When most people think of a Nebraska investor who likes to buy undervalued companies that have strong cash flow, someone named Warren Buffett probably comes to mind. Aside from the renowned chairman of Berkshire Hathaway, there is another, less flamboyant Omaha denizen with a knack for finding companies whose stocks sell at a discount to private-market value.
Like Buffett, Wally Weitz, president of Wallace R. Weitz & Co. and manager of the $4.2 billion Weitz Value Fund and the $2.8 billion Weitz Partners Value Fund, assigns his own value to companies based on what he believes a private buyer would pay, not what the public thinks they are worth. But that, he insists, is where the similarity between himself and Buffett ends. "The comparisons between us are more geographical than factual," he says. "I don't want to give the impression that I'm trying to ride on someone's coattails."
Given the performance of his two funds, which are nearly identical in their holdings and investment approach, few would accuse Weitz of that. Over the last one, three and five years ending August 1, Weitz Value Fund has had average annual returns of 21.14%, 16.16% and 25.28%, respectively, compared with -14.42%, 4.06% and 15.01% for the Standard & Poor's 500 Index. (Not all of the funds in the family have done well of late. After a strong run in the late 1990s, Weitz Hickory Fund, run by Rick Lawson, plunged more than 17% last year.)
Weitz's investment strategy focuses on mid-cap companies generating significant free cash flow that are selling below their private-market value because of investor overreaction to bad news or, more often, because investors just aren't interested in them. Says Weitz, "The stocks I buy aren't really contrarian plays. They're just vanilla, boring and slightly cheap." Given Weitz's pricing criteria and his insistence on lots of free cash flow and understandable business models, the funds he manages pretty much sat out the technology boom and bust.
In addition to a good price, Weitz insists on characteristics that will allow a company to sustain free cash flow. Those qualities might include a niche or franchise that insulates them against competition and having what he refers to as "honest, intelligent management who treat shareholders as partners in the business, rather than necessary evils."
Weitz admits that judging management is one of those "squishy" things that are more art than science. "A favorite question I like to ask is how their strategy would be different if the company were private," he says. "If they tell me there wouldn't be much difference, I view that positively. It signals that they would do things similarly even without the added scrutiny that comes with being a public company."
Weitz isn't afraid to buy companies with those qualities even if they have high levels of debt, as long as cash flow is strong and predictable. In the early 1990s, for example, he began buying stocks of cable television companies when most investors wouldn't touch them. At the time, many of those companies were in their build-up phase and were so highly leveraged that they had trouble getting bank financing. Yet Weitz felt that strong, growing revenue from subscribers would overcome those heavy debt loads, which eventually proved to be the case. He took profits on those positions in 1998 and 1999 as their prices peaked.
In late 2000, he began buying back some of those industry favorites, such as Insight Communications and Adelphia Communications, after the market downturn brought those stocks back to attractive levels. Each of them, he says, is a solid cash-flow generator selling at a reasonable price. The family that controls Adelphia has been very aggressive about using borrowed money to build the company, but Weitz feels "cautiously optimistic that they mean it when they say they plan to deleverage the balance sheet. Still, I have to admit, they're testing the outer limits of my comfort zone at this point."
Sitting It Out
The large portion of the portfolios in cash equivalents and short-term bonds-which now stands at a nearly one-third of assets in both funds-reflects Weitz's low comfort level with the stock market in general. "After a 25-year bull market, many investors developed unrealistic expectations. My guess is that the process of unwinding the speculative excesses will take perhaps another year or two. But it's perfectly plausible we could be in a sideways market for a lot longer than that."
As for his current stable of stocks, Weitz says he "is pleased with what I own. But I'm not excited about most of what's out there now. And if I'm not excited, I don't buy."
Sitting on the sidelines isn't unusual for Weitz, who has held the funds' fixed-income allocations at the same level since the beginning of the year. Even when he's enthusiastic about the market, he frequently deploys 15% or more of assets to cash equivalents and short-term government bonds so he can jump on new opportunities without having to sell other securities in the portfolio.
This is a truly iconoclastic and controversial stance, particularly at a time when the vast majority of equity mutual funds pledge to remain fully invested, whatever happens to the stock market and regardless of the level of new cash inflows. Yet Weitz insists the strategy isn't a statement about where he thinks stocks are headed or an attempt to time the market. Instead, it's a product of large cash inflows from new investors and his inability to find stocks that he really likes.
He admits that keeping a large percentage of the portfolio out of stocks for prolonged periods has cost him some business from pension providers who are used to adhering to strict asset-allocation rules. "One Fortune 500 company told me that they liked everything about the funds except for their large cash positions, since they already had a cash-investment option for employees," he says. "It's unfortunate to lose that business, but I'm not going to change my strategy to fit into a certain asset-allocation mold or style box."
On the other hand, he says, financial advisors "are willing to be a bit more open-minded, as long as returns are good." About 40% of mutual fund assets come from omnibus accounts through discount brokers, mainly Fidelity and Charles Schwab & Co. Financial advisors account for about half of those omnibus-account assets.
Keeping It Simple
With his cash position near a peak and his enthusiasm about the stock market well in check, Weitz is deploying much of the new money that comes in toward adding to positions in his current stable of stocks, rather than adding new companies to the roster. His holdings represent an eclectic mix of companies in bread-and-butter, easy-to-understand businesses such as banking, cable television and real estate.
Yet beneath this seemingly unassuming fund exterior are some dashes of daring that show that Weitz isn't afraid to take a stand when he thinks he's right. Although he plays in some fairly risky sectors of the market, he does it on his terms.
Take telecommunications stocks, for example. Fed by a combination of new technology, regulatory changes and easy access to capital, the sector zoomed in the late 1990s, only to crash in early 2000 as investors became spooked by network overbuilding and excess debt. Fund holdings Alltel, Telephone & Data Systems and Citizens Communications, all rural telephone companies, were not spared in the bloodbath. In the case of Alltel, the fund's average cost for the shares is slightly higher than their current value.
Yet Weitz sees these companies as one of the few bright spots on his investment radar screen and recently has been adding to those positions. "These aren't in the same category as telecommunications companies that have gotten mired by costly build-outs," he says. "These rural companies face less competition. And the economics of offering second phone lines, Internet access and high-speed DSL lines can be very favorable. Each sells at a significant discount to its intrinsic business value. And they all generate lots of discretionary cash flow and have managements I trust to use the cash flow wisely."
The small-town theme extends to the banking sector, which represents about 14% of fund assets. Instead of focusing on large multinationals, Weitz's funds zero in on local and regional banks and thrifts, such as North Fork Bancorporation, Washington Mutual, Golden State Bancorp and Astoria Financial Corp. "These are primarily single-family home mortgage lenders that are not exposed to as much credit risk as most commercial banks. They are growing slowly, but steadily, and sell at very reasonable valuation levels."