[PODCAST] Value Investing in Today’s Environment

Prospector Partners Portfolio Manager Kevin O’Brien, CFA, and Havener Capital Partners Founder & CEO Stacy Havener recorded a podcast in which Kevin elaborates on his backstory as an analyst and co-portfolio manager of a flagship Neuberger Berman mutual fund, among many other topics.

By listening to this podcast, you will also hear Kevin elaborate on:

  • The struggles of value investing in today’s environment
  • How Prospector differentiates itself
  • Approaching value investing through a credit lens
  • Why a return of inflation would be so beneficial for bank stocks
  • How the team has re-positioned the portfolios

We invite you to listen to this podcast (previously recorded in October 2020--22 min).

Listen to the interview

Or read the transcript of the interview below. 

Interested in more insights from Prospector?  View our content library for access to Q&A’s with Prospector Portfolio Managers, commentaries, white papers and more. 


Kevin O'Brien, CFA & Portfolio Manager/Analyst at Prospector Partners
Stacy Havener, Founder & CEO, Havener Capital Partners

Stacy: Hello, everyone. I'm Stacy Havener of Havener Capital Partners. And today, we're pleased to have Kevin O'Brien, Partner and Portfolio Manager at Prospector Partners with us in the studio. Kevin, thank you for being here.

Kevin: Thank you for inviting me.

Stacy: So, we're going to start at the beginning. And, as I said, you've had a little prepping for this call. This is really a chance for investors to get to know the people behind the portfolio. So with that backdrop, everyone's got a story, a backstory, if you will. Tell us yours.

Kevin: Oh, my backstory?

Stacy: Yeah. How'd you get here? How'd you get to Prospector? What was the path?

Kevin: Oh, that's a good question. So, I started out working at much larger firms. Alex Brown in Baltimore for a half-dozen years. And then Neuberger Berman. And what attracted me to Prospector, which I think is what you're asking, is the fact that it was going to be very much of an entrepreneurial environment where you would know exactly where you stood at the end of the year, based upon the firm's performance.  So, as a partner there, I knew if we did well, I would do well. I think sometimes in larger organizations, things can be a little bit less clear.

Stacy: That's a great point on the entrepreneurial nature of Prospector versus Neuberger, certainly. But... and I love this. This is one of my - it's the most curious thing to me about portfolio managers – because of course, I know what you really want to talk about is your portfolio and your views on the market. And I'm making you have this conversation about your backstory!

But I'm not letting you off the hook

Kevin: Uh-oh!

Stacy: I know. So, you worked at Neuberger Berman; it sounds like you were in the mailroom. What did you do there?

Kevin: Okay. So, I was originally hired to analyze insurance stocks. And over time, the breadth of my coverage increased. And then I was actually following the firm's largest position, which was Citigroup. And Neuberger has - I think they still have - a little bit of a unique model in that you would pitch to all the big portfolio managers at Neuberger. And then the salespeople who worked there would then distribute that research to the sell side, so you were really doing both at the same time.

So I wound up following the firm's largest position, which was Citigroup. And one of the really great things about Neuberger was whether it was Hank Greenberg at AIG, or whether it was  Sandy Weill at Citigroup, they had incredible connections and were able to get all those management teams into the office. And that's something that I value to this day. Being able to interact with the managements of the companies that we own.

Stacy: That must have been amazing. And when you left Neuberger, you were the co-portfolio manager of which of their funds?

Kevin: The Neuberger Berman Genesis Fund. So, I will probably touch on this a little bit later. But when I was basically asked by the Genesis Fund to come and be an analyst. I started out with financial services, and then wound up spending some time in a bunch of other different sectors, including consumer and technology. After, I think it was probably about two years, they asked me to become a co-portfolio manager with them.

Stacy: Right. And a lot of investors know that fund, which is why I wanted to make sure we tied it back. Okay, Kevin, staying with backstory, but maybe pulling it forward a little bit: You've been at Prospector for a very long time. You've been there for 17 years. What are you most proud of?

Kevin: What am I most proud of? I would say that we have a very unique philosophy. And our common theme is that, you know, we look at the downside of companies first. So, I think what I'm most proud of is that when everybody is getting nervous, we've been a sleep-well-at-night firm, for the most part. Where, we tend to lose a lot less than our competitors when the market environment is really tough. And I think we've done that - we've proven that over a long period of time. So that that would be it.

Stacy: That's a great answer. Let's stay with the philosophy. You mentioned philosophy there. And one of the things you say at Prospector that's different. I want to explore it a little bit. Is that you approach value investing from a credit perspective. What does that mean?

Kevin: So, it ties in with my last statement really nicely. In that, so most people focus on the income statement first and then make their way to the balance sheet and cashflow statement, et cetera. We look at the balance sheet first.

So, probably the single most important thing when we're analyzing a company is really stressing how much debt do they have currently. And if things go really poorly, can they afford to have that amount of debt? You know, would, would there be anything that would cause them, um, to have a problem?

And anything is probably a little too strong. But what we'll do is we will go back to the Great Financial Crisis. And we'll look at how bad things got then, and say, "If it happened again, you know, how, how impactful would it be for this company? And, would they make it through with a margin of safety?"

And so, that's what we're really talking about, is looking at the debt, looking at the cashflows, looking at their ability to service that debt, and obviously going through the environment that we just went through. It'll be another good stress point for all these companies to see how they, they weather the storm.

Stacy: That's interesting, and it ties back to what you said earlier, too, about what you're most proud of. You know, focusing on downside first. I think a lot of people say that. A lot of investors say that. But very few actually have a process that is oriented around that. So that's great color.

So let's move a little bit into strategy and outlook. There's this quote that I love from Seth Klarman, which says, "You don't become a value investor for the group hugs." And certainly in the last, I would say, few years; but it's more than that; value investing has been, and still, really, under some pretty significant pressure. What gives you faith that value is not dead?

Kevin: Yeah. That's a really good quote.

I think most, most good investors, and most value investors, have a bit of contrarian in them. That's my belief. So one of the most important things when we're looking at companies is, we want the Street to hate it.

We don't want to see a lot of buys. And the philosophy there is, if everybody hates it, and they're all at sell or neutral, there's only one way that they can go. If everybody's already a buy, there's only one way that they could go.

So, we're very happy to sort of bid on; it seems like it's a smaller and smaller and smaller group of value investors. So, you know, I think it's exactly right. But, to answer your question, what makes us think that value isn't dead; I would reflect back on the first portfolio management job I had at Neuberger Berman. As we were in the latter stages, thank God, of a tech bubble. And what happened was every single day, we were getting redeemed, because we were too boring and we were value, et cetera. And, then it switched. And I see a lot of the same characteristics today that I saw then. A lot of speculation. A lot of people willing to pay any price for an increment of growth. You know, super-stretched valuations on certain companies. People, basically companies that were started, only a couple years ago, they're willing to pay super-outrageous prices for. So, I also think that we're setting up pretty well for higher inflation for better economic growth in the future.

Kevin: Also, I think we're in the early stages of a V-shaped recovery. And value tends to lead in those type of environments. And the market action over the last couple of weeks, seems that more and more people are starting to, agree with this line of thinking. And, hopefully this is a trend that can last for a couple different years.

It helps that the Fed is going to let inflation go higher. I think it also helps that we're confident that stimulus will get done, which we think will also be inflationary. And depending upon the election goes; if the polls are right, which we're skeptical, but we'll see. You could easily see a Biden victory and a blue wave, and a big infrastructure bill, which would also be extremely inflationary. Which would, which is good for value stocks, actually.

Stacy: Great insight.

You know, you said something, I want to go back to, which is that there's not that many value investors anymore. And I think that's true on a lot of levels. But do you think that because they've capitulated?

You mentioned the tech bubble. I know a lot of true value investors were pressured at the big firms to, like, get growthy. Because that's what people want. So, is that happening now? Or are people just giving up? Are value shops closing? What do you think the dynamic is there?

Kevin: I think you're 100 percent right. As you know, there are some classic value investors that I've come in contact with throughout my career. And many of them own, a bunch of the names that would be considered growth stocks. So, I understand where they're coming from.

I think a lot of people have gone for the growth because it's worked over a very long period of time. And so, not to say that a lot of those companies aren't great companies. Many of them, many of them are.

It’s just, I look at some of the numbers on my screen. It's like, "You think they really created 462 percent of additional value over the last 12 months?" I mean when you see so many stocks up 100, 200, 300, 400 percent, I just don't think that companies compounded those kind of rates. It doesn't make sense.

Stacy: Yeah, there's some common-sense thinking that needs to go into that, for sure.

Let's go back to your comment about balance sheets and value investing from a credit perspective. So clearly, as a firm, I would say, Prospector is not afraid of a complex balance sheet. You invested in financials throughout '08, you know, some of the most difficult markets. And then obviously, you, in your career, have dealt with some very complex balance sheets.

Kevin: Right.

Stacy: So, talk about what you're seeing right now in banks. That's the kind of area; if you have a complex balance sheet; it's a little bit of a sweet spot for Prospector. What's the market missing?

Kevin: Okay. So, you need only to look at what we have going on in the last week.  I would say a couple different things. The consensus is, "Oh my God, interest rates are going to go negative." That's one. Two: "Oh my God, every business is going to go broke." And frankly, a lot of small businesses probably will go broke.

I would say the, the last thing is, they're gonna struggle to get any kind of loan growth. So, there's a lot of negatives, which is why we're in bottom decile–type valuations. But I think one of the things that people are missing is, I talked earlier about rising inflation. Obviously, higher interest rates would be, like, manna from heaven for the banks.

While we have a spread between twos and 10s, with the 10-year sitting at under one percent, it definitely puts strain on banks. And would be way better if rates were double or triple that on the 10-year, which I think could happen over a long enough period of time.

And so, what happened this week, and what, what is interesting, is that there was an accounting change, right when the crisis hit called CECL, which required particularly the large banks, but many of the small and mid-size guys are following and doing the same thing.

They were required - as opposed to putting up the reserves as on a pay-as-you-go-type basis - they have to put up all the reserves based upon whatever their economic forecast is.

So to get to the point: If, as of the first quarter you thought the unemployment rate is going to be, let's say, 15. And then it turns out, as of the third quarter, you're down to a much lower number. Companies are going to reserve a lot less than what people were thinking. And that's exactly what's going on right now in this quarter.

Such that if you were to project forward, you could see many of these companies' earnings estimates rise by an excess of 20 percent. Because the Street had assumed that they would continue reserving for far longer than, than it now appears. You know, and I don't think the Street will literally just bump estimates that aggressively.

Of course, we're still in a very uneasy and unpredictable economic environment. But I think that's the first thing they have wrong. The credit loss is particularly at the mid and larger banks, I think are going to be less than what's implied in the stock prices.

The second thing is, I don't think interest rates are going back to four or five, six percent anytime soon. But, I do believe that they can gently rise to one and a half or two on the 10-year. I think these stocks would absolutely rocket in that type of environment. So, that's the second thing.

And the third thing is, I think if we get an infrastructure bill - an additional stimulus - I think you'll see better economic growth than, than people think.

And the other thing is, that I think Biden winning will probably loosen a lot of the trade restrictions that are currently in place, that the Trump administration put in place.

So I'm not bearish on Biden winning, because I think that there are plenty of offsets in his plan. Such that I think, no matter which way it goes, I think we're gonna have decent economic growth going forward. Which would help their loan growth. Um, of, of, of these banks.

Stacy: Super insightful and timely. You mentioned sort of what's happening with small businesses, and maybe the picture's not as bleak as consensus might lead us to believe. But is there something happening between sort of the smaller banks and the regionals, versus the big? What's going on there?

Kevin: Yeah, that's a good question. I would say that one of the changes that we made in our portfolios is that the bigger banks are banking customers that have access to the capital markets; whether it be debt or equity. And the smaller companies - the smaller banks are banking smaller companies that don't have access to the capital markets.

So, I don't think it's hard to figure out that while the credit losses might take a little while to run through; and they might be reserved for them; I think it'll probably be somewhat worse at the smaller banks. So, for a whole bunch of different reasons: better liquidity, same; in many cases, same or better valuations, we moved up market caps to a certain extent with our bank holdings. Thus we thought that they were better positioned than a lot of the, the really little guys. We still like a bunch of the smaller banks. But in general, we did a little bit of a shift.

Stacy: Okay. And that's a difference from how you played '08.

Kevin: Yeah, that would definitely be a difference from '08. You know, the, the other thing that's probably worth mentioning on the banks is that some of our smaller banks are now buying back stock. Because we tend to own names that are very over-capitalized. And for, for a little while there, in the midst of the early stages of the crisis, it didn't seem like anybody was gonna be allowed to buy back stock. But the smaller companies are being granted permission to repurchase shares. Meanwhile, the bigger banks are still handcuffed.

Stacy: That's just great. That's good, good insight there.

So I want to end with something; normally I would end with my favorite question. I'm going to give you a pass, because I'm going to make you come back, and talk with us again. But normally, I'd ask you the question about what's your walkout anthem? And then you have to give us a song. But today, we had an investor call recently and an RIA asked a great question. And I thought, "Oh, this is a good one. I'm going to ask Kevin."

So, the question that the RIA asked of the portfolio manager was, "What book had the most impact on you as an investor?"

Kevin: Yeah. So, I would preface this by saying I've been an avid reader; particularly of value investing. So I've read countless Warren Buffett books and I love reading about market wizards and a lot of the stories about some of the great investors.

But I would actually pick Soccernomics. And, and the reason why is they were essentially value investors in that book. So there are certain clubs, soccer clubs, throughout the world that do a very good job of performing at an extremely high level on a budget. And what they're doing is assigning values to their players. And when somebody is willing to pay, overpay, by a vast amount for one of their players, they sell them. And they actually have a list. And they always have the next guy and the next guy on the reserve teams that are backups to the first team, et cetera. So that they could slot somebody into that same position. And, it just struck me as, "Hey, this guy's a value investor." So, it was impactful.

Stacy: And not to mention that you're a huge soccer fan and play soccer. So there's a lot of ties on that book for Kevin O'Brien.

Kevin: That is true.

Stacy: It's interesting. I'm glad you said that book, actually, because... not that it wouldn't have been cool if you had picked one of the Buffett books… it would have been.. but it would have been sort of expected, and I think Soccernomics is an unexpected answer, which is fun. And different. And a great reminder that we can all learn so much from other industries, not just our own.

Kevin: And, and if anybody wants a copy, let me know because I managed, as a good value investor, I managed to ... one book was something like 20 dollars. And I think 60 was... I don't know, maybe it was 100 dollars. So I bought 60 of them!

Stacy: So amazing.

Kevin: I gave them to everybody on my team and anybody who has any desire to learn a little bit about soccer and the economics of it. I give them a copy.

Stacy: I love it.

Kevin: And I still have a bunch left over.

Stacy: I love it. It's a perfect ending. Thank you so much, Kevin, for being here. Really appreciate the time with you, and look forward to talking with you again soon.

Kevin: Thank you.



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