Hersh Cohen: In Depth on "Good Old Fashioned Value Investing" in an HFT World

Consuelo Mack WealthTrack - October 2011

CONSUELO MACK: This week on WealthTrack, in a market dominated by high frequency, computer driven trading, how does the individual survive and flourish? ClearBridge Advisors’ Great Investor Hersh Cohen takes us back to the basics of good old fashioned value investing, in a TV exclusive next on Consuelo Mack WealthTrack.

Hello and welcome to this edition of WealthTrack. I’m Consuelo Mack. Investors are spooked. And confidence is key to investing: when you buy a company’s stock, you are counting on growing business prospects, earnings, and in many cases, dividend payments. Otherwise, why take the chance? That’s a question many investors are answering with sell orders. They’ve been pulling money out of domestic stock funds in particular, with large cap mutual funds suffering more than two years of monthly outflows.

Investors are being buffeted by a rotating and repetitive list of worries, political, economic, and global: the budget divide in Washington, government deficits, high unemployment, the European debt crisis. Being overlooked are the positive signs: companies are making money, a recent stream of better than forecast reports in manufacturing, construction, and retailing, the stimulative seeds of recovery being planted by record low interest rates and falling commodity prices- the huge decline in oil prices, which is the equivalent of a big tax cut for businesses and individuals.

Exacerbating the sense of uncertainty and crisis is the nearly unprecedented volatility in the markets. According to a recent Grant’s Interest Rate Observer, published by WealthTrack regular Jim Grant, “at the end of World War II, the average American investor held the average American equity for four long years. By 2000, those four years had dwindled to eight months. By 2008, eight months had shrunk to just two months.” Grant’s speculates that maybe the holding period is down to 20 minutes- who knows? What we do know is that the pace of trading has accelerated to beyond warp speed. According to Grant’s, which sourced a speech by a senior Bank of England regulator named Andrew Haldane - we will have a link to it on wealthtrack.com- computer generated, high frequency trading accounts for as much as 75% of U.S. stock trading. Six years ago, such trading accounted for no more than a fifth of the volume. Human to human interaction has been replaced by computer to computer, and algorithm to algorithm trades, tens of thousands of them happening in micro-seconds, or millionths of a second.
So how can regular long term investors survive in a nanosecond market? That’s one of the many questions I asked this week’s Great Investor guest in a WealthTrack television exclusive.

Hersh Cohen is ClearBridge Advisors’ chief investment officer, senior portfolio manager and co-manager of its dividend strategy portfolios, including the Legg Mason ClearBridge Equity Income Builder Fund. For 31 years, he co-managed the Partners Appreciation Fund, being named finalist for Morningstar’s Equity Fund Manager of the Year in 2008 and to the exclusive Forbes Honor Roll eight times. As you will see, Hersh’s perspective is refreshing and invaluable.

HERSH COHEN: It’s interesting. I used to see a stock fade or be down two points and I’d call our trading desk and say track it down, what’s going on, what’s the news on this thing? And what I learned was there was no news. Now it’s just a function of the fast traders or an ETF wagging the dog and carrying everything down. So I’ve stopped asking and what I’ve learned to do now is just to try- try, I don’t say I always successfully do it- try not to chase strength because the strength can be random and try to wait for periods of weakness to buy the companies that I want to buy. I mean, I don’t know how else to do it.

CONSUELO MACK: What constitutes a period of weakness? Is it actually like a period, or is it, gee, the stock’s down to 34 and this is what I’ve been waiting for and you put your order in right then and then?

HERSH COHEN: Well, I like to use levels. You know, it’s not a science. I like to use levels that I’m willing to buy a stock or stocks at and we keep a list of that and I got over that with my team fairly frequently. So that might be 10% below the market. I mean, the stock might be at a level that we’re no longer interested in buying it, but if it got down to a certain point. So it might not be on a day, but if you get a period, if you get a month of weakness then you do it. So for example, the stock W. W. Grainger is one that we, I missed it all the way up and then it went up to 160 and it came down to 130 in the summer and that was a level that we felt comfortable. So in a period of market weakness, we took a small position for individuals. So there’s no formula. So it can be a matter of minutes or an hour or you have an idea that you want to buy a stock, but you’re just waiting for it. There might be a stock that we’re buying on a regular basis. Let’s say Proctor and Gamble. Let’s say we’re buying it on a regular basis.

CONSUELO MACK: Long time holding of yours.

HERSH COHEN: Long time holding. But you don’t want to be buying it on days when the market is up three percent. You’d rather be buying it, as hard as it is, towards the end of the day like today or tomorrow morning when it’s down. Of course, you never know if you’re right. You might be paying a point too much or something.

CONSUELO MACK: So the point is that approach still works? So far.

HERSH COHEN: Does that approach still work? I hope so, I think so. I don’t know a better way to do it. Is there a better way to do it? If there’s a better way to do it, I don’t know it. I have this line I use on a day like today. I don’t mean to sound glib, but not one of my companies cut their dividend today.

CONSUELO MACK: So that’s a positive, right?
HERSH COHEN: People look at the market too closely. That’s the trouble. And people never stay around for the good gains. It’s hard. I don’t know. There’s no formula. It’s just hard work. You want to own great companies and try to buy them during either a daily or weekly or monthly weakness, and you hope you’re not overpaying, and you have to be willing to trim if they go way above where you think there’s fair value, but of course, that has not been much of a problem recently.

CONSUELO MACK: So have you seen any long term impact of this? That the volatility and the trading on actually the stock’s performance that you invest in, these value high quality stocks?

HERSH COHEN: The moves are accentuated on a very short term basis, clearly. On the long term performance ultimately, define long term. I’ll define long term as decades, which is not really what you’re asking. But long term, what I see is that earnings, dividends, and stock prices- if you graph them, the graphs will super impose. On a 20 year basis that’s probably true; on a ten year basis, clearly, that wasn’t true. Dividends went up. Earnings went up for many companies. Stock prices went down in the last decade. 2008, some dividends went up, some earnings went up, and stock prices could have been down 30 or 40%. So on a one year basis or a three month basis, no, they do affect things, yes; but on a longer term basis, on a very long term basis, which is how I try to think and what I can tell you firsthand from stocks that I’ve owned it does work. It really does work.

So put it this way, look at the overall market. I tell people this. I like to when I talk, I like to talk about this. I say we have all these problems now. They’re very obvious and the market volatility scares people away, but let’s go back to 1973/1974. We had a president and vice-president resign in disgrace. You’ve got oil prices- you had an oil embargo- oil prices went from three dollars, they went up eventually ten-fold and you couldn’t even get gasoline. They had to line up around the block. The country was torn apart by the Vietnam War. New York City tax free bonds were selling at 50 cents on the dollar. It was effectively bankrupt. And then I tell people, I ask people, well, guess what the Dow Jones Average was? Some people, you know, they’ll know. But they’ll say, you know, 3,000, and I’ll say 580 is where it bottomed, 580, not 5,800, 580. So it’s up 20 times. And oh, by the way, there have been all these dividends in that same period of time too. We’ve had a lot of trouble since then too. You know, Mexico went bankrupt. You had an S&L crisis in 1990. You had 9/11. Many, many. You had the crash of ’87.

CONSUELO MACK: And perspective helps, which is why we have you here on WealthTrack to remind us of these things- that things aren’t as bad as we think. So it doesn’t sound like you’re doing a lot differently. Your average holding period has been four years.

HERSH COHEN: Yeah, 20 to 30% turnover. So four to three to five years, I would say. And some holdings forever.

CONSUELO MACK: So that hasn’t changed?

HERSH COHEN: No, no, no. Why would it?

CONSUELO MACK: Only reason is because of the market volatility? Are you finding cycles?

HERSH COHEN: If people would learn to use it for their advantage by taking advantage of the periods of weakness. But what really upsets me is the kind of call that I got today from an old friend whose money I manage who has done really well over the years, who is 63 years old. And he called and said, “I can’t stand this volatility.” I said, “Well, I don’t even know what to sell in your portfolio. Everything is good.” He said, “But I’m really nervous and if things crash.” I mean, so he’s done well. He’s a market veteran. He’s been around forever. He does a little trading on his own outside, but he’s got these great long term investments- when people like that start to feel that way, that makes me nervous about people never meeting their goals. And I don’t mean to sound like a shill for the stock market, but I believe in the stock market. At a time when the savers are earning nothing and stocks give dividends of-- high quality stocks give dividends in many instances two, three times the rate of the ten year treasury, then I think you really want to be thinking about some stocks. And yet money has been flowing out of mutual funds at rates--

CONSUELO MACK: Right, stock mutual funds.

HERSH COHEN: Equity mutual funds at a greater pace, I just read, than it was in 2008. And at a time when people should probably be thinking about high quality stocks and thinking about dividend growth, they’re not. They’re going the other way. Even in the last decade, between 2000 and the end of 2009, the S&P 500 dividends went up over five percent compounded, including the travesty in the banks all cutting their dividends at the end. A well managed portfolio of high quality companies where- if you were fortunate you avoided a lot of the collapse in the financials- compounded at somewhere between eight and nine percent. Compounded. You know, that’s a double in your income in ten years.

CONSUELO MACK: Your colleague, Bill Miller- one of the past times he’s been on Wealth Track was talking about how one of the advantages that individual investors have is that they have time. They don’t have the pressure of quarterly performance numbers. They don’t have the pressure.

HERSH COHEN: You can wait for that perfect pitch.

CONSUELO MACK: So the time arbitrage--

HERSH COHEN: But people don’t. People don’t. That’s that the trouble.

CONSUELO MACK: But talk to me about the advantage that individual investors have with time.

HERSH COHEN: Perfect example. In institutional accounts, foundations, endowments, in mutual funds, you’re benchmarked and everybody sees your numbers everyday. I go every morning and I check how my mutual fund is doing compared to all the other funds that I look at.

CONSUELO MACK: Because you have to?

HERSH COHEN: Because you have to because it determines how many stars you have.

CONSUELO MACK: Every day, Hersh, you do that?

HERSH COHEN: Yeah, of course.

CONSUELO MACK: You’re more obsessive.

HERSH COHEN: It’s obsessive, but I’m sure every fund manager does that, I would imagine. And no individual, not a single individual- I think that’s true in my career- has ever said to me, you trail your benchmark by two percent, you’re no good. But I can’t tell you how many institutional accounts I lost in 1999 because I had 25% cash. “We’re not paying you to run cash, you don’t know what you’re doing.” So it’s frustrating. So the individual has a huge advantage. They don’t have to answer to a committee. I love Morningstar. Their write-ups are great. I love Morningstar. But if I were a younger portfolio manager I would have had to be fully invested in Microsoft and GE in 50 times earnings to outperform. It’s hard. As an individual, you can pick and choose, pick and choose. Pick great companies. If you want to speculate, you can speculate with a portion of your money and you’re not beholden. I tell people you can buy anything you want, but if you’re wrong, just don’t forget to sell it because that’s the mistake. Individuals, unfortunately, I think, tend to hold onto losers too long, but that’s a discipline.

CONSUELO MACK: And why do they do that?

HERSH COHEN: Well, you don’t want to admit you’re wrong.

CONSUELO MACK: I see. Or they keep thinking it’s going to come back and you can sell when you--

HERSH COHEN: Yeah, you know that’s what makes, what used to make- I’m not sure fund managers, for example, are any different they just run bigger pools of money. So a stock goes down and there’s a little disbelief and then a stock, you know, you hope it will rally. There’s the hope phase. And then it goes down more and you hope. And then finally you say if I ever get even I’m going to get out. That’s what people, I think, tend to do and then, of course, that’s when the stock improves and often keeps going. It’s crazy.

CONSUELO MACK: So individual stocks?

HERSH COHEN: Individuals can wait. I’m sorry. Warren Buffet said it the best. He said, “You can sit there with your bat on your shoulder and wait for the fat pitch.” It’s hard to do.

CONSUELO MACK: Is the stock market stacked against individuals anymore than it ever has been? What’s your sense of how individuals fare buying stocks themselves?

HERSH COHEN: That’s a great question. Is it stacked against individuals? I think it scares the devil out of individuals. Is it stacked against them? No. I wouldn’t say it’s stacked against them. You still have great companies they can buy. It’s still the most democratic institution in the world. Anybody can plunk their money down and buy stocks. I think, no, it’s not stacked against them. And people can have their money managed. They can manage it themselves. No, it’s not stacked against the individual. I think there’s a huge amount of information available out there.
I was talking to one of our traders today and I said, “Why do you think there’s so much volatility?” And she said, “The information flow is so rapid that people react to it so rapidly.” Individuals don’t have to do that. They can get the information, but they can filter it. I’ve told young colleagues of mine, I said, “I don’t want to make decisions during the heat of the day. Talk to me about buy and sell decisions early in the morning when we don’t have the pressures of the market.” Individuals can do that. It’s hard to do though when you’re sitting there watching things. It’s easy to get carried away.

CONSUELO MACK: So that’s interesting. So you’re saying talk to me before the market opens, essentially?

HERSH COHEN: Yeah, about what our plans are.

CONSUELO MACK: Right. So you’re going to implement--

HERSH COHEN: Don’t make a decision based on what the market’s doing.

CONSUELO MACK: So don’t be reactive.

HERSH COHEN: Right.

CONSUELO MACK: Be proactive. So that’s a novel idea, Hersh, actually have an investment plan. I’m sure it’s a novel idea to a lot of the young people you talk to.

HERSH COHEN: Well, it’s not a daily investment plan, but you should have some kind of outline of what the stocks you want to own, the kind of stocks you want to own, and have some price sets.

CONSUELO MACK: Makes sense to me. So earnings. What are earnings are tell you as far as the market?

HERSH COHEN: Well, that’s the big thing right now. Because earnings have been really good. Dividend payout ratios- that is the percentage of earnings that companies are paying- out is still low. You have dividend yields that are incredibly attractive compared to, I don’t know how else you measure it, compared to fixed income investments. Do I think earnings will be up strongly next year? I do not. Do I think they could be down? I do, but I think the market, that’s why the market was down in July and August. I think the market was understood that earnings were not going to be up strongly next year so the market, you know, the market is a discounting mechanism. I think it knows that earnings are not going to be great.

CONSUELO MACK: Interest rates. So what are interest rates telling you about the market?

HERSH COHEN: You’ve got to buy them. That’s what Bernanke’s telling you. You have to step out on the risk curve. With interest rates at zero, and they’re telling you, what are they telling you? Interest rates are going to be at zero for two years.

CONSUELO MACK: It doesn’t get much clearer that that.

HERSH COHEN: It kind of gives the shaft to savers. And so he’s saying to savers, you need to do something risky.

CONSUELO MACK: Sorry.

HERSH COHEN: Not sorry, but step out on the risk curve. And let me tell you, it’s frustrating because my whole career, for individuals I would always would have some portion in fixed income. It was easy. It was easy. Especially as people would head into retirement or whatever you could get your--

CONSUELO MACK: Just shift them into bonds.

HERSH COHEN: --get your good returns from the bond, kind of get your anchor there and then have the stocks. Actually, dividends now are better than they, the yields are better in stocks than they have been. And I’m telling people now because they’re saying how am I going to retire, what am I going to do? And I say you’re going to have to take out a principle. It’s hard.

CONSUELO MACK: Very hard.

HERSH COHEN: Yeah.

CONSUELO MACK: That’s anathema to a lot of people.

HERSH COHEN: I know, I know, I know.

CONSUELO MACK: So when people come to you, Hersh, and they say, I need income. I’m going to retire. I need income. Where do I go?

HERSH COHEN: I send them to Consuelo Mack’s Wealthtrack.com and tell them to look at my list of dividend stock. I love it. It’s a good list, by the way.

CONSUELO MACK: Which is one of our most popular features.

HERSH COHEN: It’s a good list.

CONSUELO MACK: And so tell me about this list of great balance sheets and high dividend yields.

HERSH COHEN: Growing dividend yields.

CONSUELO MACK: Growing dividends.

HERSH COHEN: So what do I tell people? I say diversification. You know, 25, 30 stocks. Companies that tend to make products that people want or need. The balance sheets are good. There’s a history of dividend increases or the ability for companies to raise dividends or the history of them. I think it’s a really good list. And in fact, I own them all. I own them all myself because we actually have a program that does that. My two biggest investments are that program, the separately managed account, and the Equity Income mutual fund. Those are good. So again, I’m not touting those, but I like them, I believe in it. And why wouldn’t I? So if individuals come and say what do you do? I say these great companies.
So tell me, Proctor & Gamble has been paying dividends for 100 and some odd years and has raised it for 50 consecutive, whatever it is, 50 consecutive. Kimberly-Clark, it’s like a bond with a rising coupon. Kimberly is an incredibly well run company. People are still going to be using diapers, and facial tissue, and paper towels, and disposable hospital things. And it was yielding 4.25% a year ago and they’ve raised the dividend. They’ve raised the dividend every year for 40 years and Tom Falk has done a great job running the company. Johnson & Johnson, even though they stubbed their toe with the consumer products, and it drives me crazy, they still raised their dividend 6% this year and they’ve raised their dividend every year since I don’t know when. 3M has raised its dividend every year for, I don’t know, 45 years, and they make products that everybody uses. Those are good.

CONSUELO MACK: So how do you use that list? I mean, when do you invest in them, when do you--

HERSH COHEN: We set levels on what prices we’ll pay and when they hit it, when they hit those levels, we’ll trigger the buys. And if stocks get too expensive, we’ll maybe nip some off.

CONSUELO MACK: But the point is this is like a core list.

HERSH COHEN: Core list.

CONSUELO MACK: And so as individual investors –

HERSH COHEN: Won’t change that much.

CONSUELO MACK: As individual investors, I mean, should we have some sort of a core list as well?

HERSH COHEN: Yeah. I think so. I mean, I believe there are certain companies- it’s always dangerous to go on camera and say this for posterity, but I mean I think there are certain companies that have proven their ability that one can own forever. Why wouldn’t somebody own Exxon, apart from that people don’t want to own energy and, you know, Exxon is still reviled by some people for Valdez, but you know, Exxon, Chevron. They’re great. They raise their dividend every year. They buy in shares. They do the right thing for shareholders, high return on capital. I think those are kind of hold forever kind of companies. Johnson & Johnson, Proctor & Gamble, 3M. Those are a good list.

CONSUELO MACK: One Investment for a long term diversified portfolio, what are you going to tell us that we should all own some of?

HERSH COHEN: The Consuelo Mack/Hersh Cohen Wealthtrack.com Dividend Grower List. I love it. Yeah. You know, it’s funny. I was asked by our IR people to talk to a magazine and give them our one best stock idea. I said, “We don’t do that.” I said, “Talk to Consuelo Mack. She knows. She asks for one idea, we give 20 or 30 stocks.” There’s this old joke about sports handicappers. You know, they’ll give half their customers one side of the bet and they’ll give half their customers the other side and so they’re always going to have 50% of the people who think they’re really smart. Why would I tell people just one stock? I mean, I could be right or I could be wrong.

CONSUELO MACK: And of course, we will have that on, once again, one of our most popular sections of our website, Wealthtrack.com, Hersh Cohen’s list will be there and I know that people are going to be logging on to get it.

HERSH COHEN: It’s a list that we have put together, but I mean, anybody could put a list like that together, but it requires some work and we do put a lot of work in it. And it’s a lot of years of experience and judgment, I think. So I do want to say it’s a group of really nice companies. And so, you know, I look back at last year’s list. It’s a nice list.

CONSUELO MACK: It is a very nice list.

HERSH COHEN: I think they’ve all raised the dividend.

CONSUELO MACK: I think they have too. Well, Hersh Cohen, thank you so much for being with us.

HERSH COHEN: It’s a pleasure.

CONSUELO MACK: The chief investment officer of Legg Mason ClearBridge Advisors--

HERSH COHEN: This was fun. Thank you.

CONSUELO MACK: --among many other things.

HERSH COHEN: This is fun in a very difficult environment. Thank you.

CONSUELO MACK: It is. You’re such a relief. I love talking to you.

HERSH COHEN: And vice versa. Thank you.

CONSUELO MACK: At the conclusion of every WealthTrack, we give you one suggestion to help you build and protect your wealth over the long term. This week’s Action Point: check out Hersh Cohen’s “Great Balance Sheets and Dividend Growers List.” Hersh talked about buying great companies on weakness. These companies have been suffering along with the rest of the market, and even though large cap stocks have held up better than mid and small cap ones this year, investors have been bailing out of large-cap mutual funds for more than two years now. Their selling has created both price and income opportunities for the rest of us. As mutual fund and hedge fund manager Whitney Tilson told clients recently, he and his fellow value investors have never seen such a disconnect between company prospects and what the stocks are doing.
Next week on WealthTrack, Great Investor and Financial Thought Leader Robert Arnott joins us. He has been correctly bearish on developed world stock markets, but he has some alternatives to discuss with us. And for those of you who want to see our WealthTrack interviews ahead of the pack, we have a new opportunity for you. Subscribers can now see our program as early as Thursday morning on our website along with timely interviews exclusive to WealthTrack web subscribers. To sign up, go to our website, wealthtrack.com. Thank you for watching and make the week ahead a profitable and a productive one.