By Michael Brush, MarketWatch
Companies with diverse lines of business get a “conglomerate” discount. They can be harder to value. The discount goes away after a spinout, when sector analysts get a better chance to dig in on pure plays. Next, companies spinning out divisions hate to burn shareholders. So they push businesses out at reasonable valuations without splashy roadshows to drum up interest. Finally, the initial reaction of fund managers to spinouts is often to dump shares, because they already have their allotted exposure to that sector, or it’s not a group they want to own.
An example from Broad’s portfolio now is Wyndham Hotels & Resorts /zigman2/quotes/209332327/composite WH -3.02% , a franchise hotel business spun out of Wyndham Destinations /zigman2/quotes/206717710/composite WYND -1.90% a year ago. It runs about 20 hotel brands in 80 countries. Wyndham’s significant discount to peers will narrow over time, believes Broad. “It takes spin outs a few years to get their sea legs and get fully recognized,” he says.
4. Take concentrated positions
Funds that outperform consistently take concentrated positions. While the typical diversified mutual fund caps positions at 2% of a portfolio, the 10 largest holdings in Broad’s fund are at 4% to 7%, according to Morningstar. The fund only has 29 stocks.
“Because we own fewer names for longer, we can invest an enormous amount of time in research,” says Broad. “We only need to come up with a handful of names every year. It is a quality vs. quantity exercise.” This approach creates better conviction in names, which lets managers take larger positions.
Broad has a 7% position in the New York Times /zigman2/quotes/202090840/composite NYT -1.07% , his largest position. Why does he like what President Donald Trump calls the “failing” New York Times?
“The standard thinking is ‘newspapers are dead.’ It is an easy narrative. The reality is, the New York Times is among a handful of media properties with the brand equity and franchise value to convert to the digital model,” says Broad.
“The industry structure reminds me of the Napster era when everyone expected to get music for free,” says Broad. “Now you have pay subscription models like Spotify /zigman2/quotes/207488629/composite SPOT +0.17% and Apple, and people have gotten used to paying for music.” The same transformation is playing out today in journalism, he says. The New York Times divvies up its content to offer narrow subscriptions to subcategories like crosswords, or food and cooking. “They have the ability to become the Netflix of news with lots of different verticals.”
courtesy Jackson Square Partners
5. Focus on value
Broad pays attention to value, but he reject standard metrics like the price to earnings (P/E) ratio. It can be thrown off by accounting assumptions.
Instead, he uses a combination of discounted cash flow analysis and return on invested capital to come up with what he thinks is the intrinsic value of a company. This approach is used by value investors, but he applies to growth stocks. Return on capital is key here.
“You can have a lousy business that you dump money into to grow earnings or revenue, but if you are not earning a compensatory return on capital, you are not creating value,” says Broad. Wyndham Hotels & Resorts looks cheap using this system.
6. Hedge your bets
Though Broad runs a growth fund, he takes defensive positions as long as they have potential for growth. Consider Equity Commonwealth /zigman2/quotes/200970836/composite EQC +0.97% , a real estate investment trust (REIT) in office properties.
Equity Commonwealth has sold off scores of holdings in the last five years. So it now has $3 billion in cash. That’s about $23 per share or 70% of the current $33 stock price. The huge cash position makes this a defensive position. “This was our best-performing stock in the fourth quarter,” says Broad.
But there’s potential upside, too. Real-estate mogul Sam Zell chairs the operating company and he’ll be ready to pounce If office real estate gets hit in a recession. “He’s an astute real-estate investor sitting atop dry powder,” says Broad. “We are betting on a dislocation in the real-estate market. And if that happens, Equity Commonwealth will be a huge contributor to performance.”
At the time of publication, Michael Brush had no positions in any stocks mentioned in this column. Brush has suggested NFLX, WMT and MSFT in his stock newsletter Brush Up on Stocks. Brush is a Manhattan-based financial writer who has covered business for the New York Times and The Economist Group, and he attended Columbia Business School in the Knight-Bagehot program.