QUALIPORT
Learning From The Value Experts

By Maynard Paton (TMFMayn)
October 26, 2004

It's been difficult to ignore the success of Brandes Investment Partners in 2004. The US investment firm has made serious money this year after taking big stakes in Marks & Spencer (LSE: MKS) and Abbey National (LSE: ANL) prior to some high-profile takeover developments.

Though its selections are not Qualiport candidates, what's really striking about Brandes is its dedication to the stock-picking approach pioneered by the 'Father of Value Investing', Benjamin Graham, during the 1930s. A money manager must be worth following when it continually refers to The Intelligent Investor and 'margin of safety' within its promotional literature, and has a Managing Director of Investment that remarks: "We don't ask our analysts to recommend stocks -- we ask them to value businesses"!

Not surprisingly, Graham's value philosophy has served Brandes well over time. Indeed, it has become one of the fastest-growing fund managers in the world. After its formation in 1974, total assets had reached $11m by 1984. However, by 1994, those assets had swelled to $3.9b and by 2004, they topped $85b.

Strategy

So what's the Brandes strategy in practical terms? The following has been extracted from The Search for Value, a document from the group's website that outlines its stock-picking philosophy:

How do you determine whether a stock is good value?

We analyse long-term rates of return, cash flows, balance sheet strength, management, asset values, and liquidation values.  We also often look at private market transactions to determine intrinsic, or fair, value.  We look for a business with a potential margin of safety -- one selling at a price below our estimate of its intrinsic value.  A margin of safety provides some protection from error and uncertainties.  This is a conservative approach that aids in preserving capital and gives us the opportunity for profit.

How important are book values in your methodology?

Book values can be very misleading as a measure of value… For example, an obsolete steel plant may be worth far less than the stated value on the balance sheet.  Conversely, a well known, dominant brand name may have accumulated tremendous value that is not reflected on the balance sheet. 

Do you own stocks with low price to earnings (P/E) ratios?

Most of our stocks carry low P/Es.  This is fundamental to our approach.  But as in the case of asset values, earnings may need adjustment -- and we focus on "normalised" earnings, not the most recently reported results.  In general, we tend to pay as little as possible for the earnings stream of a business. 

How important are dividends?

Typically, dividends are not considered in our process of screening for value stocks.  However, businesses priced at bargain levels in many cases pay higher-than-average dividends.

Is it really possible to acquire companies at bargain prices?

Yes.  Many companies are overlooked, misunderstood victims of investors' overreactions, misplaced fear, and exaggerated focus on short-term performance.  We are often able to acquire companies inexpensively when they experience temporary difficulties or when market conditions are generally weak.  We think independently and make investment decisions based on quantifiable evidence.  We seek to shield ourselves from the influence of short-term public sentiment, and our actions tend to counter current opinion.  We are patient, conservative investors who are willing to wait for values to surface.  We also seek to capitalise on changes in corporate direction and strategy that increase a company's intrinsic value.  Often, the market is slow to respond to positive changes, creating an opportunity for the patient value investor.

What is the role of economic and industry analysis on your investment process?

Analysing or attempting to predict future macroeconomic trends plays virtually no part in our investment process.  For example, we do not base investment decisions on our opinion of future changes in interest rates or economic growth. 

How important is company management in arriving at an investment decision?

We prefer companies with management teams dedicated to the interest of shareholders, not to building empires and their own net worth, independent of the shareholders.  We look at a variety of factors such as compensation arrangements, stock holdings, management goals and statements, and actions that indicate attitude toward owners.

How diversified are your portfolios?

We concentrate our portfolios in 45 to 75 stocks…We believe our value discipline enables us to confidently take positions that can be significantly different from the composition of popular indices.

How long do you hold positions and what is your sell discipline?

We have no fixed holding period.  We may hold an investment as long as the intrinsic value exceeds the stock's market price.  When a company's stock price reaches our estimation of its intrinsic value, or if we are able to identify a superior alternative, it is sold.  Our holding periods typically average three to five years.

Latest reported holdings

This table lists the eighteen London-listed shares that Brandes has traded in the past twelve months:

Company	Percentage owned	Value of holding (£m)
Marks & Spencer (LSE: MKS)	11.9	954
British Aerospace (LSE: BA.)	13.1	929
Abbey National (LSE: ANL)	8.0	714
BT (LSE: BT.A)	4.0	623
William Morrison (LSE: MRW)	7.3	424
J Sainsbury (LSE: SBRY)	8.0	335
Corus (LSE: CS.)	15.8	335
SABMiller (LSE: SAB)	3.0	230
ICI (LSE: ICI)	9.0	224
Royal & Sun Alliance (LSE: RSA)	8.1	171
Rolls-Royce (LSE: RR.)	3.9	167
Reuters (LSE: RTR)	<3.0	<156
Invensys (LSE: ISYS)	18.0	141
Greencore (LSE: GNC)	6.2	23
Aberdeen Asset Management (LSE: ADN)	2.9	15
British Energy (LSE: BGY)*	6.9	6
Heywood Williams (LSE: HYWD)	6.9	5
Elementis (LSE: ELM)	0.9	1

(*Delisted. Valuation stated at last traded price)

The list raises two points:

1. Buying into trouble: Brandes is not afraid of investing in troubled businesses. Most have gone through major upheavals of late and, save for William Morrison perhaps, none come anywhere near to being Qualiport material. (Note: the Morrison stake stemmed largely from a prior investment in the struggling Safeway.)

2. Debt: Unlike many value players, Brandes appears not too concerned with firms carrying onerous borrowings. Invensys, Heywood Williams, BT and Corus for instance all have rather large debts relative to underlying profits.

Anything worth buying?

But can Brandes fans glean any 'value' tips from the list? There are three shares that currently trade within 10% of their 52-week low, which should allow a purchase not too far from a recent Brandes buy price. Here are the trio's obvious value characteristics:

1: Royal & Sun Alliance: The recovering insurer scores well on P/E, yield and asset grounds. At 73.75p, the shares trade on a forward P/E of 7.5, offer a prospective yield of 6.2% and (after accounting for a £525m pension deficit) equal the firm's net asset value per share. Read more.

2. J Sainsbury: Depressed profits and a cut dividend have left the ailing supermarket a pure asset play at present. At the last count, the balance sheet (less intangibles and pension deficit) was worth 267p per share, or 9% more than the 246p share price. Notably, freehold properties were by far the largest balance sheet component. Read more.

3. BT: Despite flat revenues, various cost-cutting initiatives at BT are set to help earnings improve 8% this year and next, alongside double-digit improvements in the dividend. At 181p, the main value attractions are a 2005 P/E of 10.0 and a yield of 5.7%. Read more.

Interestingly enough, all three companies were profiled within the Motley Fool's Value Investor newsletter earlier this year. For a free, no-obligation 30-day trial of the newsletter -- and access to past editions -- click here.

Finally, before ploughing into RSA, Sainsbury and BT, beware that Brandes is not perfect. For instance, the investment firm announced a stake in British Energy (LSE: BGY) in July 2000, at which point the shares traded around 240p. Four years of averaging down later, Brandes finally faced up to the inevitable last week; British Energy shares were delisted at 14.25p to help the group stave off insolvency proceedings.

More: Brandes Investment Partners

Maynard Paton writes every month for the Motley Fool's Value Investor newsletter.

Portfolio value

Holding	Number of shares	Closing price 25/10/04 (p)	Value (£)
Associated British Ports	681	462.5	3,149.63
Emap	372	770	2,864.40
Halma	1,920	163.75	3,144.00
Johnston Press	1,608	549	8,827.92
London Stock Exchange	2,018	345	6,962.10
Cash			1.15
Total			24,949.20