Value in Action: Pat Naccarato

Pat Naccarato of AIC Ltd is a textbook deep value US equity manager in the tradition of Benjamin Graham, but he is also an acolyte of renowned investor Warren Buffett who counsels buying “great companies at a fair price.” The distinction is real and hinges on the types of companies Naccarato is buying because great companies are easily recognized and rarely available at a great price.

The most basic tenet of value investing is to buy a company with a margin of safety, at a price that offers a sizeable discount to its net worth. This is a risk management strategy to account for the fact that the investment manager never has a complete picture of the investment environment and the company in questions, and that things can go wrong. The implementation of this strategy varies for Naccarato, however, based on the type of company that he is considering.

Great companies consistently earn high returns on capital and consistently increase their earnings. Since they rarely falter, less margin of safety is acceptable, which is perhaps a good thing because great companies are easily recognized; therefore, they are rarely available at a great price. “The very good companies tend to be priced in,” says Naccarato. “I look for these great companies when there is a bump in the road, and I try to buy them at a fair price.”
Here the company is valued as a going concern, based on its discounted free cash flow, the present value of the free cash that a company is expected to produce over the long run. This is an appropriate valuation metric because consistency in earnings means those earnings can be forecasted with a high degree of certainty; therefore, the value of the company is readily ascertainable.

The technology boom of the last 90s was a rare moment in history when great companies were really cheap. They [investors] were “throwing away” companies that had these brands that had been established for decades. “Everyone was saying: ‘why I would want to own Procter and Gamble when it is only growing at 8 percent per year when I could buy ABC technology stock that is growing 8 percent a week?’”

Most days, however, Naccarato has to settle for finding merely good companies trading at a great price. With good companies, margin of safety takes on a new meaning in the sense that earnings are not consistent and free cash flow is not easy to predict. Therefore, calculations of value centre on liquidation value rather than discounted free cash flow.

Here the focus shifts from the income statement to the balance sheet. The former provides a snapshot of a company’s earnings whereas the balance sheet provides a picture of its assets and liabilities, the difference of which determines its net asset value.

This is a traditional deep value approach in the discipline of Benjamin Graham & David Dodd’s as articulated in the seminal book on the subject, Security Analysis. Valuation is determined by a company’s liquidation value, essentially the sum of its parts. If a company can be purchased at or near liquidation value, the only risk to an investor is the opportunity cost of his or her money, what it could earn somewhere else.

Naccarrato runs “screens on assets” to find companies that may be trading at or near liquidation value. For example, he looks for companies that are sitting on lots of cash. A company could be punished by the market for having “a poor product cycle yet” it may have been managed prudently with a clean balance sheet and substantial cash. After discounting inventories, adding them to cash and receivables, and subtracting liabilities such as payables and debt, to calculate liquidation value, if this derived value of the company per share exceeds its price, then it is potentially cheap.

A company trading below liquidation value represents a free call option on its common shares. If management can turn things around for the next product cycle and increase earnings, then the share price will undoubtedly rise. If management fails and the company goes bankrupt, Naccarato figures he will recoup his initial investment.

Bausch and Lomb (NYSE: BOL) hit Naccarato’s screens in the Spring of 2007 after the company’s share price was “cut in half” because users of its contact lens solution were developing inner eye fungus. Naccarato recognized that BOL had two other businesses, contact lens manufacturing and pharmaceutical products, which were separate from and unaffected by the solutions business.

Naccarato had “no idea what the problem was; no idea if it would ever get resolved; and no idea what the reliability was.” So he assumed the worst, that the business was “worthless, going to zero,” and that it had one billion dollars in potential liability. Even with those assumptions he realized he was paying for less than the other two businesses and getting the contact lens solution business for free.”

As the problems at BOL were worked out, private equity firm Warburg Pincus recognized the value, stepped in, and took the company private at a substantial premium (over 50 percent) to its share price. In this case, Naccarato was able to recognize a substantial return on his investment in a few short months.

While this type of quick turnaround is rare, it is commonly the case that well-researched value opportunities are eventually recognized by the market and don’t stay cheap forever.