Ricky Sandler founded Eminence Capital in December of 1998 in New York City. Since inception it has achieved close to a 13% net annual compounded return. Despite being a value-oriented fund, it had positive returns in the internet bubble and growth obsession of 1999 when most value investors were down in double digits. Actually, during its 13 year lifetime, Eminence Capital has had only one down year (19%) in the financial crisis of 2008. Their investors have rewarded the performance by entrusting close to 3 billion dollars in the flagship fund Eminence Capital.
Although his father is a Goldman Sachs alum who operates his own independent hedge fund, Mr. Sandler, right after graduating from University of Wisconsin, started his career on his own as a research analyst for Mark Asset Management. At the age of 25, having honed his investment talent under Morris Mark, he co-founded Fusion Partners with his colleague Wayne Cooperman. The partnership started in 1994 with assets of 28 million dollars and after 31% net annual returns mushroomed into 350 million dollars by 1998. Differences between their investment philosophies led them to dissolve the partnership in an amicable manner and start their own funds in late 1998.
Ricky Sandler’s investment philosophy is oriented around what he calls “quality value”. Although it is indeed similar to what he practiced at Fusion Partners and Mark Asset Management, it has undergone some vital modifications – namely, an emphasis on pricing “growth of value” and the virtues of short selling – which distinguish it from his previous associations in particular and value investment theory in general.
Under the mentorship of Morris Mark he absorbed the importance of conducting deep quantitative and qualitative research to uncover great businesses worthy of owning. Unlike Mr. Mark, though, Mr. Sandler is more focused on the price being right even for a great business, seeking a discount akin to deep value investors. On the other hand, if there is a mediocre business available for a yet deeper discount in the market, that always comes into Eminence Capital’s investment radar. He captures he two extremes of this spectrum by saying he is interested in owning a “great business at a reasonable price” and “a reasonable business at a great price”, and anything currently outside of this range is not part of their investment universe. More pointedly, there is no place for a low quality business regardless of rock-bottom stock price or any actual or perceived event – not on the long side of the portfolio anyways.
Unlike his tenure at Fusion Partners, where he retained an 80 to 20 long to short position ratio, in his current fund Eminence Capital there is more allocation given to the short side. In the 13 years of its existence, Eminence Capital has averaged a 120% long and 70% short exposure. The reason for this long-short mix dates back to 1998 when in the market downswing Fusion Partners saw an approximate 15% profit go to a 15% loss within a couple of quarters. This brought about the realization that it is psychologically very difficult to average down in long positions when the threat of extinction of the investment management business itself is looming over the manager’s head. Although 1998 ended up being a mostly flat year for the fund, Mr. Sandler made a commitment to pay as much heed to short positions as to his long exposure, since simply being able to go long aggressively when everybody else is selling from fear and redemptions in itself can yield significantly higher returns.
Besides the advantage of being able to unemotionally average down on current long holdings and buy newly undervalued stocks in a falling market, shorting also introduces the element of skepticism which plays a crucial role in investment management, especially for a value investor. Having to seek shorting opportunities triggers the thought process of assessing stocks in a totally distrustful light and exposes value traps created by creative accounting or unreasonably optimistic management projections.
Moreover, in a short-long portfolio, the invested capital is subject to less volatility. Again, this provides the fund an emotional and psychological advantage, and further prevents redemptions from jittery investors in a down market. Also, since Eminence Capital seeks to make most money on their value-oriented long expertise, to be gross long upward of 120% with less volatility than a 100% long exposure works well from a leverage perspective. Lastly, the short exposure allows them to be reasonably protected from systemic risk caused by outliers such as terrorist attacks and currency meltdowns.
Although Mr. Sandler originally used to construct the fund’s short positions mainly through individual stocks, now he also employs indices to achieve the same. The main reason for that is to dodge the risk of M&A deals whereby a truly bad company can be bought at a high valuation because of a strategic fit desired by the buyer. For instance, Eminence Capital had shorted Albertson’s and Sport Authority, which they believed were structurally poor businesses, but both of them were acquired at a higher valuation than the then current market price.
While shorting individual stocks, the research is focused on reported earnings – the disagreement between the markets and Eminence Capital about the reported earnings. Often the earnings are being taken at face value by market players that result in the overvaluation and the opportunity to short. Mr. Sandler concentrates on accounting issues such as accounts receivable growing much faster in relation to revenues, cash from operations that is not translating into net income, and shrinking returns on invested capital, to understand the true earnings of a company. Also, he finds a disconnect in his projections and consensus forward earnings of companies that he deems to have structural issues. Since analysts tend to only revise their estimates when the structural issues have clearly emerged, this creates a shorting opportunity for the early mover.
As to shorting of indices, after his initial wagers on smaller cap stocks in the late nineties and early 2000s, it seems Mr. Sandler has continuously found the small cap stocks to be overpriced in relation to large cap stocks. Back in 2006 he thought the Russell 2000 index comprising many undesirable companies traded at a 20% premium to large caps. As recent as late 2011, he highlighted how cheap the high quality large cap stocks are today.
On the long side, Eminence Capital actively searches for discounts that are created by: (1) A good business in an industry shunned by analysts for any reason, (2) A good company that has “tripped” by delivering disappointing short-term earnings or through other catalysts that have not impaired the company’s long-term value, and (3) A good company that is not in plain-sight or analysts’ radars for various reasons ranging from being overshadowed by more prominent lines of business to undergoing through a special situation such as a spin-off.
According to Mr. Sandler, he has been reproached by value investor friends for his seeming willingness to pay too high a price for quality companies. Yet, it is not that he is paying for growth in the traditional sense of growing revenues or earnings at a fast pace – instead he is willing to invest in high quality companies that are growing numbers at a slow pace. His concentration is on above-market rate of growth of value.
In order to capture this value growth, the entry price is crucial. So for a very high quality company, Mr. Sandler will buy the stock even if it is trading at a 25% discount to his estimated valuation. On the other hand, if the company is somewhat mediocre, then only a 40% to 50% discount to stated valuation will attract their funds. Overall in the long side of the portfolio, the blend between high quality and mediocre companies are ideally bought at an average discount of 30% to 35% to intrinsic value and the subsequent value growth rate averages 15% to 20%.
His preferred entry into a stock is in the context of what he terms “old research, new events”. These are usually companies that they have already identified through diligent research as high quality but they could never purchase because of high valuations. The new event (which could be the company being tripped or the industry falling out of favor) suddenly triggers a discount, and they can move in “quickly” as the research has already been done.
Even on the shoulders of “old research”, however, they do not build their position in one trade, but initially take a smaller “R&D” stake of 1% to 2%. Prior to even the “R&D” carve-out, though, the stock is subjected to further detailed research.
An analyst is assigned to the stock that helps one of the principals in deeper and on-going evaluation. With the input of the principal, the analyst prepares a succinct two-page report summarizing the relevant quantitative and qualitative aspects of the company.
On the qualitative side, where usually a lot of research has already been done, the internal report outlines the company’s lines of businesses, the competitive environments in which they are operating, the background and quality of management, and whether there is any outstanding litigation.
On the quantitative side, they scrutinize all the quarterly and annual SEC filings along with the conference calls to encapsulate all the numbers. Special emphasis is paid to return on capital in that the ratio of EBIT to invested capital is at the minimum in high teens. This ratio is studied with and without the role of goodwill in order to isolate the influence of capital-allocation decisions as opposed to operating decisions. Having analyzed EBIT, the amortization and depreciation of the EBITDA is examined. Some form of amortization is preferred as that often translates into a higher cash flow that is not reflected in net earnings (the latter being the choice method of markets to value companies, thereby the reason for the undervaluation). The relationship between capex and depreciation is stress-tested to ensure the business is not unreasonably capital intensive.
After the qualitative comprehension of the business and quantitative number crunching, they get on direct calls with the company’s management to ensure their internal analysis is aligned with the management’s operational and financial outlook. As long as that matches up, the R&D stock position of 1% to 2% enters their portfolio.
Now begins the actual on-the-ground research which determines whether the position will be eliminated or increased to a meaningful stake of anywhere from 5% to 7% of their portfolio. Mr. Sandler contends that having invested capital creates a sense of urgency in the follow-up research that is not psychologically possible with a mere theoretical interest. The assigned analyst and principal spend numerous weeks visiting the management of the company and engaging in discussions with whoever is relevant to the business, franchisees or vendors or distributors. If all the information they gather from these various sources bodes well for the business and the industry, and nothing points either to an earnings miss being a structural rather than one-off event or the industry’s woes being permanent rather than temporary, only then they deploy further capital into the investment idea.
Although they have no general criteria for exiting a position, their investment time horizon is usually no more than two years. During their holding period they continue to closely monitor emerging information about the company and it industry, and the price of the stock. They will exit a position earlier if new information nullifies their original investment thesis, or if the stock appreciates much faster than they anticipated. In the latter case, say, if 50% of the anticipated gains happen in two quarters , they would book them and roll the funds to a stock that offers more value growth, the true measure of value.
“There are two ways to win: Appreciation to intrinsic value and appreciation from intrinsic value.”
“Volatility can be a friend of the value investor – it provides more situations where stocks significantly diverge from their intrinsic value and can allow us to turn our capital faster.”
“High quality stocks are often less sexy than low quality stocks”
“It’s not about how sales are going this month, it’s trying to understand from the people in the trenches things like how good the products are, why they have the market share they do, what’s happening to the market share and where the money is made in the system.”
“We like businesses that grow in value.”