Steamroller Blues… Active Management & Value

The FEG client education piece mentioned in this podcast is titled "Walk, Don’t Run," and covers the pandemic, bear markets, and opportunities. If you’re interested in this piece, please contact us.







Staley Cates of Southeastern Asset Management, a Memphis native and music buff, joins us for today’s episode in our Dallas on Download series, Steamroller Blues…Active Management and Value. Listen in to the conversation as we dive into:

  • The current market environment compared to those of the past
  • Does active management still work?
  • Value versus growth
  • Will giants like Microsoft, Facebook, and Amazon take over the world?
  • Extracting value through engagement
  • Buying what others are selling


Staley Cates

Vice-Chairman | Southeastern Asset Management, Inc.

Mr. Cates serves as Vice-Chairman of Southeastern and has 35 years of investment experience. He is a co-portfolio manager on the Longleaf Partners, Small-Cap, International and Global Funds, as well as the Longleaf Global UCITS Fund. Mr. Cates is a member of Southeastern’s Executive Committee.


Greg Dowling

Chief Investment Officer, Head of Research, FEG

Greg Dowling is Chief Investment Officer and Head of Research at FEG. Greg joined FEG in 2004 and focuses on managing the day-to-day activities of the Research department. Greg chairs the Firm’s Investment Policy Committee, which approves all manager recommendations and provides oversight on strategic asset allocations and capital market assumptions. He also is a member of the firm’s Leadership Team and Risk Committee.

Podcast Transcript

Greg Dowling (00:09):

Welcome to the FEG Insight Bridge. This is Greg Dowling, head of research and CIO at FEG. This show spans global markets and institutional investments through conversations with some of the world's leading investment, economic, and philanthropic minds to provide insight on how institutional investors can survive and even thrive in the world of markets and finance. As we all stay home to do our part to flatten the curve, our current series, Dallas on Download, highlights speakers who were originally going to be featured at our Dallas Investment Symposium that was canceled due to the coronavirus. This limited series will offer insights across a variety of asset classes and styles, including energy markets, credit markets, value investing, and biotech.

Greg Dowling (00:56):

For today's show, our guest speaker, Staley Cates of Southeastern Asset Management, is a big music fan and a native of Memphis, Tennessee. Therefore, I could not think of a better title for today's podcast than the old Elvis song, "Steamroller Blues," especially when talking about fundamental, active management and value investing.

Greg Dowling (01:17):

All right, big FEG welcome to Staley Cates of Southeastern Asset Management. Staley, thanks for joining us today. If you wouldn't mind, if you could introduce yourself and Southeastern as we start.

Staley Cates (01:32):

Sure. Well, Greg, thanks a lot for having me, and indirectly, us. I am vice chairman--which means pretty much nothing--of Southeastern Asset Management. We manage the Longleaf Partners' mutual funds, so some clients know us as Southeastern and some as Longleaf. I've been here 34 years and the firm was founded 45 years ago. We're an all-equity shop. As you know, we're in the value camp. I guess the best way to explain our own cut at that would be a Benjamin Graham mindset of how you look at Mr. Market and how you try to take advantage of that. We'll of course talk about that more later. If you look at our most descriptive terms, we talk about being long term, concentrated, and engaged. Those mostly speak for themselves. I think the "long term" part is super rare these days in terms of measured holding periods and how people come with a horizon or how they approach the work. That seems to be more and more rare.

Staley Cates (02:37):

We are concentrated, and our "engaged" adjective is really about just treating these businesses like we own them ourselves and trying to be good stewards, good owners, and active participants in the process. Our most important feature would be our alignment. We think this is the best in the industry--at least we don't know of a better version. Ever since we've been formed, and especially ever since we had the mutual funds as a vehicle, we require all employees--not even just the investment people, but all employees--to do all of their equity investing in our own funds. That does not mean we will be right or great, but it means we are properly aligned and it's going to hurt us first if we do a poor job. What that has meant over that many years of compounding and doing that is that we as a shareholder group, including our foundations, we are our largest shareholders. So we come at this as principals, not agents. That colors everything we do.

Greg Dowling (03:31):

Alignment is important, definitely. Hey, Staley, thanks for that introduction. In your introduction, you said that you all have been around since the 1970s, so that means you've seen a lot of different market environments. I think we'd be remiss if we didn't ask you, just given when this is recording, during a pandemic, to compare and contrast this current environment to other environments that Southeastern has invested through.

Staley Cates (04:01):

Well, I guess starting with the least analogous, the crash of '87 was kind of up there in terms of speed with this one, but in no other way. There was not an economic problem, there was obviously not a pandemic, and it was the reverse of earnings yields and bond yields. Earnings yields were half of bond yields--that was way out of whack and that got corrected. That's the opposite of today's situation. Being master of the bleeding obvious, the speed part is unprecedented. The pandemic-driven part feels unprecedented in the U.S., but it's really not in Asia. Including Ken, who runs our Asian office, we've had some of our principals live through SARS and MERS, so there are some precedents on that, even though it did nothing like the market destruction this is doing.

Staley Cates (04:54):

Past that, I think I would take a combo of some of these different crashes. The internet bubble obviously featured this narrow tech leadership--although I don't think the valuations are as crazy on some of the big tech things now as they might've been in the internet bubble. But there's definitely a common feel on that, including versus value. Then on the GFC, you know, that feels a little bit similar in some of this financial madness. I mean, every day there are government, Fed headlines about stimulus and free money and all the stuff that we did, that QE stuff started. That's also not quite as bad. At that point we would talk to CFOs every day who couldn't get their cash. It was locked up. And y'all and we would have clients who were like, "We're going to 25% cash even if we're a long-term endowment." And all kind of...

Staley Cates (05:50):

I think that financial craziness might've been a bit worse in the GFC, but you do see some of this now. And we do have a lot of conversations with CFOs and do get into things like, "Tell us about your daily liquidity. Are we safe on that?" Conversations you didn't have to have at other times, even in corrections or pullbacks. I guess the last thing on this would be that another kind of unique feature has been that the leaders going into this, which had created this whole growth versus value thing, and even fed the active versus passive thing, their leadership has been maintained. Nothing's really changed. If anything, it's torqued it up a notch, such that the value gap that we'll talk about more is still there. If anything, it just accentuated it in the last couple of months.

Greg Dowling (06:35):

Being a fundamental active manager, doing deep research, how the heck do you ascertain what a company is worth? When about a third of the S&P has withdrawn its earnings guidance, how do you know what you're buying?

Staley Cates (06:54):

Well, it is a great question. For a meaningful or major slug of that universe, you don't, and you can't. This is, to us, a benefit. When we talk about being concentrated, which follows the whole Buffett and Munger coaching on... I love it when Munger says, "Sit on your ass." I love it when both of those guys say, "You don't have to swing at every pitch." We're going to own 20 to 30 names, so we don't have to play in every sector. We don't have to make a call on so many of these things. So to your question, there are plenty of things where we say, "too hard bucket" and/or "that's just unforecastable." Because going to two other categories, what we can do is we can look at companies where they're either doing just fine through this pandemic and through this economic depression/recession, or weirdly, some of them may even benefit from it.

Staley Cates (07:49):

We bought Prosus, which was a way to own Tencent. Tencent just reported yesterday an incredible earnings. They actually benefited from this. Obviously those are rare birds, but some of those are out there. That's category one of "they're fine," and your analysis is more business as usual. There's a second category where it's definitely not fine in this pandemic and this GDP crash, but these are trophy assets that have incredibly high odds of being there long term, so it's just not a huge leap to go forward. You can throw away the next two years of results and you don't have to make a guess on when things turn and when we have a vaccine--all those extremely important things. You're saying, "From year three and beyond, these are such great assets that we will be more than fine." Those are the two categories we're buying--both with the fresh cash that we had going into this and then with the upgrading of the portfolios that you would expect us to do during.

Greg Dowling (08:53):

Yeah, that makes sense. We talked about this pre-call, that the two client questions we get all the time on equity is one: "Does active management still work?" And then two: "If active management still works, does value work?" I want to put you on the spot here a little bit because I know you're a big music fan. What song title do you think accurately describes your feelings on active management, and then also value?

Staley Cates (09:27):

Well, I'll start on the active and then I will segue into value, because they're definitely related. The song titles definitely turned me towards--as a longtime Memphian, a native Memphian--towards Soulsville, which is the district that had the Stax Records label, the Hi Records label, and the Royal Studios. And since it's all about waiting and delayed gratification, and there are very few of us value dinosaurs left, I'll shout out both Stax and Hi/Royal. So Stax would be "Wait Til the Midnight Hour" with Wilson Pickett, where we're promising a bunch of good stuff later. "Tired of Being Alone" from Al Green. We definitely feel alone. And Al Green did that in Soulsville at Royal, so that's pretty fitting. I can't shout-out a better music area than Soulsville.

Greg Dowling (10:19):

I like it.

Staley Cates (10:23):

Starting with the active--and I will not sing a song here just for the mercy of your clients.

Greg Dowling (10:30):

[Laughter] Yeah, please don't.

Staley Cates (10:30):

I guess the first thing is... Of course we'll talk our own book here on active, but I would actually start by saying there's definitely a role for passive. So everything I say will be in the context of: there's a good balance of those things. I'm not trying to be the zealot about active. But on the passive part... John Bogle was a patron saint of our business. He's actually a very good friend to our firm. Even though we had different investing religions, our principles on shareholder alignment were very similar, on governance--all that stuff that everyone would agree matters. But where we would have disagreed with him is... As the leader of all passive, even he said there's a time when it could go too far and be unhealthy, but he pegged where indexation was at like mid-40s or something in the 40s. We would submit--and y'all would have better data on this than we would, but we would submit it's gone way beyond that, because that doesn't count ETFs that are functioning as index surrogates. That doesn't count, especially, shadow indexers.

Staley Cates (11:39):

If a money manager has a super low active share and they have over a hundred stocks, they're just trying to keep the fee, and that is a shadow index. So we would submit that this passive and indexing thing has gone way further than advocates say. That has just meant that many more people are buying without any regard to what they're paying for that or why. It's just mindless. Jim Grant had great stuff on mindless buying and how that's happened. That's just enormous. Part of this existential active versus passive is that active has, of course, underperformed. Even though it's done that historically. That's done that over other long periods of time. But I think the current version of why active doesn't work has to do with quant power--i.e., they're saying this time it's different, that active will never come back because the quant power out there is so widespread and large that it has beat out any inefficiencies, that there just aren't enough inefficiencies for an active manager to make a living. And if so, it's just going to be too risky.

Staley Cates (12:51):

So taking that further, a couple of things about the quant power. One would be that, just like the weather forecast that we all rely on, the quant power has meant that the next few days and maybe the next week are incredibly on target in the forecasting, because of what science and the math can do. But the weather forecast looking out a few years is totally meaningless. Not because the quant power isn't there, but because there are too many variables in that equation. The same thing applies to investing. The quant power, the research that we see and often use, that usually has to do with an edge in this quarter, maybe this year, but that is still short-term stuff like the weather forecast. It does not help the three-year forecast, such that every name we have is going to have an arbitrage of short term versus long term. And the quant power doesn't change that or take that away.

Staley Cates (13:46):

Another thing about this that's really timely in the pandemic is there are so many incredibly interesting examples during the pandemic of crazy events that show that fear and greed have not disappeared, even with the quant power and the clinical statistical analysis that's out there. Look at Williams, which is something we bought--the pipeline company with the most stable cash flows possible. It's tied to natural gas units, not prices. It has nothing to do with all this oil stuff. And that stock went down by half. It went from 19 to 9 and literally was such a panic moment at the company that they put in a poison pill, because after pipelines have sold for low to mid-teen multiples of cash flow for forever, it feels like... This had gone to 3.5. That makes no sense. They still can't really explain why it happened. It has bounced back since then, but the clinical efficiency and the lack of... Fear and greed had not disappeared in that specific example, and there are other ones. Like Exor correlating with Italy, which in turn is correlating with the coronavirus. That doesn't have anything to do with Exor's NAV or any of that. That's a long-winded way to say we do think inefficiencies will be there because they get back to fear and greed, and those emotions have not been repealed in psychology.

Greg Dowling (15:14):

Gotcha. So to summarize that, you mentioned all of that clinical versus emotional, but earlier you also said active management's really a bet on time horizon, you have to have a longer time horizon to beat the machines.

Staley Cates (15:31):


Greg Dowling (15:33):

When you get to value investing, how long of a time horizon do we need for it to work?

Staley Cates (15:40):

That is the great question, but that's also the frustrating part of being a value investor. We are not naturally patient people, so this has nothing to do with our personality traits. But the question can't be answered, which is why it does require patience. You never know how you'll get paid, the payoff patterns. Again, you guys would have the better data, but it's something of the ilk of 90% of your payoffs happen in like 10% of the trading days. That's just what it is. If you knew what the catalysts would be and how you'd get paid, it wouldn't be a 50 cent dollar. You can't have it both ways. That's why I mentioned the Buffett part versus the Grant part. That's why, when you don't know how long it's going to take, you've got to own a great quality asset with great managers, because they've got to be building the value while you wait.

Staley Cates (16:33):

That way you're not just only in this time arbitrage game. Your value is growing, and that gives you the comfort on not knowing when the payoff is going to happen. Then the last part of that is: this is why your partners are everything. You better have great partners running it for you. They've got to care more and they've got to own even more. They will figure out what those catalysts are and how to get you paid. And that's the only other reason we can afford to wait without knowing the answer to that question.

Greg Dowling (17:03):

A couple of folks have made some interesting comments that value has been discovered and it's been mined. And it's been mined by the smart beta and it no longer exists as a risk premium. There's others who will talk about metrics and that value does not include intangibles, the economies change, we've moved to big tech, and basically this time it's different. How would you react to those?

Staley Cates (17:38):

Well, first off, those questions are eternal. Those questions do come around every day or so. The growth versus value questions are always there, so my answer here is not original, it's something we've talked about in other cycles. But the first would be kind of a false distinction between growth and value, in that to do what I described, to buy great companies... Especially because this is all of our own money, we don't have other ways to diversify. Now they don't look at that on the surface, or else they would not be cheap. So I don't mean blatant, obvious quality, because that's the kind of stuff that's the 25 to 30x, usually. We do demand quality. That means growth. We just want to steal that. We just want to pay a multiple for that that's way below where the market is pricing that.

Staley Cates (18:29):

So that does lead to nontraditional metrics. When we say we're buying value, that is not simply priced to book, it is not simply low PEs. Any other easy way to measure goes by the wayside. If we have a timber company... We're able to buy southern, mature, fantastic timber right now at a thousand bucks an acre. We have no idea though, how that's going to come through the P&L. You may not want to harvest it during this depression. You may let the tree grow and get the pricing later. That's not a simple PE calculation. There are things that I mentioned, like a Prosus, which is a way to buy Tencent, which looks like a high apparent PE, but the real price to free cash flow... And this would be also true of Alphabet. By the time you take out important non-earning assets, you're paying a very low price to free cash flow multiple for the great businesses. So the answer is more complex. It is more case-by-case. This gets to us doing stuff "by hand," instead of just broad screens with thousands of stocks and very traditional metrics.

Greg Dowling (19:34):

I think that's really important. Maybe that speaks to not having a narrow view of value and trying to find value wherever it is. But to the point of the economy changing, you all have invested in technology when there's value, but is value--because of the way it often is calculated--just not viable in a new economy where there's duopolies and high profit margins and Microsoft, Facebook, and Amazon? Are they going to take over the world? Nothing's going to stop them and value is going to just linger and die and not ever rebound.

Staley Cates (20:26):

I think it, again, goes company by company. Our own answer... Different value managers will say different things about whether they will invest in technology. And instead of a, "Yes, we will," or, "No, we won't," ours always gets down to the terminal value of the company--i.e., if you're doing a DCF on any of the companies you just said and you do a terminal value, can you feel a very high degree of confidence that that company will look like something you can sink your teeth into and understand? I mentioned that we own Alphabet. That's because even though search will look different--it'll have AI components to it and more voice and different forms of search--we think that there's a high enough probability that search is there in year seven of our DCF that that is something that's real and valuable and worth a big multiple. We've paid way less than that in the market to buy Alphabet. So that's a, "Yes, go forward."

Staley Cates (21:23):

Now other things have... Apple's a little bit different, where it is dominant but it's more about the devices and the ecosystem, and that's a little bit tough for us to say what is that going to look like forever. Especially non-U.S. versus Android. And can they maintain those massively high margins? Those might be questions we put in the "too hard" bucket, there's just not a one-size-fits-all answer to that. This gets back to being risk averse and understanding how durable the cash flows are. You don't have to invest in any of this.

Greg Dowling (22:05):

Gotcha. I know a lot of the way that you extract value is just buying it and being patient. You also have several other tools in your toolkit that you'll use occasionally, like talking with management or being a little bit more active at times. When do you need to do that? Maybe you can give an example of when that's worked and your style of engagement.

Staley Cates (22:28):

It starts with this mentality of ownership being aligned with great partners, so that on step one, if we pick the best partner possible, as we try to do, there may be very little engagement necessary or required. Now, we'll be in constant touch with the management. We'll learn tons of stuff from meeting with them and asking them questions and learning the business over time. But we may not do anything on the engagement front, because we don't need to. There's not a lot we can tell Fred Smith to do on how to run FedEx. But then it becomes this decision tree where, if we've made a mistake on our people assessment, or maybe we were right on day one but things went wrong later, then we owe it to our shareholders to address that.

Staley Cates (23:18):

Now, that gets to a part of the decision tree where, if we can't accomplish what we want to accomplish, we just sell and leave. We just admit the mistake on the people and leave and sell. But if we think it's a fixable item, then we do get engaged. That is typically a flavor of... Not the hedge fund activist style of very public angry letters and all that stuff, this is behind the scenes, behind closed doors, and constructive, in the context of being long-term holders and not trying to make management look bad, but just trying to get what we want. That usually ends up with deep involvement with the management and the board, and often getting board members. So like activists do their thing off and running proxy fights trying to get directors. I think we usually get directors in a much more quiet way, and we have a pretty high batting average on doing that.

Staley Cates (24:12):

Taking that a step further though, I think another difference in how we do things is if we put someone on a board, we start with asking the company, "What do you want? What would you find most helpful?" There was a day back in Level 3... Level 3 was the best fiber company. That's now CenturyLink, which has the best fiber even though that's hidden under a legacy phone company. In the Level 3 days, we wanted to add a board member but we prefaced it with, "What do you need?" They had this incredible fiber network and great engineering, but their sales performance, just the performance of the actual sales--not marketing--was poor, and they knew it. So they were like, "We need some sales expertise." The best person we could think of was Mike Glenn, who ran the sales effort back for FedEx. He ran that and he did it incredibly well. FedEx is all about physical networks. Level 3 and CenturyLink are about fiber networks. So Mike made a ton of sense. He took that board seat, and happily now is just about to become the chairman, actually, at CenturyLink. But that's different than a lot of activists, who will put their own attack dogs on the board, and that's really to serve them. That also ties up your trading. That limits your flexibility because you're then subject to the same trading rules. So that's just, for a lot of reasons, not how we would go at it.

Greg Dowling (25:34):

Gotcha. That makes a lot of sense. In our recent education piece to our clients, we talked about buying what others are selling. What is the market selling and what opportunities are out there now that you all are investigating and perhaps investing in?

Staley Cates (25:55):

This circles back a bit to our value discussion where... In y'alls piece you highlighted this, and I mentioned it earlier as well, that value has underperformed again--so much that if you're avoiding the big index stuff... Even the U.S. The non-U.S. bargains are better, which we can talk about more later. But it's the same playbook, where we are able to buy some incredible bargains that haven't been in this beneficiary of index mania and free money. If we first look at this as a composite, I think it's the most instructive thing. And that is that normally our bucket of stocks sells for, call it 11x free cash flow, versus the market selling for 16x. That is not coincidentally lining up with--we talk in our parlance of price to value ratios--our overall composite, which again, we may be wrong on 1 or 2 companies. Especially because the S&P earnings are down, the market P in the U.S., not overseas, the USP is now over 20.

Staley Cates (27:06):

So this coiled-spring effect is even more in play. This is why our performance sucks this year, as our 9 to 10x we already thought was cheap is now, say, 7.5. But this coiled-spring has wound up even more. I say all that, because some of the stuff we've already owned we've added to, and we're able to do that at these incredibly low free cash flow multiples. This is a pretty historic difference between a market that is very scary at an over 20x. That's also a little bit back to our index discussion, where if you're just buying the index, that may feel better--and this whole passive versus active--but you're buying a multiple way over 20x. If the S&P is gonna earn, say $130, and there's a lot of risk with that and there's still a lot of unforeseen things that we've talked about on the risk front, that's pretty scary to us.

Greg Dowling (27:58):

All right, let's take it to the next level. Yes, on a valuation perspective, value as an investment style looks pretty inexpensive. But if you look below the surface, indexes are made up of different sectors--some are expensive, some are cheap--and some right now have some pretty dicey outlooks, whether it's financials, energy, retail, or cyclicals. So where within the value universe are you seeing opportunities, whether it's on the sector side or the company side?

Staley Cates (28:27):

Well, within the ones you mentioned, I think I'd start with financials. And I would also split those into some categories. The kind of financials that are big, heavy cap, capital-heavy banks, those are not of interest to us because those are leveraged by their nature and opaque, and they're a commodity. We've just never done a lot of that. I guess three areas we'd be thinking... A lot of the money managers are incredibly cheap because people are simply extrapolating their terrible results driven by the market over the last couple of quarters--or the last couple of years, really. Then I would say the wealth managers have gotten interesting, because they're kind of down with the money managers. But that's a different proposition, that's managing somebody's tax and family situations, all that kind of stuff. That's more than just, "Are they beating the market this quarter?" That's just a different proposition.

Staley Cates (29:29):

I guess thirdly would be the insurance part. The insurance group is just kind of hammered. Some of that has to do with how's this business interruption thing going to play out--and that could go to the Supreme Court and pandemic within policies and all that. We're going to avoid some of the most controversial parts of that. But other parts of the insurance world have just been busted because of that whole group doing poorly. Then, you mentioned energy and retail. We're actually avoiding those on the margin just because we can do so much higher quality stuff. It's not debating that there may be statistical bargains in there, but when I mentioned we can provide so much better quality, we'd rather have incredible quality as well as value, so that has kind of ruled those out.

Staley Cates (30:17):

Then finally, within the travel and the hotel part, some of the travel stuff, like airlines, is just flat out in the "too hard" bucket. Some of the travel stuff would get back to what I mentioned earlier about the forecasts are just too hard. If the appeal of the stock has to do with you nailing it on when travel really comes back, then forget it. The ilk we would like would be something like a Hyatt and GE. In the case of Hyatt, that's more about franchise fees. If you look at Hilton and Marriott, those still sell at very healthy multiples of cash flow because even if it takes five years to get people traveling, taking those franchise fees off the top is going to be a good business.

Staley Cates (31:05):

We can buy high at big discounts to Hilton and Marriott. And even though Hyatt is not as good on the reservation system and the points, hotel developers will tell you that they're going to grow more off of their small base and it's a very good brand. So that can... We don't have to make a case, "Is this going to take 18 months, 2 years, whatever?" That's one way to go at it. Then on the aviation side, the airlines would be terrifying and too hard for a lot of reasons, but there is going to be airline travel over a very long period. And GE Aviation, their jet engine business, even if it never comes back to where it is, that is going to be a razor blade, albeit much lower than anyone would have thought. That is going to be a great business. Culp has done an incredible job. You also get GE Health, which is a stealth way to address all the needs in society, especially now on the healthcare front. So those would be our best ways to go with the travel and hotel part.

Greg Dowling (32:02):

I like that. GE Aviation is headquartered here in Cincinnati, Ohio, so I know plenty of folks who work there. I agree. Out of the U.S., overseas, in which you talked about that things are a little bit more attractive as you get further away from the U.S., maybe we can talk about that. Maybe start in Asia. I've had the pleasure of visiting your Singapore office, and that's also been a little bit of a hotspot. So what's Asia look like, and how are the teams dealing with this? Are they better prepared? As you mentioned, they've been through SARS. Are you seeing any recovery taking place there that may give us hope for the U.S.?

Staley Cates (32:50):

Starting with the last part first, there is hope and all that. As far as how they've handled it, whether it's talking to all those teams... Our office has been there 25 years, so we've known the network there is very built-out and long time. So we are seeing them come back, as you probably have read. We also see that through other investees, of how the economies are coming back strongly. They're back in business. The travel thing is interesting in that the domestic travel in China is picking up sequentially pretty strongly. The international travel, for obvious reasons is still kind of a zero.

Staley Cates (33:34):

The other interesting thing is as they kind of go into... We are all wondering--and I don't think we bring any special insight--everyone's wondering what a second leg to this whole thing might look like. So it's interesting to note that in their case, even though you read about the second wave and they're locking some stuff back down, that that's really on a very small number of cases. There will still be brushfires. There will still be re-lockdowns and stuff like that. But when people are talking about a W, it's not like the right side of the W has been--so far, at least--anything like the left side of it. I think the investing opportunity for us is so big there because it's more detached than normal from the U.S. Now part of this is driven by U.S.-China relations being bad and probably getting worse. This all gives us a bad outlook for free trade in relation to GDP. This is not a happy story on how we're all working together globally, but you just have to factor that in as you invest over there.

Staley Cates (34:37):

One of our favorite ways to take advantage of all this is Macau. It's so incredibly misunderstood on so many levels. In the piece you did for your clients, y'all talked about not selling stuff that's down and investing for the next thing, and China was in both of those buckets in your piece. To me, Macau is by far the best way to capitalize on that. Part of the misunderstanding is that it's listed in Hong Kong, so it's traded down with that. It's incredibly cheap, but its economic future actually not only has very little to do with Hong Kong and the drama that's going to keep playing out there. That's just not where their players are going to come from. They're going to come mostly from mainland China, even though it's listed there. And if anything, the Chinese government will treat Macau as a government even more favorably the more that Hong Kong acts up, which seems like that's just going to keep getting worse and worse.

Staley Cates (35:30):

Another thing about Macau that's interesting as an analyst is that the U.S.-centric view will compare Macau EBITDA to Las Vegas EBITDA, and there's a massive math mistake in that, in that the acronym EBITDA has T for taxes in it but in Macau you've already paid your tax. They pay the government 39% off the top. So EBITDA is actually after tax and there's very little CapEx associated with it, so almost all of that EBITDA is free cash flow. Definitely not in Las Vegas, where you not only have to pay tax, but you have a whole lot of non-gaming, more hotel-looking things that you have to spend a lot of renovation CapEx on. So even how Macau is measured is off base until you really do the work. The final thing is that people who don't spend the time there and dig in, think of Macau as high rollers, VIPs, junkets, and the Chinese government crackdown. That's big on headlines and revenues, but that's almost meaningless on EBITDA because those same junkets, they take all the margins.

Staley Cates (36:40):

So a player coming on a junket, we really don't care what the corruption crackdown means or doesn't mean, or if they're laundering money or not at that level, because that is a single digit margin EBITDA player. The 40% EBITDA margin player is that mass Chinese--either newly wealthy or newly middle-class--just come into play as they did in Vegas starting 20 years ago. And they call that the "mass" or the "premium mass" player, that's where all the cash flow is. That's literally over 90% of Macau's cash flow. So we're sitting out a bet that I think Mr. Market thinks we're making. We're paying 6x free cash flow for that, which is crazy, against market PEs or market price to free cash flows, usually up over 20 for something with those kinds of barriers to entry. Great opportunity over there if you take the time and pick the rifle shot.

Greg Dowling (37:36):

Yeah. I've actually been in Macau and I've seen that mass consumer, and there's just a heck of a lot more than those high rollers. They come over by boat--and now by car--and that's where they make their money, not just the one or two whales that come over. So that's pretty interesting. What if we go to Europe? Is there anything to do in Europe? Europe's maybe the biggest mass here and they also have political issues. What is the future of Europe? Although they have great companies, are they investible and is there visibility?

Staley Cates (38:12):

Well, there's so many parts of that, as you know. If you start in the north, you've got Brexit adding on even more to all the chaos. That did throw us an opportunity in the form of Domino's UK, which is extremely interesting because on the Domino's part, pizza of course brings to mind--it's fine during the pandemic, but more specifically to that name, the multiple we're paying for a really good franchisor in London is incredibly less than where Domino's trades in all of its other pieces. So that was kind of a specific opportunity up there. More to the continent, to the macro part of the question, you're exactly right on it. It's suffering more now. It's getting worse before it gets better. We see that through various investee feedback, ranging from shipments to bearings companies to chemical companies--it's getting worse.

Staley Cates (39:06):

Like Matt Still, that's a bit scary and there are more things to sit out there. And yet, one of our biggest positions and one of our biggest opportunities in our global fund is Exor, which I mentioned earlier. Exor suffers from two Italy-related things. Most importantly is coronavirus. Italy was one of the biggest victims. As its market traded down on its daily coronavirus news, so did Exor, which has the incredible Italian heritage, but that's really just not what it's NAV is about. And then secondly, to the point of your question, there's always worry of Southern Europe unraveling first within any kind of EU malfunction. You'll see Spain and Italy often trade down when there are worries about all things euro or EU. And Exor suffers that as well, but it's main businesses, ranging from Ferrari to CNH, which is agriculture in the U.S. and Latin America, these are great assets that are fantastically valuable long term, and they don't have anything to do with Italy or Southern Europe. Or I should say they have very little to do with those things. So again, we do find specific things to do there, but unlike Asia, we'd say that's in a context of stuff getting worse before it gets better.

Greg Dowling (40:24):

Gotcha. Alright. We're going to get ready here to wrap up. Maybe just a few other questions for you. Memphis, great city. Assuming we all get to travel again, what's your favorite barbecue place in Memphis that we should hit when we're there?

Staley Cates (40:40):

When I answer this question, this means that there will be hit squads sent out by all the barbecue places that I don't name, so this is a very dangerous question. But I will go with... I got to give two. For the larger ones where you can also ship--so I'm doing an ad for them--that'd be Central Barbecue. For the hole-in-the-wall, it's gotta be Cozy Corner, which, I think it was Gourmet magazine, shouted that as one of the greatest restaurants a while back, but that would be the most authentic.

Greg Dowling (41:20):

Well I wrote that one down. I've been to Central but I've not been to Cozy, so that is someplace that I'll visit next time through. And hopefully we're all out of lockdown here soon and we can go support some of our favorite locales. Hey, Staley, this has been great. We really appreciate your comments on active management and value and we're hoping that you are right, and this is not a heartbreak hotel and we can see true returns coming from both those areas going forward. Just wanted to thank you for your time and for your comments. It's been great.

Staley Cates (41:59):

Thanks so much for having me.

Greg Dowling (42:01):

If you are interested in more information on the topic, please go to our website where we will have a list of relevant FEG publications. And don't forget to subscribe to our event communications at so you don't miss the next episode. Please keep in mind that this information is intended to be general education that needs to be framed within the unique risk and return objectives of each client. Therefore, nobody should consider these FEG recommendations. This podcast was prepared by FEG. Neither the information nor any opinion expressed in this podcast constitutes an offer or an invitation to make an offer to buy or sell any securities. The views or opinions expressed by guest speakers are solely their own and do not necessarily represent the views or opinions of FEG.



This was prepared by FEG (also known as Fund Evaluation Group, LLC), a federally registered investment adviser under the Investment Advisers Act of 1940, as amended, providing non-discretionary and discretionary investment advice to its clients on an individual basis. Registration as an investment adviser does not imply a certain level of skill or training. The oral and written communications of an adviser provide you with information about which you determine to hire or retain an adviser. Fund Evaluation Group, LLC, Form ADV Part 2A & 2B can be obtained by written request directly to: Fund Evaluation Group, LLC, 201 East Fifth Street, Suite 1600, Cincinnati, OH 45202, Attention: Compliance Department. Neither the information nor any opinion expressed constitutes an offer, or an invitation to make an offer, to buy or sell any securities. The information herein was obtained from various sources. FEG does not guarantee the accuracy or completeness of such information provided by third parties. The information is given as of the date indicated and believed to be reliable. FEG assumes no obligation to update this information, or to advise on further developments relating to it. Past performance is not an indicator or guarantee of future results. Diversification or Asset Allocation does not assure or guarantee better performance and cannot eliminate the risk of investment loss. The views or opinions expressed by guest speakers are solely their own and do not represent the views or opinions of Fund Evaluation Group, LLC.

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