20% returns annually over 21 years: What is Turtle Creek’s secret sauce?

This transcript is a transcript of a video we did record 2019 at the International Value Investing Conference in Luxembourg. Here Andrew Brenton of Turtle Creek Asset Management presented a quite interesting approach of Value Investing.

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Andrew Brenton of Turtle Creek Asset Management has presented the following topics:

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About Turtle Creek Asset Management

[00:00:07] Andrew Brenton: So the first thing I thought I would do is give a brief introduction as Turtle Creek. We’re based in Toronto, Canada. We’ve actually been around for a long time. We’ve just celebrated our 21st anniversary and we’re a long only. In other words we don’t short stocks, we will, and I’ll describe this. We often take our holdings to zero because of valuation but we’ve never gone to the point of negatively owning a company that continues to go up in price, for a bunch of reasons. We’re focused on the MidCap space. I define that as 2 -25 billion dollars. I think in Canadian dollars it’s not that different than US dollars, but we own companies that are below 2 billion.

We own a couple of companies that are larger than 25 billion market cap but that’s the pond we fish in and to date it’s only been in North America. We manage about 3 billion dollars across; really I’d describe it as one portfolio. We simply have a couple of geographic sleeves. A Canadian only fund of 25 Canadian companies, US only of 25, but the main fund which has been around for the 21 years is really a mix today. It’s almost exactly 50/50 Canadian and US companies.

[00:01:33] Andrew Brenton: As of last week, we’re up to 11 members on the investment team. So I founded Turtle Creek with two partners, we’re still at it, full-time, every day. My two partners are actually in Chicago, in the next few days, meeting with a bunch of our companies. We have had no turnover in the investment team to date. Someday that will happen but other than my partners and I, everyone who’s on the team, the eight other professionals, have all been fresh out of school.

They don’t have the same background that we do and I’ll describe that briefly and we just take them and teach them how we think about investing and how we think about companies. It’s a repeatable process and what’s missing in that comment is it’s a teachable process which is exciting for us because we have a private equity background, which I’ll describe briefly and as none of the eight other members of the investment team have a private equity background.

[00:02:37] Andrew Brenton: So, the exciting thing for us is that you don’t have to have been private equity investors to learn to think about companies the right way and we’ve seen that over the years. And then the last comment on the overview. I remember listening to Seth Klarman from Baupost once, years ago and he gave a presentation to my alma mater and he said, “We have one key competitive advantage – ” , and I was leaning in to what he would say and then he said, “we take a long-term view.” And I was kind of deflating. I thought that’s it? But as time has gone on, I’ve realized how important it is in the public market to genuinely, I mean genuinely, have a long-term view.

Founding partners of Turtle Creek Asset Management

[00:03:24] Andrew Brenton: So my background. I started in mergers and acquisitions. Actually the last time I was in Europe alone on business was when I was a lot younger working on transactions, a couple in the pharmaceutical industry in fact. So at the first part of my career was learning how companies think about what they’ll pay for other companies or what they will sell divisions for and my two partners did the same thing but they’re younger than me so they didn’t have as along a period in that first phase.

The second phase was setting up and running a private equity fund for one of the big Canadian banks. It actually delayed my plan to focus on public market investing. But I’m not complaining. It was a remarkably additive experience for myself and my two partners. And when I set that business up, the first two people I chose to join me in that group were my partners today at Turtle Creek.

[00:04:26] Andrew Brenton: So we had the view going in that we thought we could earn better risk adjusted returns in the public market so in a sense I got to test that because I had this capital from a Canadian bank and we had good returns but we constantly were seeing better companies in the public market, with better management, where we didn’t have to do anything. Whereas with the private investments we were on the board.

We had to make changes, half the time we had to change senior management and these public companies were often, most often trading at much cheaper prices than we could ever get invested in the private market. So we did a complete tilt to public investing and now I feel a little bit like maybe I’m walking into the lion’s den of a group, a room full of value investors.

A different kind of Value Investing

[00:05:18] Andrew Brenton: We did come up with our slogan, our tagline, about a year ago. It’s on the back of our business cards and it’s, “A different kind if value investing”. So I’ll describe how I think we’re different and then you can tell me afterwards whether we are or not because today I’ve heard lots of interesting comments about, if you will, challenges to what might be the traditional definition of a value investing.

In preparing for this conference, because this is the first conference I’ve ever come to speak at anywhere and especially any kind of a value conference, I did look at the videos from last year and I think there was a professor who spoke, maybe he was the first speaker and he described value investing and I thought that’s nothing like what we do. But today, I’ve heard lots of interesting comments that are pieces of at least what we do.

[00:06:12] Andrew Brenton: So let me just describe our process and in each of the four steps, I’ll highlight what I think how we’re different. So we do four things. We find remarkably good companies I think, that what I’d call the right kind of companies for us. The second thing we do where we spend most of our time is that valuation work. The only thing we think about is the present value of the cash flows, the intrinsic value of a company. The third thing we do is we size our position.

We’re very thoughtful about the initial sizing when we add a new company to the portfolio. And I will stress, we don’t change our companies very often. So this year we have added two companies which means we’ve take two companies out and we’ve re-added a third company. So I don’t think of that as a large, fast turnover and in the life of our fund in 21 years, we’ve owned about 100 different companies and it wouldn’t surprise me if the rate of additions goes down. Another way to say it, of the 27 companies we own today, if we never found a better company or a cheaper company that would be okay. We’re quite happy with the companies that we own.

[00:07:30] Andrew Brenton: And then the fourth thing we do is in a way, step three over and over, constantly, every day reacting to relative changing prices so we are definitely not a buy-and-hold. So if I can just go back to each other the steps and highlight why I think we’re different than if I can use the term, the traditional value investor. In the first step, we’re looking for companies that are all the things that we would all look for, terrifically run, shareholder focused.

I don’t believe in economic moats because if there’s one there it might go away. But the great operators, great allocators of capital, it’s what all good investors are looking for. But how we’re different is we’re looking for the public companies that we think that one might get mispriced at times. So what does that mean? It means that for example, we wouldn’t ever look at; there are five big Canadian banks that are all public. The analysts can compare them, they analyse them to death. We’re looking for unique companies.

[00:08:38] Andrew Brenton: So as an example, there’s a, it’s top of mind because they just reported this morning, one of our longtime holdings is a factory automation business. Was founded by a German immigrant, a tool and die person, who’s passed away in Cambridge, Ontario, small place outside of Toronto and it’s a remarkable world class, maybe more nichey factory automation company. So they’re the big Rockwell Internationals. This is a company just a couple of billion market cap but in the industry apparently when you have a really tough problem, the people in the industry will say well if it’s really tough you should go to ATS Automation. They have significant operations in Europe, in particular in Germany.

[00:09:24] Andrew Brenton: The point is there’s only one ATS Automation in Canada. It’s the only company that does anything in factory automation. And so the idea that that stock will be correctly priced, year in and year out, I just don’t think it’s very likely compared to more easy to understand businesses. Then we take the time to get to know the company and embrace the fact that sometimes it will be in favour. More recently it’s been in favour and they had great results this morning so it wouldn’t surprise you if the stock is up today. But times in the 12 or 15 years that we’ve owned it, it’s really been out of favour. And so those are the kind of companies we’re looking for – uniquely, hard to understand but understandable companies.

[00:10:12] Andrew Brenton: On the other extreme, I would never look at a biotech company to try to figure out whether a drug will be approved. That’s not something that I feel like we have the competence for or that most people are able to do. In the second step, evaluation, we are purely discounted cash flow based investors. But where we’re different in that regard is, and I think I just heard a couple of people make this comment today, we’re not conservative in our forecasts.

[00:10:42] Andrew Brenton: We’re thinking about three years, five years, 10 years, 20 years from now, how much bigger could this company be? And it could be a combination of organic growth, but it could also be through acquisitions if they’re good at it. So think of us as trying to get it right. Not saying I’ll take a bunch of conservative assumptions. So that’s a really important difference. The conservatism for us comes in step three and four where we’ve got a full value, our best guess on what a company is worth, but then when we add it to the portfolio, we have a way of thinking about, well how big should it be? If we add it, should it be 2.9%, 3.4%?

[00:11:23] Andrew Brenton: We have a methodology, a logical methodology to size a position. And as I mentioned, we don’t add holdings that often but when we added the two new holdings this year and the one re-addition this year, in each case we had a way to think about what should be the initial size. Has it gotten cheap enough to come back into the portfolio? And that’s really important for us because once we’ve sized it correctly; we know what to do if the price goes down after we’ve added it.

We know we should be buying more and if the price goes down a lot, we need to make it a bigger and bigger percentage and we call that continuous portfolio optimization. But it’s really taking a logical approach but if I can use this term, I feel like we’ve applied the calculus, and my teenage son hates me saying the calculus because he’s in math, he said you don’t say the.

[00:12:19] Andrew Brenton: But we’ve applied calculus to slicing the bits that we buy into smaller and smaller pieces. So literally this factory automation company, last week as it was drifting, we were at each 1% lower buying bits of the stock that we’d sold previously and who knows how long ago, and as it went lower we were amping up how much we bought at each 1% lower. And now it’s strengthened in the last few days and like I said if it is strong as a result of the quarter then we’ll be going the other way and trimming.

[00:12:58] Andrew Brenton: And that continuous process results in the fact that over a 12-month period, you can decide whether this is a lot or not, but over a 12-month period on average over the years, we turn about 50, 55% of the portfolio in the face of other people changing their minds on these companies. So think of us as a buy-and-hold intention unless prices change. And what dragged us into the public market, the wonderful thing about the public market is the prices change and sometimes they change a lot and that willingness to buy but equally and importantly symmetrically trim early is a key source of our outperformance that has occurred at least so far. So that’s our differentiation step by step.

Investment process examples

[00:13:54] Andrew Brenton: And if I can just maybe move to a case study where you can see the different pieces of that approach. So if you think of step one: find a highly intelligent company. We identified this company 20 years ago just not long after we’d started Turtle Creek. They’re based in Waterloo, Ontario which is a leading place for tech in North America. And they actually had developed a search engine and some of you will recognize this name, a lot of people don’t anymore but they decided not to try to compete against AltaVista in the search engine for the public market, for the consumer and instead focus on corporations and it’s a good thing they did that given this other company Google came along and no one knows who AltaVista is anymore.

[00:14:42] Andrew Brenton: But they focused inside the corporation, they’ve grown through both organically but mainly through acquisitions over the years. It’s a big software company but they’re very shareholder focused and friendly. So if you think about the steps, we identified a company that’s done a pretty good job for their shareholders over 20 years, a buy-and-hold has earned a 13% compounded return.

So we found a company that creates value for their shareholders just on their own. The green line that steps up over time and if I can point out sometimes it steps down, this is that forecast, this where we’re trying to get it right and I don’t like always seeing them go up. Well of course a company that doesn’t pay a dividend, which this company doesn’t, you would see that line go up over time as they reinvest the earnings.

[00:15:32] Andrew Brenton: But I like to see sometimes we take our forecast down. It’s this idea of trying to be balanced in our forecast. So the green line is our intrinsic value, our forecast. The black line of course is the share price and this is a semi-log scale so the share price has been much more volatile than when you would first glance at the screen but a semi-log helps you look at the gap between value and price. And the gray background most importantly is the weighting that we’ve had in this company, in our fund so you can see the gray at the very beginning along the left y-axis is our portfolio weighting.

[00:16:14] Andrew Brenton: When we first added it, we made it about two and a half percent of the fund but then a remarkable thing happened in 1999. The share price collapsed and actually it was for trivial reasons. Interestingly in fact, it was the Scandinavian distributor who launched a lawsuit against the company claiming that his contract gave him the right to all of Europe. And we talked to the company and said, “Is this true?” and they said, “No, it’s a frivolous suit”. They found out years later, many years later that that distributor had shorted the stock and then launched the lawsuit.

I’m assuming he made money because the stock really fell. To the company’s credit, they actually launched a substantial issuer bid and bought back a lot of stock on the New York Stock Exchange. This is a company that’s Canadian head office but trades in both the US and Canada. Actually it went public in the US as a full filer and then later listed on the Toronto Stock Exchange.

[00:17:12] Andrew Brenton: But the key for us is if you look at the fact that as the share price fell, and we thought it wasn’t changing value, we bought more and more stock. Then it went the other way in the spring of 2000 and the dot-com craze. And if you can see on the chart, there were three times post, around the time of the dot-com that we did not own this company.

We had a holding of zero and we then built it back up. In the credit crisis, we also took the position to zero not because the price went up but because the price didn’t go down and pretty much everything else we owned in the fall of ’08 went down in price. So it’s a helpful point to recognize that it’s relative cheapness that we think about across the companies that we’re following.

[00:17:57] Andrew Brenton: And the other nice thing about this chart now is that if you look in the last few years, the share price hasn’t moved around very much and our holding, the grey shading has hardly moved. So that punctuates the message that we are a buy-and-hold at core unless share prices change. And it’s back to that first point. We love to find companies where they will move around in price not because they have high business risk but because the market doesn’t get them at times.

So all of that has taken a, you know, find a good company if 13% buy-and-hold, compounded return over 20 years and we’ve made it a 55% return because of our willingness to go in heavily when it’s cheap but then continuously trim as it rises back toward value. And that’s the approach we take across all of our companies. In virtually every case and any longtime holding our return is better, and a lot of cases meaningfully like this than a buy-and-hold.

Lower risk can lead to higher returns

[00:19:05] Andrew Brenton: And so this is something that you all, I know, understand but a lot of investors don’t. You know, the box at the bottom, risk and return can be inversely correlated if you do it right. I mean we’ve all been taught in school, or I was taught that the higher the return, the higher the risk has to be.

I think it’s actually the opposite if you take the right approach. This is where I have all my money and my partners have all of their family’s wealth so we eat our own cooking, we actually never order takeout. We only have our own; we do not have any investments away from Turtle Creek.

[00:19:39] Andrew Brenton: I’ve talked about the quality of the companies and of course the last bullet point; price of an investment is the biggest risk factor. I didn’t do this to criticize Fairfax Financial because it has nothing to with them. But a few years ago, in one of my annual letters, I wrote about valuation risk and put a chart up of Fairfax Financial. It’s a terrific insurance, global insurance company based in Toronto and over 30 years at that point, the compounded returns to investors was well over 20%. So the company’s done a really good job over 30 years.

[00:20:16] Andrew Brenton: The problem is, in that 30 years, there was a 15 year period where if you’d invested, happened to be 1999, you would have sat for 15 years and made no money in fact, had been underwater and finally back to being even in 2014. So I think, and you all know this, you have to be extremely sensitive to valuation. It’s not enough just to own terrific companies.

Investor communications @ Turtle Creek Asset Management

[00:20:43] Andrew Brenton: And then finally, is my last comment. I thought you might find it interesting as to what we’ve tried to do to communicate to our investor base. When we started, one of my partners said, “You know we’ve got to find a way to make the fund less volatile”, and I said, “I don’t want to make it less volatile, how about this?” Because he was worried about investors and would investors give us money if our unit price was volatile. I said, “How about we try communicating and educating our investors?”

[00:21:15] Andrew Brenton: So on that chart, the market is the lower line. Our unit price performance, so based on market value, it the middle line, the black line. The green line is our portfolio intrinsic value. And so I thought at the very beginning, let’s tell people what we think it is, the change in portfolio intrinsic value. So if you read our annual letter, what we tell our investors is in the long term the only thing that matters is the unit price but in the short term, and we argue that it’s up to five years, you should listen to what we think we’ve done in terms of the business values of the portfolio.

So we publish the annual change in our intrinsic value for the last five years. We don’t go beyond that because you could be telling people for 10 or 20 years really the portfolio’s great but if it doesn’t show up in the share price over time, then it’s going to sound pretty hollow. And honestly, it’s been reasonably effective.

[00:22:14] Andrew Brenton: I mean investors do want to try to think long term; they just have trouble with doing it. They know they should and then they can’t. And frankly, it’s one of the things that we love about the public market. So I’ll come back to the office and express frustration with my partners about when we met with this investor and he’s complaining about the unit price in the short term but then we pause and think, that’s the great thing about the public market. The psychology that exists and why companies’ share prices, if they’re going down, they just keep going down often for a very long time. So I just thought I’d share with you. That’s one of our attempts to get our investors thinking long term but it is a struggle to have investors do that.

[00:23:06] Andrew Brenton: I often say to them we simply own companies, it’s not our fault that they’re public. So when we were private investors, we knew how they were doing, we looked at the results. We just do the same thing now with public companies and if they’re doing well and the share price is going down, that doesn’t bother us. What bothers us is the results are not up to what we are expecting. And so this is just one example of how we try to get our investors thinking about value as opposed to mark-to-market share prices. So I think I’ll stop there and see if there are any questions.

Questions

[00:24:03] Question: Thank you for a very good presentation. I had a question on what I understand to be, I guess the modus operandi of increasing exposure to situations where the share price is going down. So if I were to just to repeat that, if I understood the methodology correctly, part of it was the constant portfolio optimization. Part of that would be the modus operandi of the constantly increasing exposure to situations where the share prices are going down, in your regard, in your view for the wrong reasons.

And my question is, whether there is some sort of backstop in your, let’s say methodology there that will prevent what I guess is a fairly concentrated portfolio of being killed by one bad investment because if you theoretically would have one company going to zero and you would sort of increase the exposure all the way down, it would be extremely expensive to you. So what is your sort of thinking about avoiding that type of value trap or situations gone bad?

[00:25:10] Andrew Brenton: So firstly, I don’t want to own companies that could go to zero and I think for a lot of investing, the risk isn’t that you own things that blow up and go to zero. You can avoid that if you own good companies with strong balance sheets that make money, so there’s no zero. The risk is that you own something that just doesn’t earn very good returns over the long term.

So we’re not blindly buying more of something when the share price is going down. We’re constantly checking, has something changed, have they had results, have they done something stupid? We’ve had companies that have done stupid things but we’ve then decided we’re not going to buy more of that company if it declines in price. Often or some cases we’ve decided it’s not what we thought, it’s not a highly intelligent company, it’s voted off the island. We don’t blow it out. The last time we blew out a position was in 2003. So the last time I felt like this was a stupid idea, we never should have owned it, was now 16 years ago. And it was my fault. It was the last time I dragged my partners into a company because of the industry.

[00:26:22] Andrew Brenton: I love the industry and they were saying all the right things but then I realized over time, within the first six months, they’re saying the right things but they’re not doing the right things and so we sold it at a bit of a loss and exited. Since then, we’ve never had a situation where it wasn’t the right idea to buy more as the price went down. Now I won’t tell you that we always felt like we bought the right amount at every price but the concept of making something a bigger and bigger holding, has always been the right decision.

If you think, and I mentioned, we’ve owned a hundred companies over the life of our fund. I don’t know the exact number but let’s say roughly half of them have ever been a big holding. And I think of that as a 5% position or more. In essentially all cases, we made money on that investment, so we haven’t had that situation of going to zero. And your comment about value trap, my view on value traps is if your forecast is reasonably right and they’re generating cash and they don’t sit on cash and they have a properly levered balance sheet. A lot of comments today which I liked was, you know people comfortable with senior debt and having the right amount of senior debt and they will buy back shares, then that that can’t be a value trap. You don’t need the market to recognize value.

[00:27:47] Michael Gielkens (Moderator): Any other questions?

[00:27:52] Question: So what I saw also that if the discount visibility, your intrinsic value is higher you buy more, if it gets lower it makes a lot of sense. I guess that your stocks will also correlate among them. So your strategy would work perfectly if your stocks don’t correlate. But if they correlate a lot then you may find yourself with a lot of cash or without any money to buy more even if you wanted to. Do you look at, do you consciously pick industries or watchlists of different industries so as to get low correlation?

[00:28:36] Andrew Brenton: So we don’t think about that but whenever I look at the portfolio, we never have two companies in the same industry. So they’re not correlated from an industry standpoint but you’re exactly right. In the fall of ’08, we were less active than typical even though the share prices have fallen. Because they all fell. Well other than OpenText. We got to sell OpenText but that was basically it.

We aimed for zero cash. So we went into the credit crisis without a lot of dry powder but we used it all and we kept invested, stayed invested through that period. A better environment for us was later. Early into 2009 and as people realized the world wasn’t coming to an end, some companies’ share price recovered quickly and others actually continued to go lower and lower. So last December, when the market corrected sharply, we are not very active. Again it’s an example where if everything goes down by 8%, there’s nothing for us to do. The good news is, if you own different companies.

Right now, this earning season, it’s been perfect so far. Half of our large holdings have surprised on the upside and half have disappointed. And that would be an ideal scenario for us. But if you think about the turnover, 50%, 55% in a 12-month period, it’s not that much. Sometimes it’s been as low as 35% when you don’t get those movements of a company by company. So I actually think the best environment for us, given our approach, is a sideways market where the market stops worrying about Donald Trump’s tweets and instead listens to, pays attention to each company’s results. Because flip a coin, every quarter, half the time it’s going to be ahead of expectations and sometimes it’s going to be below.

[00:30:27] Michael Gielkens (Moderator): Okay, any more questions?

[00:30:30] Question: Your screening process for your companies, your selection process and the due diligence that you do. How does a company get into your portfolio? Do you speak to management? Just on the selection of the individual companies.

[00:30:41] Andrew Brenton : Yes, so screening, we’ve never run a screen. There is not button on Bloomberg to say give me all the highly intelligent shareholder focused companies. So you have to find them and how do you do that? Well sometimes you know it when you see it. So our fourth largest holding today is a company called SS&C Technologies. It’s out of Connecticut. It’s a remarkable company and the person who runs it started it 30 years ago and he is a force of nature.

And one of my partners was a conference in the States, saw him present for 30 minutes, followed him into the breakout session, spent another half an hour with him with a couple of other investors but my partner did all of the questions. He came back to Toronto and said we really have to look at this company. I went and listened to all the quarterly calls, the investor day and it didn’t take long for me to realize this company’s special. And it is special but it doesn’t mean it’s cheap. That’s the second step. And so that’s one way we find our companies.

[00:31:49] Andrew Brenton: A really common way is to speak to research analysts. Nothing against Goldman Sachs and Morgan Stanley and JP Morgan but not the bulge bracket firms but the firms that have a research culture and have analysts. They’ve covered their sector sometimes for their entire careers, they’re more seasoned and you meet those people as they come through Toronto and they market and we say this is what we’re looking for.

This is the kind of company we’re looking for. And they’ll say oh well in that case, the only company that I cover that you should spend time on is this company. So there are a bunch of ways to find them. You just have to ask behind closed doors. And then your question about management. We then don’t talk to the analysts. Then we spend our time with management over a multi-quarter, multi-year period, really trying to understand the company.

[00:32:44] Michael Gielkens (Moderator): All right, well time for our next speaker so I want to thank you Andrew for your presentation.

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Tilman is a very enthusiastic, long-term investor. Over the last years he has taught himself important investing concepts autodidactically. He tries to combine a positive climate and environmental impact with his investments.
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