WARNING LABELS (September 2002)

Labelling fund managers as value or growth investors risks distorting

the investment process

When I use a word, Humpty Dumpty said in a rather scornful tone,

it means just what I choose it to mean neither more nor less.

Lewis Carroll, Alice Though the Looking Glass

Marathon has often been pigeon-holed as a value manager, a description that we resist
because it over-simplifies and misrepresents our investment approach. The traditional
definition of a value manager is one who invests solely in companies with low valuations as
measured by price-to-book, PE, price-to-sales or price-to-cash flow. The value approach is
associated with Benjamin Graham who sought unloved stocks with low stock price multiples
which could deliver more than was generally expected what was termed cigar-butt
investing in the sense that the object had been discarded as worthless but nevertheless
could provide one last puff. A growth manager is one who invests at the other end of the
spectrum in companies with high stock price multiples.

Companies in the Marathon portfolio have tended to have below average multiples but this
is not because we have been engaged in seeking cigar-butts. In fact, the stocks in our
European portfolios have relatively strong earnings growth. Part of the reason for this
apparent contradiction is that we have found that smaller companies with above average
growth prospects are often cheap.

Whilst smaller companies have, in the recent past, tended to have low valuations, large-cap
stocks have attracted unjustifiably high valuations. The growth of very large fund managers
is largely to blame. In Europe, the MSCI Europe index consists of 540 stocks of which only 88
have a market capitalization above $10bn. Liquidity reasons (that is, the amount of time it
takes to trade in and out of a stock) preclude fund managers with vast assets under
management from investing in stocks with market valuations below this threshold. The
trouble is that the largest cap stocks are concentrated in certain sectors and under-
represented in others. Since three-quarters of industrial stocks have a market cap of less
than $10bn, industrials are essentially screened out by the large-cap managers. By
contrast, 85 per cent of the healthcare stocks have market caps above $10bn. As a result,
pharma stocks attract disproportionate attention from institutional investors.

The issue with style labelling is somewhat deeper, however. Similar to the recent obsessions
with tracking error, indexation and understanding the "new economy", it risks grossly
distorting the investment process and requires/encourages managers to use inappropriate
tools and measurement systems to construct portfolios. Many great investors will interpret
value according to their perceptions of value. The renowned "value" investor Bill Miller of
Legg Mason has championed Amazon.com and AOL, whilst Warren Buffett, that great
disciple of Ben Graham, has preferred growth franchises such as Coke and Disney. The
latter, however, believes (or at least did believe) that these high quality businesses were
cheap (i.e. good value relative to the present value of their expected future returns) and still
regarded himself as buying value.
The fact is that one person's growth stock is another person's value stock. Recently, the
investment data company Lipper has reported that Citigroup, AIG and IBM are among the
top 15 holdings in both their large company value and growth categories of mutual funds.
This brings us to our next point which perhaps best explains why Marathon should never be
labelled as a pure value investor. Our capital cycle process examines the effects of the
creative and destructive forces of capitalism over time. A growth stock usually becomes a
value stock after excess capital, lured in by large current profitability, brings about a decline
in returns. When this becomes extreme, as was the case during the technology bubble, the
resultant bust can turn growth stocks into value stocks almost overnight.

The telecoms sector provides a good demonstration of this. Energis, the UK alternative
telecoms carrier, was bid up to a value of 10 times invested capital during the New
Economy boom of the late 1990s due to the perceived growth potential for broadband and
data networks. After an excessive amount of money had been invested in the sector,
Energiss shares were sold down to a tiny fraction of capital invested. They continue to
languish. The lesson here recently is not only the slim dividing line between value and
growth but also the danger of "value traps" since Energis (like Worldcom) never turned out
to be cheap however much the stock fell.1

Marathon's portfolio strategy in Europe and elsewhere is now shifting from the deep value
biases, maintained over the last five years, to more of a relative valuation orientation, as
stocks that were previously overvalued on their perceived growth potential have slumped.
At the same time, yesterdays deep value sectors such as basic materials, paper, chemicals
and certain capital goods now do not look such good buys from an intrinsic value
viewpoint. Our thinking is best illustrated by two recent portfolio trades. Assa Abloy is a
world leading lock company, owner of well-known brands such as Yale, VingCard and
Vachette. It has grown sales at 25 per cent per annum for the last ten years and
compounded earnings by 38 per cent a year over the same period, helped in part by
acquisitions. Its shares have fallen by 56 per cent as growth stocks have derated. Having
been bid up to 4 times sales, Assa Abloys stock now trades at less than 1.5 times sales, a
discount to our estimate of intrinsic value. We are buyers. On the other hand, we are
disposing of Stora Enso, a Finnish paper company that we have long owned, but whose
corporate strategy we have issues with. No longer a deep value stock, Stora Enso remains
cheaper than Assa Abloy on every single valuation metric other than the one which matters
but which can't be screened on a quantitative basis namely, intrinsic value.2

Investment style labelling is another convenient box-ticking, quantitative oriented procedure

beloved of consultants. Investors who adhere to one particular style are likely to end up in
trouble, sooner or later. Our belief is that stocks should be viewed not as growth or value
opportunities, but rather from the perspective of whether the market is efficiently valuing
their future earning prospects.

1
Energis was placed in administration in July 2002. It was subsequently turned around and sold to Cable & Wireless in 2005.
2
From the date of writing (September 2002) to the end of 2014, Assa Abloys share price rose by 452 per cent in US dollars,
comfortably outperforming Stora Enso which was up by 0.7 per cent over the same period.