Philip Durell is the senior advisor of Inside Value , our interactive newsletter service for value investors. After working this past year on my team in Motley Fool Hidden Gems, Philip impressed all of us at The Motley Fool. We felt it clear that he'd be a truly outstanding stock picker and teacher of the core principles of value investing, with a few contrarian twists thrown in for good measure. This past year, Philip was voted the most valuable member of The Motley Fool Online by our worldwide base of members. We recently sat down and discussed his strategy for beating the stock market with value investments.
Tom Gardner: Philip, let's start by hearing how you define "value investing" in Inside Value.
Philip Durell: Sure. My idea of value investing is to look for the stocks that others aren't interested in, ones that are being dumped by institutions, downgraded by analysts. Some of them, of course, are downgraded for a very good reason. But many are not. Many sound companies have their stocks downgraded simply because of a poor quarter or two. Or maybe they're even struggling with something worse, like an SEC investigation, but the price has been bid too low. In Inside Value, I dig in amongst the figures and work hard to determine how wounded the company is. This is where you'll find some of the truly great investment bargains. And with value investing, whenever we find situations we like, we always apply Ben Graham's margin of safety to any buy price. We demand healthy discounts before buying.
Tom Gardner: What style of investing would you say is in direct contrast to your approach?
Philip Durell: Interesting. One direct contrast for me is what I'll call the "easy, safe stock," where people covet what's accepted as prudent and relatively automatic. I find it difficult to locate many bargains here, where there's a unanimous acceptance of the safety and greatness of a company and its stock. One example has been Coca-Cola (NYSE:KO). It's been viewed as a great investment, one that lets you sleep at night. For a long time, it's been a great stock. But, to my eye, Coca-Cola over the past few years has been as much as 30-40% overvalued. So I do reject investing where people buy what they think is safe, regardless of the valuation of the business. I don't believe in inevitable winners.
Perhaps a more extreme contrast to my investment approach is investing in what I'll call "glamour stocks". The ones that are going to the stratosphere because everybody's jumping on board. That's really the antithesis of my approach to value investing. A good example over the last couple of years might have been Krispy Kreme (NYSE:KKD). I know it's one of David [Gardner]'s picks, but it's one that I would not have gone with. I know David has done extremely well as an investor overall, but the Krispy Kremes only become more interesting to me when they run into trouble, and the stock gets hammered. Then I get interested in taking a look.
So, I avoid the stocks that people love either because the prevailing opinion is that they're safe and automatic or because growth investors find them hot and irresistible.
Tom Gardner: What stands out as your most satisfying value investment ever and what did you learn from it?
Philip Durell: Ah, well, it's a relative unknown! My most satisfying value investment was in MGIC Investment (NYSE:MTG) . A lot of people were knocking it, saying that private mortgage insurance had had its day. But I did a lot of digging into that one and came up with a valuation of around $70. At the time, the stock was trading at $44. The reason I fondly look back on and love this investment is that after I bought, the stock fell to $35. Down 20% from where I got in. I went back through all my work and concluded I still felt it was worth $70. So I bought more in the mid-$30s. Today, the stock is around $70. So that was a very, very satisfying value investment because it really captures the elements of a great value play: (1) buying when others hate an industry, (2) being willing to accept a short-term fall in the price, (3) going back through your work after the price has fallen, (4) buying more at a deeper discount, (5) sitting back and letting the value of the business emerge. Very satisfying.
As for what I learned, the main learning was to stick to your guns. If you really believe in your estimation of the company's future prospects and your own valuation, don't bail out. If the stock slips, double down on your homework, and buy more if you confirm your earlier assumptions. That doesn't mean overloading a single position. But definitely be willing to extend the position when you've really done your homework and feel confident. We adhere to those principles in Inside Value.
Tom Gardner: Now let's do the reverse. Is there an investment that stands out as the worst value investment you've ever made and what did you learn from it?
Philip Durell: You know what? While I've had lots of bad investments in my overall investment career, as I was learning early on, I actually haven't suffered pain as a value investor. Not all my value investments take off, but when you learn to apply that margin of safety, and look for a satisfactory return from a sound business, you substantially reduce the chances of having a blow-up. You really get good at preserving your principal.
Tom Gardner: Your debut recommendations in Inside Value were two companies that have really taken it on the chin over the past couple of years. You've gotten in at what you expect to be a very low price, banking on turnarounds. How do you distinguish between a great turnaround and a great big flop?
Philip Durell: I usually look for a change of management. I look to see what the record of that management was before they came on board. While helping out in Hidden Gems, this is why I took to Alderwoods (NASDAQ:AWGI) -- because I studied the past performance of the new management team. They had consistently met with success.
Secondly, I look to see that a business has great assets. That's not always immediately obvious. I'm not talking here about earnings per share and meeting Wall Street analysts' short-term expectations. I'm speaking of finding a business with great foundational assets that might well be performing poorly today, from the standpoint of generating high and rising earnings. But the business is fundamentally strong. What I look for is a really good balance sheet and attractive tangible assets.
Finally, I look at cash production because most of the companies that are in trouble have a larger amount of debt than we would normally like. But if they have the ability to pay down the debt, and even reschedule debt at lower interest rates, then it's likely they'll be profitable and debt free in the future, attracting a lot of new investors.
So I am looking for new management with a proven track record, great assets, and cash production. That's what I look for in great turnaround stocks.
Tom Gardner: You've done a remarkable job in Hidden Gems of covering companies like Fresh Del Monte (NYSE:FDP) and Alderwoods that fit within your overall strategy. Where do you go hunting for great value investments?
Philip Durell: Well, I certainly spend a lot of time on our Motley Fool community boards. There are lots of great ideas. I think with each passing day, we're attracting brighter and brighter investors here. Now, obviously, I don't take any tip, leaving it at that. I go digging myself, through the filings, through the product lines, and evaluate the prospects, the management team, then value the business myself. But I've found some great ideas pitched around in the Fool community.
I also run a bunch of screens, some pre-made by others, some that are personalized by myself.
Finally, I look at what other successful value investors are doing. I study a select group of value fund managers that I really admire because if they have already done some digging, then they've done the initial screening for me. Often times, the great value investments don't take off right away. So we can study what other great value investors have picked up in their funds, research them ourselves, and select the best of them. That's a wonderful way to screen for great investments.
Tom Gardner: When you make an investment, what's the ideal scenario?
Philip Durell: Ideally, I'll find a business that I want to make part of my core holdings. To get there, it really has to have a long-term, sustainable advantage over its competitors. When I find one of these at a cheap price, some readers won't believe this, but it's unlikely that I'll ever sell it. If you get a truly deep discount on a sound business, your long-term, tax-deferred returns can be simply outstanding. In those situations, I'm more inclined to look for further opportunities in the future, maybe two or three years down the road, to add to the position. I'm not spending time trying to figure when to sell it. If you stay on top of the story of a sound company for a long time, you'll learn to spot bargains on the price of the stock repeatedly. So my ideal company is one that I feel that I can hold for 10 to 20 years.
However, not every company is like that. Other companies may be opportunities rather like Ben Graham's cigar butt idea, where you take one puff, get your stellar results, and flick it away. These are businesses that are undervalued, significantly undervalued, but not really companies to hold for a long period of time. But I would like to get the value out of them before selling. That holding time frame may be anything up to two or three years.
Tom Gardner: Let's look back 10 years from today. What do you suspect will be your average holding period?
Philip Durell: I would think it would be in the two- to three-year range. That's my estimate.
Tom Gardner: How often do you re-evaluate how management is doing, how the business is developing, and whether the stock's valuation is attractive?
Philip Durell: I like to look back on each company at its quarterly report, as a quick review for myself. But it depends on the investment. If it's one of my long-term companies, I'll do a careful review just once a year. That's another reason to love this grouping of stocks. If you get skilled at finding outstanding organizations, then buying their stocks in times of temporary trouble, you can check in just once a year on them. Less work, more reward.
But there are wonderful shorter-term opportunities, where you can generate excellent returns in short order because of ridiculous undervaluation. In this case, I do a thorough review every six months. In any case, though, I always check the quarterly reports and the conference calls of every company that I recommend in Inside Value.
Tom Gardner: What are the circumstances that would cause you to sell a stock?
Philip Durell: The primary reason I sell a stock is when the fundamental reason I bought it has changed. If a company that I felt was a reasonably conservative group suddenly decided to go on an acquisition binge in areas unrelated to its core expertise, that would really cause me to wonder about the future of the enterprise.
If there's a change of management, or departure of a prominent executive or board member, which I didn't particularly approve of or that made me anxious, that forces consideration of a sale. Finally, SEC inquiries can be very damaging to a company's reputation among investors. I like to invest in otherwise solid companies after the taint of the SEC, after the stock has gotten crushed. So what's the reverse of that? When I feel the accounting is getting sloppy at a company, if I sense that there are real attempts to mislead outside shareholders, I look to get out before the SEC gets in!
Tom Gardner: Let's get into valuation a little bit. Give us a few of the factors that cause you to think a stock is badly overvalued.
Philip Durell: So many investors have focused on the price-to-earnings ratio. And now there's been a backlash against that. But I still believe it's a useful measure. One good way to look at the price-to-earnings ratio is to invert it. In other words, look at the earnings-to-price ratio. This just provides some helpful context. A company that's got a price-to-earnings ratio of 25, when we invert it, that means the return is 4%. So for every dollar you put in, you're expecting to get 4%. Although there are other factors that come into play -- like the company's growth rate -- nevertheless, history has shown that lower price-to-earnings ratio stocks yield higher returns.
So I look first at those metrics. But then I look at the ratio of enterprise value to free cash flow. That's one of my favorites because it forces me to think about buying the whole company. It's too easy when buying stocks to forget that they represent ownership of a business. But if you work valuations off the enterprise value of a business, you really see the price of the whole company you're considering buying a stake in. That's very important.
Tom Gardner: Using those and other tools, what makes you think you've found a deeply undervalued stock?
Philip Durell: OK, the sort of screens that I might run, I would look for companies with low price-to-earnings ratios, low price-to-book-value, lots of cash and companies selling at a very low price-to-sales ratio, too. Now, different industries have different norms, so I always compare valuations within the industry as well.
Tom Gardner: Will you be looking, in Inside Value, for any undervalued stocks among fast-growing companies that might trade at higher multiples?
Philip Durell: We will possibly look at some, but we aren't going to buy a 30% growth company selling at a P/E of 35 or 40. We will not overpay for growth because the risk is too high for us.
Tom Gardner: I'm going to provide you with a few scenarios, and I know you won't have complete information on any of them, but let's talk about what might excite you, if anything, about the following circumstances. Are you ready?
Philip Durell: Yes.
Tom Gardner: A company just made it through Chapter 11 bankruptcy and now has a clean balance sheet and a new management team. Why might that interest you?
Philip Durell: That interests me because the business now has a new competitive advantage against its competitors -- it has just had its debt wiped off. So that immediately gets me interested. The new management team is also a key in all turnarounds because the old phrase is right: The trouble with turnarounds is that not many of them turn around. That's why the key lies with management. So, again, a good balance sheet, debt wiped clean, fresh start accounting, and strong new management. Then I'd look to see what other assets they have to see whether they'll repay new investors.
Finally, a lot of investors are very, very shy about going into companies that have just lost them a lot of money when they went into bankruptcy. So coming out into the public markets again, they are shunned by most people. That can create some great bargain opportunities. Just look at Kmart (NASDAQ:KMRT) over the past year.
Tom Gardner: All right, scenario two. A company just missed its quarterly earnings number. All four analysts covering the company downgraded it in succession over a two-week period and the stock now trades at less than one times book value.
Philip Durell: (Laughs.) You're trying to make me salivate. It depends on the industry, and we need to know a lot more, but that may be a really good opportunity for us. When that happens, I begin researching, and as I come to like the situation, I just hope the market doesn't realize its mistake in too much of a hurry. That's the sort of stock that may be a really good stalwart. When you get a discount on a solid company after one slow quarter, because analysts are downgrading it, that can make for a great long-term investment. It kind of reminds me of McDonald's (NYSE:MCD) about 18 months ago.
Tom Gardner: Scenario three. Three quarters ago, this company's sales declined 25%. Two quarters ago, sales declined 9%. Last quarter, sales were flat.
Philip Durell: OK. What I'd expect in a company like that is that it's taken a huge hit to its stock price. Declining sales can terrify investors. And I'm assuming that we've had a significant decline in earnings as well. However, sales may now be bottoming out. There might be a steadying of the ship. You can find stocks in this scenario that are tremendously undervalued.
Tom Gardner: In your debut issue of Inside Value, you wrote that you bought your first stock all the way back in 1968, the year I was born. What stock was it and how did you do?
Philip Durell: I did fine but not tremendously well out of the gate! I worked for a company that is now P&O, Princess Cruises. At that time, we had the opportunity to buy the company's stock for 80 cents on the dollar or, I should say, pennies on the pound, because it was in England. I did OK with it, but it's a transportation company. At that stage, I didn't understand the cyclical nature of transportation. But I did OK. Eventually I sold when I got married and we bought a house. My takeaway from that investment is that it is critical to get in the game of investing. Get started. Don't become so worried that you'll make a mistake that you delay saving and investing. It isn't how well your first investment does that matters. It's how well the next dozen do, and the dozen after that. What matters is that you get smarter and better every year.
Tom Gardner: You've held a wide variety of executive positions in business. How has your professional career influenced or shaped your investment strategy?
Philip Durell: That's been a major benefit to me, because as a senior executive in a lot of companies around the world, my particular expertise was in turnarounds and in green field start-ups. I guess the title I'd have carried in the States would have been chief operating officer and, once in awhile, chief executive. As such, I got to see the whole side of it: operations, marketing, and the finances. So that's been a great advantage when looking at researching stocks.
Tom Gardner: What sort of industries were you working in? And do you focus on those industries when you look for stocks?
Philip Durell: I was working in transportation. When I was an executive, I was in what are called seaport enterprises. But, no, I don't invest a lot in this category. It hasn't been an area of great returns for investors. That said, I have recently had really, really good success with one investment in a port terminal here in British Columbia.
Tom Gardner: So, then what ponds do you fish in to find value stocks?
Philip Durell: Probably the area that I like best for the broadest group of investors is in the category of big stalwart companies that have run into some bad times. I like to find the company that has performed well over a long period of time and that's temporarily out of favor with the market. These give great opportunities. As I just mentioned, McDonald's 18 months ago is the classic.
My second area of opportunity is former growth stocks. Here, I'm talking about something that might've been a story stock for a long time, trading well above my fair valuation. Then it hits a bump in the road. An example of this in recent memory would have been Home Depot (NYSE:HD). It was trading at $60. I felt it was well overvalued. Then it hit a few bumps in the road. All of a sudden, everyone thought its competitor, Lowe's (NYSE:LOW), was going to eat its lunch. Home Depot was sold off aggressively, down to $25 and then to just over $20. That's a value investor's dream. The stock is back above $35 now.
My third area is companies that have really serious problems. My best one over the last few years was Elan (NYSE:ELN). Absolutely terrible, terrible problems. Too many off-balance-sheet entities, hiding some of their debt. The stock went all the way down to penny-stock status, in the $2 to $3 range. It has since come back to over $20. That's one I invested in. That was a great stock, because as they cleaned up the problems, investors came back. But you only found this one if you did the deep research, concluding that the problems were correctable.
Other investment opportunities come in the field of bankruptcies. Your own Hidden Gems has Alderwoods as a classic example. The company goes into bankruptcy, gets a terrible reputation, then brings in new management who are very, very, very good cash managers, then returns to the public markets. Value investors see the high probabilities of success, where others dread the tainted, formerly bankrupt business and stay away.
I also like some cyclical stocks, but these make up a real minority in my portfolio. I guess the best ones that people know of would be companies like Intel (NASDAQ:INTC) and semiconductor stocks. Intel offered a 100% return if you'd bought on the first day of 2003 and sold on the last day of 2003. You simply need to master buying the cycles correctly.
Tom Gardner: The market goes through crushing periods, as we experienced at the turn of the century. I know that in your work life, years ago, you barely survived a hurricane while at sea. I haven't heard the full story. Can you tell it and maybe compare it to investing for us?
Philip Durell: (Laughs.) Well that's a bit of a long one. When I was in my twenties, I was the second officer on a cargo ship and we were working cargo in a Hong Kong harbor. We learned in the morning one day that typhoon Rose was approaching Hong Kong. This is way back in 1971.
We very hurriedly finished our cargo work, securing all our cranes and cargo equipment, but in a very hurried fashion. But we were one of the lucky ships. We got out to what was called a typhoon-mooring buoy (typhoons, of course, out there are hurricanes here). The hurricane came and hit us. I was on the bridge with the captain. We had our anchor chain out on the buoy and we had lashed that thing like you wouldn't believe. Yet the force of the hurricane completely stripped every lashing that we put on it and our cable began to run out. The wind was blowing so hard, the old man had the bridge windows down and the rain was driving horizontally and we were all soaking wet.
Once we realized that we nearly lost our anchor cable, the old man had the engines going between slow- and half-ahead all night and I was dispatched forward. It was extremely difficult to even walk. I was leaning about 45 degrees and holding onto the ship's rail. Bits of wood from the cargo, what we called dunnage, were flying over my head. But of course, being about 23 years old, I just thought it was exciting, not dangerous.
Anyway, we always talk about the calm in the eye of the storm and boy did that hit us. It just went silent. You felt like it was over. It was really eerie. About 20 minutes, 25 minutes later, the storm started up again with the wind from the opposite direction. We had our mast blow down. That was our radar mast.
Later that morning, we found out that half of the Kowloon had been flattened. Several hundred people had died and 38 of the 150 or so big ships in the harbor had sunk or gone aground and numerous small vessels had also sunk. I think we did good work, but I guess we were also lucky. I'm not sure who it was up there who saved us, but I am sure a part of it was the skill of our captain. He was excellent, very calm in the center of that storm.
Tom Gardner: And is there an analogy to investing through very difficult times?
Philip Durell: Absolutely. Sometimes we're going to have a storm hit us, whether it's the aftermath of September 11th or just an unexpected deep recession. We're going to have a time when our ability to remain steadily on course will be tested. And the only way to meet that challenge is through excellent preparation before any storm hits. Back to the story, as investors, we need to get onto the typhoon-mooring buoy and we need to have an experienced captain at the helm. In my work in Inside Value, I draw off of that analogy. I'm responsible for leading members to superior returns and for preparing the group in advance to deal with the inevitable storms.
Tom Gardner: When did you first see the light on value investing?
Philip Durell: You know, to be honest, I was a late convert to value investing. Back in the days when we didn't have the Internet, it was really difficult for retail investors to get much of the information that we're able to get today. When I came to The Motley Fool Online, I certainly knew about value investing and I was drawn to it. But it was at the Fool that I really realized that value investing was far and away my preferred style. I've got a lot of regular Fools to thank for that.
Tom Gardner: Are there any particular value investors that you find admirable and that you follow closely?
Philip Durell: The ones that I like, I read just about everything they write. Guys like David Dreman and Bill Nygren. Bill Miller is an absolute favorite. Those are three that I particularly like. You notice that they all have a little bit of a contrarian flavor, even within their value approach. That's my disposition, too.
Tom Gardner: What books, shareholder letters, or investment publications do you read and recommend to Inside Value members?
Philip Durell: Well, I've read all of Buffett's letters to shareholders at BerkshireHathaway.com. They're an entertaining and invaluable educational source. I recommend that everyone read those. But I like to read letters from the fund managers that I like, as well. I mentioned Bill Nygren's work. This is all available for free online.
Tom Gardner: Philip, what do you make of market valuations today? I'm sure you've looked back at history and seen the 10- or 15-year periods that can roll by delivering very little in rewards to equity investors. Does this influence your investment approach at all?
Philip Durell: I do care about it because when the market's undervalued, it makes my job easier. Now, I honestly believe that there is always value to be found. There are always undervalued stocks. Obviously, if the market in general is overvalued, there are few of them, and we all have to work harder. So I care about it in that sense.
But then the reverse is beautiful. Just go back to January to April of 2003. That's very recent. It was almost like shooting fish in a barrel for a value investor at that time, in my opinion. There were plenty of major stocks that we could have picked and ridden to outstanding returns. And there were other periods too, back in 1999, when the growth market was getting ready to collapse, the value approach paid off handsomely.
Tom Gardner: Are there still fish in the barrel today for value investors and do you still have bullets in your rifle?
Philip Durell: Oh, yes, yes. I keep a watch on a number of stocks and I'm always adding to my watch list of potential great investments. I'm excited about my early selections in Inside Value, and optimistic about the collection of businesses I'm following closely.
Tom Gardner: Sell Hidden Gems members on taking a free trial to Inside Value?
Philip Durell: That's an easy one. I don't want to take your members away! But I want them to seriously consider that a small-cap approach isn't the only approach. In my view, you need to have some larger-caps stocks in your portfolio. My feeling is that Inside Value will be an excellent complement to Hidden Gems.
As far as I can see, at Hidden Gems, plenty of the stocks are going to be growth stories. They're small. Certainly some of them are value stories, but a lot of them are growth stories. I think that my value approach will give people a bunch of companies whose stocks will be less volatile. And they can put them into a collection and keep them for a long time. Now there's nothing wrong with volatility per se except that a lot of people can't sleep at night with it. So I believe Inside Value would be an excellent complement to Hidden Gems. But I don't want people to abandon the Hidden Gems strategy. I believe in it.
Tom Gardner: Philip, you won the Feste Award this past year. Our tens of thousands of community members voted you the single best contributor to the overall service. How do you plan to use community to the greatest effect in Inside Value?
Philip Durell: That was a wonderful surprise. I love the intelligent exchange that's unique to The Motley Fool, and so I've fashioned the community at Inside Value as one of the distinguishing characteristics of the service. This is very, very close to my heart. So much so that I've brought together a team of people who know value investing inside out and who love the idea of teaching it. Our staff is ready to answer all of our members' questions, promptly. Again, we love the idea of teaching the principles of value investing.
Tom Gardner: How confident are you, Philip, that you'll beat the market over the next five years in Inside Value?
Philip Durell: I'm very confident. Because we do the work. In fact, if we are close, only just close to the market return after five years, I'll be mightily disappointed. I am very confident that we will handily beat the market over the next five years.
Tom Gardner: Those are all my questions. Is there a question that I should have asked?
Philip Durell: Tom, I want to say something. I am really, really appreciative of the personal interest you are taking in this. It is quite amazing to me. I knew that you were supportive. I didn't know you were this supportive.
Tom Gardner: Well, I think it is really going to be remarkable service and Philip, for years you've represented the best of what we are doing. That's why the members voted you the Feste Award. I'm going to be an active reader of Inside Value, so I'm really looking forward to using this service myself as an investor. So, again, thank you for taking the time to sit down.
Philip Durell: My pleasure, Tom. Thank you.
