Value investing is like a ‘pop quiz.’ This fund is scoring high.

  • By Nicholas Jasinski,
  • Barron's
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It’s a sad fate that befalls numerous value investors: buying cheap stocks that screen as highly attractive on a variety of valuation criteria, then watching them stay frustratingly cheap as declining fundamentals justify their discount.

But effective value investing is about more than just looking for cheap stocks, says C.T. Fitzpatrick, founder, CEO, and CIO of Vulcan Value Partners, based in Birmingham, Ala. (That’s “Vulcan” as in the hard-laboring blacksmith and Roman god of fire whose colossal statue towers over Birmingham—not the extraterrestrial humanoid species from Star Trek.)

A value investor still needs to own high-quality, defensible businesses. The value lens just defines the entry point: when a stock’s price falls meaningfully below its intrinsic value. That gives it a “margin of safety,” a term coined by Benjamin Graham, the father of value investing.

“The future is going to come at you and it’s going to do what it’s going to do,” says Fitzpatrick. “If you have a shock-absorber margin of safety, then you’ll be OK.”

Fitzpatrick, 57, emphasizes the importance of culture and alignment of incentives at Vulcan, which he founded in early 2007. All employees at the firm must invest exclusively through Vulcan funds, signaling their commitment and keeping them focused on the long term. The firm now has more than $20 billion in assets under management and 65 employees, including 18 on its research team.

Vulcan maintains a “MVP list” of some 500 stocks from across the globe. Those are businesses that Fitzpatrick and his team would feel comfortable owning for at least five years: They have competitive advantages, earn superior returns on capital, and have balance sheets strong enough to weather periods of stress. Those types of stocks are overvalued most of the time, Fitzpatrick says, and finding an entry point requires some patience.

“I think of it like studying for a pop quiz,” he says. “You never know when the quiz is going to happen, but if you’ve done your homework you’ll be ready for it.”

The result is a focus on both the numerator and the denominator in a valuation multiple like price-to-earnings. It’s about buying great businesses at attractive prices, with both that margin of safety and the potential to grow—not just looking for cheap stocks.

The philosophy underpins both the Vulcan Value Partners fund (VVPLX), with 23 holdings and $2.1 billion in assets, and the Vulcan Value Partners Small Cap fund (VVPSX), with 26 positions totaling $1.4 billion. The large-cap portfolio has returned about 51% over the past year versus a 42% gain for the Russell 1000 Value index (.RLV). Its small-cap sibling has surged a whopping 111% in the past 12 months, topping the Russell 2000 Value’s (.RUJ) 69% return.

Both funds are ahead of their category peers over the past three-, five-, and 10-year periods. The small-cap fund stands out especially, ranking in the top 1% of its category on a one- and three-year basis. But investors need to pay up for such performance: The large-cap fund has an expense ratio of 1.08% and the small-cap fund charges 1.26%, both above their category averages.

The top holding in both funds as of the end of the third quarter was fintech Upstart Holdings (UPST), thanks in part to the stock’s 160% surge from early August through late September. Upstart went public in December 2020, with fast revenue growth and solid profit margins, says Fitzpatrick. Unlike many recent initial public offerings, Upstart had been producing free cash flow for some time.

Upstart’s credit-rating algorithms take in hundreds of different data points to assess a potential borrower’s risk profile and ability to pay. The company sells that service to banks and other partners who customize and extend personal, auto, and other loans based on that information.

“They’re using artificial intelligence to basically come up with a 21st century FICO score,” says Fitzpatrick, referring to the credit score developed by Fair Isaac (FICO), which Vulcan has owned in the past.

Fitzpatrick is bullish on the real estate services industry in the wake of the Covid-19 pandemic. The small-cap fund’s holdings include Cushman & Wakefield (CWK), Colliers International Group (CIGI), and Jones Lang LaSalle (JLL). It’s a highly fragmented industry, with those three among the handful with global footprints. Their services include property and facility management, representing owners and tenants in leasing transactions, advising, and helping with asset sales or financing. Their scale and diversification across classes of real estate is a selling point for Fitzpatrick.

“Unlike a REIT [real estate investment trust], they don’t have capital tied up in the physical real estate asset,” he says. “And they can shift: while retail real estate is struggling, industrial warehouses are booming. So they win no matter what.”

Cushman & Wakefield, Colliers, and JLL’s results have been hurt by Covid-19, but Fitzpatrick sees a cyclical rebound in the coming years, not a secular decline.

Amazon.com (AMZN) was, until last quarter, the top holding in the Vulcan Value Partners fund, which it first bought in 2018. The stock has more than doubled over the past few years, and trades for 62 times consensus forward earnings.

“Stock price aside, the value growth that we’ve seen [from Amazon] has been extraordinary and much higher than we’ve modeled,” says Fitzpatrick. “They’re one of the clearest winners in a post-Covid world.”

Amazon’s namesake online retail business is Fitzpatrick’s least favorite part of the company, with slim profit margins. He’s a bigger fan of its Amazon Web Services cloud-computing unit, which has only become more competitively entrenched and relevant than before the pandemic. Fitzpatrick is also bullish on Amazon’s fast-growing online advertising business—it’s akin to brands buying favorable positioning on grocery store shelves in a digital economy, and has enviably wide profit margins.

Like several of Vulcan’s holdings, Amazon’s eye-watering price-to-earnings multiple would make price-focused value investors swoon. But when measured against the company’s rock-solid competitive positioning and rapid growth potential, there’s plenty of value to be found.

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