Battening Down the Hatches

The skippers of the Beverly Hills-based Clipper Fund see rough sailing ahead for the stock market.

Portfolio managers James Gipson and Michael Sandler have guided Clipper to one of the best track records in the mutual fund business: Their $580-million-asset fund’s 271% return for the 10 years ended March 31 far exceeds the 195% return of the average general U.S. stock fund, according to Lipper Analytical Services.

But both men strongly believe that most stocks now are fairly valued or overvalued. Hard-pressed to find appealing issues, they are keeping nearly a third of the fund’s assets in cash.

Gipson and Sandler, who have worked together since 1984 (when Gipson founded his investment firm, Pacific Financial Research), were interviewed by Russ Wiles, a mutual funds columnist for The Times.

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Times: Mr. Gipson, you started investing at a very young age, and that is said to be an interesting story in its own right.

Gipson: I was 15 years old. I won $2,100 on a [TV game] show called “The Big Game.” That was during the days of the quiz show scandals, but I might add that the show on which I appeared was conducted honestly. I was living in Burbank, near the NBC studios. I just went over to see a show in person one day, and they asked if anyone was interested in trying out.

How I wound up investing my winnings is a sad story, actually. I wanted to buy stock in IBM and DuPont. But being a minor, I couldn’t do it myself. So my mother went to a lawyer, who went to a stockbroker, who said those stocks would be much too speculative for young James. So he put me into a load mutual fund, which, by the time I needed the money for college, had simply recouped the load and nothing more.

In the meantime, those were the glory days for IBM and DuPont. In fairness to the facts, however, I knew nothing about security analysis at that point. I just wanted to invest in two stocks that eventually soared, [and] my mutual fund did not.

Times: Mr. Sandler, you started out as a lawyer?

Sandler: I earned a law degree and an MBA from the University of Iowa. But I definitely had more fun picking stocks than studying law. After graduation, I worked for some businesses, including International Harvester, where I helped to liquidate part of the company. One of the lessons I learned is that “book” value [a company’s theoretical net liquidation value] has little real relevance. It’s an accounting fiction.

We were selling off the construction equipment business at Harvester, and we basically received 20% of the book value. That seems pretty cheap, but Dresser Industries, the buyer, lost money [on the business] every year after purchasing it. So that was a great lesson that book value is meaningless in most scenarios.

Times: The Clipper Fund’s performance over the last decade owes a lot to a relatively small number of stocks, because your strategy has been to run a very concentrated portfolio--just 19 stocks are in the fund currently. Can you elaborate on the strategy?

Sandler: The way we add value over the long term is pretty simple: We concentrate on our best ideas. The only way you can feel comfortable doing that is by doing your homework on these companies.

Times: And generally, you also have stuck with shares of large, well-known companies?

Sandler: Yes, for the simple reason that larger companies historically have had better franchises.

What does a good global franchise mean? It means you can spend a lot of money on advertising and marketing, but when you look at the cost per unit sold, it’s often lower than [that of] your competitors. So you have this built-in profit margin advantage.

The companies in our portfolio generally dominate their markets, whether domestic or global.

Times: Can you give a few examples from among the fund’s holdings?

Sandler: Two stocks that dominate their markets domestically are Fannie Mae [the Federal National Mortgage Assn.] and Freddie Mac [the Federal Home Loan Mortgage Corp.].

They have defined and refined the whole mortgage-guarantee business. They’ve created a very efficient market [for mortgages], which, in turn, has lowered homeowner costs. They clearly dominate the lending business for conventional loans.

McDonald’s is [another] one. It’s true the company’s domestic business has slowed, but they have much more potential internationally. No other fast-food franchise can hold a candle to them outside of the U.S. McDonald’s has broken into Russia with quality products. McDonald’s has been the only [fast-food company] able to execute that strategy there. They already enjoy economies of scale [in Russia], so the others have to play catch-up.

Gipson: Wal-Mart is another. Until about a year and a half ago, the company had achieved 99 straight up quarters [in earnings growth], but then announced they would not be able to make it to 100. At that point, the stock encountered selling pressure, dropped to $18 a share and became a bargain. Though Wal-Mart isn’t perfect, it’s still the best retailer in the country. It presented a good opportunity for a contrarian investor to buy a fine company cheaply.

That’s precisely how it has worked out, with the stock up 50% over the last year and a half. By the turn of the century, Wal-Mart is going to be generating a significant amount of excess cash, a position it has never been in. So it will have the twin benefits of continued growth along with surplus cash, which [management] intends to use in part for share repurchases.

Although Wal-Mart stock has been marked up over the past year and a half, it’s still reasonably cheap at current prices. This provides an opportunity to be partners with one of the best retailers in the country.

Times: You mentioned earlier that book value, as derived from a company’s balance sheet, isn’t very relevant when judging a business’ true worth. What do you use in judging a stock’s value?

Sandler: Basically, we ask what a rational private buyer would pay for the whole business. The problem is that, over the past few years, we have seen a lot of strategic buyers acquire companies for a product line or distribution system. They’re often paying higher prices than what a rational buyer would pay for the whole business.

This has led us to another valuation process, which is a detailed, “discounted cash-flow” analysis. We spend a lot of time looking at the individual operating segments of a company. We look at volume growth, pricing, market share gains and operating margins. After sifting through all that information, we look at the capital-expenditure program, depreciation, net working-capital requirements and any other nuances that generate or consume cash consistently.

Then we look out five to 10 years, calculate the stream of excess cash flow and the stream of dividends, bring those numbers back to present values and set a “terminal value” for the company [against which the current stock price is judged].

Times: From the percentage of the fund’s assets you’re now holding in cash, it doesn’t seem as if you can find many stocks that you’d call true values.

Gipson: Most stocks are aggressively priced. Over the last year, we certainly have found more stocks to sell than to buy. With the risk-reward equation, there are a lot more opportunities to lose money than to make money. That’s one reason we have a large cash position.

Total equities make up almost 65% of the portfolio. We recently bought some bonds comprising 7% of assets. That leaves our short-term Treasuries and cash at nearly 30%.

Sandler: We’ve gone through a 6 1/2-year bull market. It’s the longest ever in terms of duration, maybe the second-highest in terms of returns. When you’re at the end of a bull market, there are a lot of overvalued stocks. You have to stretch to find cheap stocks.

Times: In the Clipper Fund’s March 31 quarterly report, you use the phrase “Murphy’s Law has run in reverse” to describe what has happened in the stock market. Could you explain that?

Gipson: Virtually all of the major things that could go right have gone right. The return on equities in corporate America has hit the highest levels in history. Our grandchildren will look back on the ‘90s and say, “Gee, Granddad, those were the good old days, weren’t they?” The profitability of American companies, as measured by return on equity, is the best we’ve ever seen.

But this is not a world where everything goes right forever. In part, the high level of corporate profitability has been due to a weak dollar, which has allowed U.S. manufacturers to beat or deter the Japanese and others. But the dollar, you may have noticed, is no longer weak. By late ’97 or ‘98, you will start to see the results of that in corporate earnings.

Sandler: From our perspective, the only issue is when returns [in the stock market] go back to the mean, not if. If they take a while, we’ll probably muddle along at 5% to 10% yearly returns. If they go back very rapidly, we could be in for a nasty bear market.

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Clipper Fund

Strategy: Invests mainly in shares of large companies that dominate their industries. Takes a “value” approach toward stocks and tends to follow a buy-and-hold strategy.

VITAL STATISTICS

Year-to-date total return: +12.6%

YTD total return, avg. general stock fund: +6.0

1996 total return: +19.4

1996 total return, avg. general stock fund: +19.5

5-year total return, through March 31: +128.0

5-year total ret., avg. general stock fund: +88.9

Five biggest holdings as of March 31: 1. Federal Home Loan Mortgage Corp. (Freddie Mac) 2. Fannie Mae (Federal National Mortgage Assn.) 3. Wal-Mart Stores 4. McDonald’s 5. Philip Morris

Max. sales charge: none

Assets: $580 million

Min. investment: $5,000

Phone: (800) 776-5033

Morningstar risk-adjusted performance rating, 1-5: HHHHH

Sources: Lipper Analytical Services, Morningstar