From the February 2011 issue of Investment Advisor • Subscribe!

Back to Basics

A focus on quality companies and strong fundamentals has BBH Core Select Fund far ahead of the pack

“I went to Harvard Undergrad and got an MBA from the University of Michigan,” Tim Hartch begins, when asked about his investing pedigree. “I also got a J.D. from Michigan Law School.”

Too bad it’s all for naught; wasted time, wasted money. Okay, we won’t go that far, but when asked what makes them overlooked managers, the investment process Hartch and co-manager Michael Keller describe is something even a state school journalism major can immediately grasp.

“We’re focused on strategy,” Hartch says. “We have a buy-and-own approach that’s focused on very high-quality companies. We have a goal of protecting capital and we utilize a discount-to-intrinsic value framework that is a core part of our approach.”

Over the last five years, Hartch explains, his investment team has executed extremely well, putting together a strong track record, but they’ve been overlooked due to the fact that the funds were not marketed externally from the 192-year-old privately-held Brown Brothers Harriman. They’re now looking to attract potential investors, but want to focus on people who understand their approach and where they align in terms of objectives.

“When we say ‘like-minded,’ I mean our objectives are to protect and grow capital over time at an attractive absolute compound return,” Keller adds. “The primary focus is our strict investment criteria and a margin of safety that we employ in the evaluations in the types of businesses that we have in the portfolio. The more we’re able to preserve during weaker markets, the more capital in which we have to compound in the good markets. There are quantitative attributes that matter to us, but really understanding the business and whether it fits with our investment criteria comes first. We narrow the universe by qualitative attributes, not quantitative.”

When asked to expand on the strict investment criteria he mentioned, Keller says they begin by looking for companies that meet specific business attributes, financial attributes and management attributes. Speaking first to the business attributes, the team looks for companies that provide essential products and services either to business customers or to individual consumers. They look for a large and loyal customer base, and companies that have a sustainable competitive advantage that are leading in good markets.

The financial attributes they look for are companies that generate after-tax free cash flow and have strong balance sheets that are self-financing or have manageable amounts of debt. The companies have high returns on invested capital which, he says, is often an obvious manifestation of a profitable business model that can execute and grow without consuming a lot of incremental capital.

“So high ROI is certainly an attribute that is in many ways intertwined with the other qualitative business attributes that we look for,” Keller says. “And often, you get a higher ROI just by a company fulfilling those other characteristics.”

Finally, he says, the management attributes they look for are a high-quality and trustworthy management team with an “owner mindset,” one they allocate capital to effectively over time.

“With these types of cash-generative companies there’s a lot of capital that continues to come through the door,” he adds. “The capital allocation exercises are important for us. We study this very carefully because it drives so much of shareholder return over a long period of time.”

But as Hartch pointed out, the fund employs a discount-to-intrinsic value framework, making them value managers at heart.

“We come in everyday looking for securities that are undervalued and we only invest in companies that we feel are trading at a discount to their intrinsic value,” he says. “And it’s part of our margin of safety that we spoke about. It really has two components, the discount to the intrinsic value, but also those qualitative aspects that Michael spoke to.”

No homebodies, Hartch and Keller research the intrinsic value by getting out and kicking the tires. They travel to meet with management teams and they’re always happy when management teams stop by their New York offices. Their analysts are the first line of contact and will travel to attend conferences, presentations, etc. This level of commitment to due diligence is something Keller calls “a distinct attribute of a concentrated approach.”

“Our investment universe is significantly smaller than the broad market universe just by virtue of the criteria that we have,” he says. “This actually makes it a manageable universe in the sense that Tim and I can devote the time to learn these businesses and meet with these management teams in person.”

“I think if you were to speak to knowledgeable people in the industries in which we’ve invested in the consumer sector, waste management sector, property/casualty insurance, in the health care and dental markets, you would get consistent feedback that these are some of the most admired businesses in the world,” Hartch adds.

Admiration is one thing; returns another. Where are they finding the good deals currently? Hartch begins by noting they hold most of their companies longer than their contemporaries, for the simple fact that they have an ownership strategy, not a trading strategy. Their turnover is in trending less than 20%.
Nestle is mentioned as a consistently strong performer that has grown through the recession. They’ve also done well in the financial services sector with a number of large holdings like Berkshire Hathaway, Chubb and U.S. Bank Corp. In the technology space, Intuit has performed well on an absolute basis, but is no longer trading at a discount to intrinsic value (in their view).

With the team in place for a little over five years (and the worst global financial crisis in history during that time) they’ve outperformed by 500 basis points.

“Our goal as an investment team is not to try to beat the S&P 500 every quarter or even every year,” Hartch says. “It’s to generate attractive absolute returns over time and we’ve done that over the past five years. We outperformed in down markets like 2008, when our strategy by some measures was the best performing large cap core strategy. And in up markets like 2009 and 2010, we’ve largely performed in line with the broader markets. As Michael said earlier, great track records are often built in bad markets. If you can protect capital and then participate in up markets, we think, over time, you can come out in a pretty good position. We then let the relative rankings and results work out for themselves.”    

John Sullivan can be reached at jsullivan@investmentadvisor.com.

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