEOs, portfolio managers and research analysts. This special issue is available by calling (212) 952-7433 or via The Wall Street Transcript Online.


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