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Stick to quality

The belief of leading a simple life is extended to investments by Francisco Garcia Parames, also popularly known as the Warren Buffett of Europe. In this interview, he shares his value investing secrets and tells why sticking to quality businesses pays off

The belief of leading a simple life is extended to investments by Francisco Garcia Parames, also popularly known as the Warren Buffett of Europe. In this interview, he shares his value investing secrets and tells why sticking to quality businesses pays off.

Stick to Quality

How did you get into investing?
I was very lucky. I started working for Acciona, a large industrial conglomerate, in 1991. A few months into the job I was assigned as an analyst to Acciona's small investment management business, Bestinver. A year later when the fund manager, who was a value-oriented guy left, I took over the management of the fund.

Around that time I chanced upon Peter Lynch's One Up on Wall Street. I also started reading everything about Warren Buffett, Benjamin Graham and other value investors. All these things allowed me to develop a clear framework very early in my career. You could say that value is now ingrained in my DNA.

What is your approach to stock picking?
We approach stocks the same way as an entrepreneur would. If an entrepreneur sees a company that is undervalued, he buys the whole company. We buy shares. We look for good businesses with strong competitive advantages that are trading at a discount to our estimate of their fair value. We also follow what other value investors are doing-what they are buying and what they are recommending. We are very open to that.

How do you identify companies with strong competitive advantages?
A strong competitive advantage is one that we understand will still be there after ten years. For instance, we look at the economies of scale and whether new competitors will develop that scale. We talk to clients-whether they are willing to leave the company. We talk to a lot of people-the company, competitors, suppliers and customers-to understand how strong the competitive advantage is.

How do you differentiate between a company that has a strong competitive advantage and one that has only a strong brand?
Well, take the case of Sony. Sony is a good brand and everyone knows Sony. But it cannot charge 20 per cent more than its competitors. On the other hand, take BMW. It can still charge more than its competitors. So by definition, you have a good competitive advantage if you can charge higher prices and as a result of which you will end up with higher returns than the competition.

There are a lot of companies with good brands like BMW. You will find that the value of the brand does not get reflected in the balance sheet. How do you factor brands into your valuation?
Brands are extremely important to some companies. BMW, for instance, would be worth a lot less without the brand. But we don't calculate the value of the brand per se. We value the brand because of its ability to allow the company to earn higher returns and generate higher amount of free cash flow (FCF). In the case of BMW, the brand allows it to earn 25 per cent return on capital employed. That is an extremely good return because all the other mainstream companies are earning only 10 per cent (ROCE).

How to identify value traps?
After being in the business for 20 years, I have learnt that value traps are companies with low-quality businesses. We used to buy average businesses at five times free cash flow; now we only buy high-quality businesses at 10-12 times FCF. A company with a return on capital of 12 per cent which enjoys a good position in the market but is unable to raise prices because of competition could be an example of a value trap.

How do you avoid companies that may not grow in revenues or profits?
We have had our share of value traps over the years. But lately, we have moved to high-quality businesses with high return on capital employed and high balance sheet strength. We have moved away from average companies that are only undervalued. In the case of high-quality businesses, even if they don't grow, they tend not to be value traps. That is because they generate so much free cash flow that the value of the stock grows over time.

How do you arrive at fair value in the case of value stocks?
If the business is good and it has a competitive advantage that is sustainable, which means that free cash flow should be stable over the next ten years, then we apply a 15 times multiple to the free cash flow. It is that simple.

Why 15 times? Is it the maximum that you are willing to pay?
Fifteen times is the average that stocks in the US have traded at for over the past 200 years and it translates to about 6.5 per cent free cash flow yield, which seems reasonable to us. We like to pay 11-12 times FCF; 15 times is the maximum, the target price. It is very uncommon for us to buy stocks trading above 12 to 13 times FCF. But this also depends on the alternatives available in the market. If the overall market is overvalued, we may pay 14 times. We try to buy as low as we can but you have to see what the market is quoting at.

Do you apply the 15 multiple to all companies?
Not all, but most of them. In some cases we make an exception for very high-quality businesses, in which case we apply 17 times multiple. But for the not-so-good businesses, we apply 13 to 14 times FCF. As a general rule, we apply 15 times, and that's it.

What do you do when you find a company that you like, trading at, say, 20 times or more?
You never say 'never' in life, but I can say that in 20 years we have generally not done it. And, in case I do find a company that I like at more than 20 times FCF, I will go for a holiday!

For how long do you wait for a stock in your portfolio to perform?
Oh, forever! We have been shareholders of some companies for more than 20 years and we will continue to hold those shares provided the business is growing every year in value and the market doesn't recognise it. For instance, there is a Spanish company that we have been holding for the last 20 years, which has gone up from 15 to 400. We have made 25 times our money but we still continue to hold our shares in it because we think it is worth 600 or more.

So, when do you sell?
We sell only when we find something better. When a stock goes up 20 per cent, it becomes 20 per cent less interesting for us and we may be interested in buying something else. But sometimes a stock doesn't move and we find alternatively something more interesting. So, we sell something we like for something we like more. But it's also relative. When a stock approaches 15 times FCF, we are more willing to sell, but it all depends on the alternatives. If the alternative is cash, we will sell more slowly.

Are there businesses that you avoid?
Well, we stay away from businesses that we don't understand or businesses that we think change too often. This is the Warren Buffett approach where we avoid things that we cannot forecast for the next ten years.

What is your experience in managing investors' expectation?
It is difficult. That is why we allocate a lot of time to properly talk to and inform our clients. We consider our clients and potential clients as co-investors. Thus, we need to make sure that they share our values and targets before they take the decision to invest with us. The decision, very importantly, always rests with the client-we don't push them to come. This requires an exercise of communication, education and honesty, which we have implemented in several ways to guarantee alignment of interest in both directions. If we do our communication job correctly, the expectations of our clients should be exactly the same as ours.

How do you reconcile your investors' ability to redeem their investments anytime with the fact that your portfolio positions are built to be held forever?
The first point is that we openly recommend to our clients to invest in Bestinver, and in general terms when they invest in equity, they should invest only the money they will not require for at least 5-7 years. This reduces very much the amount of money someone is able to allocate. We thus avoid short-term investors or nervous money.

And, we recommend repeating this process annually, renewing their investment commitment only with the portion of money that has this patience at each moment. If investors are rigorous, they will cash out gradually, just keeping the portion of their money with the recommended 5-7 year horizon. Of course, this is not a written commitment; it is only a moral commitment to be used as a guide. And majority of our co-investors follow our recommendations.

We also release the appraisal value of our portfolio versus the market price every month; it is a very important signal to decide if one should be invested or not. The wider the gap between appraisal and the market price, the more they should invest and vice-versa. We must remember that Mr. Buffett stayed out of the market playing bridge for two years because he couldn't find any interesting investment.

The game is not only a matter of being invested for good but a rational selection process. The only reason to be invested in an asset (our funds) is a rational selection of alternatives (risk-reward). We consider that our money could not be invested better than in our funds because the businesses and companies in which we are invested are the best risk-reward alternative that we know. But anyone may know other assets which bring a better risk-reward. In that case, they should look at those investments.

And finally we dedicate a lot of effort to education. We have an annual investors' meeting in which more than 3,000 investors gather. We write papers to share our views and values with clients. We participate in investor summits, which are limited in number but are very focused and of high quality. And we have an Investor Department that permanently keeps in touch with investors to inform them about investments of the portfolio, views, news, risks, etc.

You are known to be an avid follower of the Austrian school of economics. What can an investor learn from the Austrian school?
You can learn a lot of things. For instance, if a company is making a lot of money you will have other companies coming in with more capital and returns will go down. On the other hand, when everybody is losing money, then capital goes out and returns will start improving.

You can learn that if you manipulate interest rates, you can run into problems. If you lower interest rates too much, that could lead to an incentive to invest too much. Take another instance. Growth in an economy should be based on savings and productivity growth. If you look at China, you will see a savings rate of 30 per cent with productivity growth of 6-7 per cent every year. We are absolutely confident that China's growth is sustainable and that's due to the Austrian economics approach. It helps to have a framework that can help in stock selection from the many stocks that are available.

Are you invested in any Indian company?
Not really. But we invest in companies in Europe that have operations in India, like BMW and Schindler, among others. We invest in Europe because we think Europe is much less efficient than the US. And it is closer to home. We find very good companies at very good prices of around eight times earnings. So we have not gone far to China or India. Plus, we think travelling too far from your home country to invest makes the investment process weak. We try to avoid that as much as we can.

You invested in Arcelor only a few days before Lakshmi Mittal made a bid for the company. What attracted you to Arcelor?
We invested in Arcelor in the Spanish fund. We used to own Aceralia, a Spanish company that was bought by Arcelor, and then Arcelor was bought by Mittal. It was a commodity business and we bought it when the commodity was still low and was not recognised by the market.

And how much money did you make out of the whole Arcelor-Mittal acquisition?
It was 50 per cent but that was pure luck.