What is Value Investing – Market Masters Interview with Michael Sprung
In his recently published book Market Masters – Interviews with Canada‘s Top Investors, Robin R. Speziale interviewed Michael Sprung and discussed his approach to investment management.
Michael Sprung must have been both the shyest and smartest kid in class. You know, the kid who coasted through school with A-pluses without much effort. Well, Michael would go on to study actuarial science, which — based on what it takes to grasp and fulfill the curriculum — is right up there with rocket science as far as I’m concerned. After that he obtained an MBA and then qualified as a CFA. Today, Michael is still relatively shy. He looks exactly how you might expect an actuary to look: white shirt, black slacks, black shoes, and tidy white hair. The thick lenses of his glasses enlarge his eyes. He is soft-spoken. Our interview starts slowly, but Michael opens up as he gets more comfortable with me and the format. The more he talks about investing, the more he comes to life.
Investing happened to be Michael’s calling. He could have very well become a salaried actuary employee at an insurance company, tucked away into a neat little cubicle. Instead, he founded Sprung Asset Management, and as Sprung’s president, Michael’s got lots of interesting stories, insights, and forecasts on investing in the market. Reading the transcript of our interview later, I realized that of all the interviews I had conducted, his transcript was the most cohesive and succinct in its raw form. Michael is a man who thinks clearly and articulately, and who speaks the same way.
Michael Sprung is a student of value investing. Michael’s “school” was his first employer, Confederation Life, where he learned value investing and worked under value managers who would go on to storied careers of their own. “Anyone who went to Confederation Life would consider themselves value investors today,” said Michael during our meeting. Michael and I met in a small, spare meeting room. We pulled our chairs up close and then began with the click of the red button on my recorder.
CFA: Chartered Financial Analyst (an official accreditation).
Conglomerate: a large company that contains an expansive and diverse set of businesses (e.g., Berkshire Hathaway).
Conservative Investing: an approach in which investors make safe investments in the market.
Large-cap Stock: a public company that usually has a market capitalization over $10 billion.
Mid-cap Stock: a public company that usually has a market capitalization of between $2 billion and $10 billion.
Risk Management: when an investor implements controls in his or her trading or investing practice that protect the downside in order to pre- serve capital.
Small-cap Stock: a public company that usually has a market capitaliza- tion of between $50 million and $2 billion.
Watch list: a list of stocks that an investor creates to monitor, and pos- sibly invest in, in the future.
Weighting: the percentage of capital that you allocate to each of your investments (stocks, bonds, etc.)
What is Value Investing – Market Masters Interview
Where did you grow up in Canada?
I grew up in Waterloo, Ontario.
How did you first get interested in the markets?
I got my undergraduate degree at the University of Waterloo studying actuarial science. My father was an actuary and I thought that was the way I might head. However, by the time I finished my undergrad- uate degree, I decided that I wanted to do something different, but something that would still use my mathematical skills. So I went from Waterloo to the business school at the University of Western Ontario (now called the Ivey School of Business), and it was in my first year there that I really began to focus on investments. I had just heard about the CFA designation, so I began to take the courses that would lead me in that direction: corporate finance, investment management, international finance, financial accounting, and so on.
When I finished my MBA, I stayed on at the University of Western Ontario for years as a research assistant with a professor who had taught us quantitative methods. I researched with him and we pub- lished a couple of papers together. I audited and enrolled in a few more courses in this period. As it turned out, a couple of my class- mates had gone on to work for Confederation Life in the investment research department. I heard from them that Confederation Life was looking for another investment analyst. In those days the LifeCos [Life Insurance Companies] had huge research departments. At Confederation Life there were 13 to 16 analysts who were reporting to half a dozen or more portfolio managers. They were big departments, so it was a good place to go for early training, and that’s the genesis of my beginnings in the industry.
What were the first couple of stocks you were asked to cover at Confederation Life?
Well, the first stock I covered was Thomson Newspapers, which is now Thomson Reuters. And then from there I went to look at the broader communication sector: Bell, Rogers, and so on. Within a short period they wanted to broaden you so that you weren’t just coherent in one industry, so the second industry I tackled was forest products. Back in that day I began to cover photography: Kodak and Polaroid in the U.S. When I left Confederation Life, I had had exposure to at least five or six industry groups.
Where did you learn value investing?
Confederation Life was a school of value investing. That basically fit in with my philosophy and temperament anyway. Anyone who went to Confederation Life would consider themselves value investors today. There are different degrees of value investing, though. There is deep value, which Foyston and Gordon practised there. And then there is relative value, which became popular once people started to follow Berkshire Hathaway’s Warren Buffett. Warren Buffett was as big then as he is now. Also, some of the portfolio managers we reported to were Prem Watsa, John Watson, Tony Hamblin, and Tony Gage, who all subsequently had great careers in the business. So it was quite a school of value investing.
Did you read The Intelligent Investor prior to joining the company?
No, but I certainly had to read it during my time there [laughs].
Did you have a mentor who instilled value investing in you?
I would say to some degree it would have been Prem Watsa or Tony Gage, who was actually a fixed-income guy. Whenever you had trouble or you were trying to sort out a problem, they were very enthusiastic, very mentor-like, and they would give you different ideas of how to look at the company maybe a little bit different or how to tear the numbers apart.
In those early days, did you personally invest?
I didn’t have a lot of extra change but, you know, I managed to finish school without any debt, so, yeah, I began to tinker in the markets a little bit.
Do you recall your first big win from those early days?
No, because in those early days I was initially investing in safety. So banks and so on.
Where did you go after Confederation Life?
I went to a firm that technically would be considered on the sell side of the street: Cassels Blaikie and Company Limited. I was a partner there for about eight years. And at the time, that firm was probably the oldest surviving member of the Toronto Stock Exchange. I can’t remember when they got their original seat but it was in the 1800s. So a lot of the clients in the firm were fourth generation. It had a lot of discretionary management, but it hadn’t yet congealed into what I would call a formal counselling environment.
They hired me as the first person to establish a fundamental research department and work with the fellows who managed the discretionary accounts in order to streamline the portfolio management process. The discretionary management side of the firm operated quite inde- pendently from the brokerage side. We did have clients in those days that were penny stock investors, as well as more serious investors, and then we had the discretionary management side, where we managed some family foundations and individual accounts for some fairly well- known Canadian families. That was a really good period.
Elaborate on how you streamlined the portfolio management process at Cassels Blaikie and Company Limited.
Well, not only picking stocks but trying to look at things as a cohesive whole. For example, portfolio structure, industry exposure, alternative strategies, and things like that. I worked closely with other members of the board. One person I worked most closely with in that period was Peter Harris. Peter Harris had been the former chairman of A.E. Ames, which in its day was a leading brokerage firm in Canada. A.E. Ames eventually got purchased by Dominion Securities, which even- tually rolled into Royal Bank. In their day they were one of the big- gest, oldest firms in Canada. They would have competed with Wood Gundy and so on. And so I worked a lot with him.
One exciting part of that was that in addition to just looking at the large-caps from an overall perspective, we got involved in looking at a number of small-caps. For instance, I think we were among the first people to go down and talk to Frank Hasenfratz at Linamar. We were probably very early in going to visit Michael DeGroote at Laidlaw. There were a number of companies like that that we got in at the ground level. And eventually one or two of those companies would be sold to larger entities and the senior management of those entities became clients. So that was really neat.
Clearly, Linamar became a great success. But what ended up happening to Laidlaw?
At that time they were pretty much strictly in garbage collection. Then they branched out into school busing. And then in the late eighties they sold out to Canadian Pacific Railway [CP]. After that they incurred a lot of liability associated with running school buses. CP eventually sold off the business. One thing I’d say I’ve observed over the years is a lot of the large Canadian companies, whether it be CP or Bell Canada or whoever, at various times have diversified and transformed into conglomerate companies. But then later they decide to go back their core business model again.
Investing into non-core assets diluted their returns for shareholders.
Yes. There was Imasco, which was in a lot of industries. All of a sudden they made the bid for Canadian Tire. Imasco put a huge premium on the voting stock. So you had companies that were going into entirely different industries. TransCanada Pipelines got involved with so many different assets that eventually they had to just go back to their core business.
Let’s fast forward. When did you start up your own firm?
It would have been towards the end of 2005.
What is your core investment philosophy at Sprung Asset Management?
We mainly manage money for families. A lot of the money that we manage is actually in family trusts. So it tends to be very conservative management for the most part. We’ve got a few clients who would be a little more risk-tolerant, but those would be exceptions rather than the rule. We’re still in what I would call the building phase of this company. Hopefully we will be for some time. Our core philosophy is trying to minimize downside risk. A lot of our clients are survivors of what I would call the “chasing the performance” game. Particularly after 2008, we had a number of new clients come who had been very happy when they’d been with very hot managers when times were good, but when things went bad they realized that risk is a two-edged sword.
How do you limit downside risk?
As value investors, we invest with what is commonly called a margin of safety. Most of the accounts that we manage are balanced accounts, so they have a mixture of fixed income and equity. More recently, on the fixed-income side, given interest rates as low as they are, we’ve gone to a short duration, which tends to stabilize that part of the portfolio, which in turn counteracts some of the volatility we’ve seen on the equity side.
You must avoid the technology sector then. That can be extremely volatile.
As a value investor, and as a general principle, we have not invested a whole lot in technology. Valuations look out of line. We tend to look for real earnings multiples, price to book, return on capital employed, and so on. As a result, the technology sector has never been an area where I’ve had a lot of exposure. Over the years I’ve had some, but it’s been rare.
You mentioned that some clients invest with you because they were burned dearly in the past; for example, in the tech boom/bust. I’m sure you’ve experienced many bubbles.
Yes, I’ve been doing this now since 1979 when I started at Confederation Life, so I’ve seen many bubbles. I think the first bubble I saw burst was gold, which would have been in the very late seventies. One of the fellows who was covering the gold sector was on holiday; he phoned from the Eaton Centre and said, “Sell our gold stocks, people are lining up to buy gold.”
Was that an indication of the peak of the gold bull cycle — insatiable demand for gold?
When you see that retail investors are all rushing in and that people are lining up to buy something, that’s usually a good time to sell out. And then over the years we saw the Mexican debt crisis and the emerging world debt crisis. In the early nineties we saw the real estate crisis; there were a lot of very large real estate companies in Canada then that all went bust in that period.
Do booms and busts change you or what you invest in?
No, it evolves over time. Hopefully when something like either real estate or technology or any industry becomes really popular you’re selling [laughs]. The whole key to value investing is to buy often when stocks are unpopular, when people do not recognize the inherent value in those companies.
Are markets and most stocks too popular now?
We’re finding it harder to find significant value in a lot of sectors right now. I’d say selective areas in the financial sector offer some good value at the moment. Other than that, a few companies in the industrial sector and even the energy sector. We’ve seen more of a diversion between the U.S. and the Canadian market in the last few years. The U.S. economy has become much stronger. Our economy has been hurt most recently by its exposure to oil and gas. For the most part, materials and commodities have been in a secular downtrend for the past few years. However, these cycles come and go, and so it becomes a function of where you look for opportunities.
I’d say today we are turning our attention more to those depressed areas: companies that have the balance sheet or the financial stability to survive the current climate. And so whenever the next turn in that market comes, you’re going to see some fairly significant price appreciation. Now, there’s always the question of whether you are too early or too late, but as long as we are fairly convinced that a company has the wherewithal and good management to be a survivor, we don’t mind being too early.
Do you see a bottom now in the commodity market?
I don’t think anybody knows where the bottom might be. Although, as a value investor, we do look at the macro-economic environment. We just don’t spend a lot of time there. We try to concentrate more on the micro-economic studies of the individual companies.
Are you taking on any positions in those depressed sectors?
We’ve added one or two positions in the material sector. We’ve added some oil and gas companies, too. So we are beginning to pick away. Our view is that you don’t have to buy a full position immediately. But like anything else, you’re not always right. So if you buy a stock and all of a sudden it goes down 15% or more, the real question at that point becomes, were you wrong or is this an opportunity to buy more?
How do you determine whether to cut your losses or to stick to your thesis?
We try not to look at the short term very much at all. We look at everything with a three- to five-year time horizon or more. And I’d say more towards the five years than three. What we’re always trying to determine within a business cycle is which companies are selling relatively inexpensive today that at some point in that cycle should eventually reflect value.
Which eventually successful stocks did you stick with regardless of others who said you were dead wrong?
There are two examples in recent history. Alliance Grain Traders, which is now called AGT Food and Ingredients, and Progressive Waste, which is a waste management company. Progressive Waste was well managed, but was having some difficulties in the Northeast U.S., where it was oper- ating. It was selling in the mid- to low $20s. More recently, people have begun to see the value in those companies and they’ve come up quite a bit. Those are always the really nice ones to own [laughs]. Oh, and around 1999, I made a bet with some portfolio managers that over the next four years Manulife would outperform Nortel, and they thought I was a fool. Nortel was trading at 120 times earnings. Anyway, Manulife outperformed in that period. I won the bet.
What about the stocks that kept on declining? Essentially, your critics were right.
Oh yes, we’ve all had many of those, especially in the last down-cycle.
Can you give an example?
Teck Resources took quite a beating in the last downturn.
How do you avoid value traps?
By looking at how the components of how the company achieves a return on equity. What is its financial leverage? What does its balance sheet look like? Look for those companies that have deteriorating leverage or margins relative to their competitors — that’s usually a sign that a value trap is going to develop. Although we’ve never owned BlackBerry, they were once at the very top of the market with huge market share, which was probably was not sustainable for a long period of time. Ultimately BlackBerry failed to address the consumer side of that market or see the demand for greater functionality. So it’s usually a range of dynamics that causes us to cut losses and get out but, like anyone else, we’ve been known to ride stocks down quite a ways before we give up. I think as Charles Ellis, who’s a famous investor, said, “a lot of investing is winning the loser’s game.” You just try to make fewer mistakes than your competitors. And as long as your winners outweigh your losers, you’re doing well [laughs].
What have been some of your biggest winners?
AGT was certainly one of them. Progressive Waste was another. Another stock we bought into quite early was Loblaw. Well, indirectly, through the parent company, Weston. Both of those stocks have turned out to be winners. More recently, Loblaw has turned out to be a bigger winner, and Weston still reflects that to a great extent. Back then, people were saying that Loblaw had lost their competitive edge. “They’re losing, they’re bound to lose market share, you’ve got Metro and Sobeys all making moves in the Ontario market, it’s a competitive market.” Unfortunately, what people started losing sight of was the fact that Loblaw was a market-dominant company with great financial resources behind it.
Would you argue then that the markets are not efficient?
Well, I’ll quote Benjamin Graham: “In the short term the market is a voting machine, in the long term it’s a weighing machine.” I’d say in the long term, Efficient Market Theory has some application. Though in the short term there are anomalies within the system where stocks do get mispriced. Hopefully you’re prepared enough to catch those anomalies. As value investors, we can’t cover every stock in the world, so we set up mechanisms by which companies come into what I would call our working list or watch list. Companies leave over time but there’s a large selection of companies that we’re monitoring at any point in time, of which a subset is companies that we’re actually interested in investing in.
What criteria do you use for your watch list?
We look at a number of components. But there’s two very important ones that we use. First, we utilize what is called a DuPont analysis, which breaks down the return on equity into the sources of that return: pre-tax margins, tax rates, financial leverage, and asset turn- over. Second, we prefer companies that have long histories as opposed to short histories so that over time we can look at companies and discern what they have been able to earn, and how they have been able to earn. This is useful information, because they may not be earning that today, so what are the chances of some reversion to the mean? Or what trends are happening within that company that could cause it to become more profitable than they traditionally have been?
But most of the time it’s the former rather than the latter. You’re looking for companies that maybe currently are not earning an adequate return on equity, but given the business cycle or a longer time frame, you can see good advantages for that company to get back to where it once was.
Do you also employ the discounted cash flow model?
We do. I’d say depending on the company, or the industry, we look at discounted cash flows, return on capital employed, cash flow analysis, and economic value added. We look at all those factors, and some of them are more applicable to some companies than to others. There’s not one valuation technique where we’ll say, “Oh that company fits perfectly in that particular peg.”
What was it like for you during the financial crisis?
That period was very painful. You’d come in to your desk every day and you’d see the market down three hundred, four hundred, five hundred points. It was just like having butterflies in your stomach some days. You’d see valuations deteriorating before your eyes. That was so much different from 1987, when you had a one-day 25% drop, and there — you’re done. But even that was a crawl back because I think after any market correction of those kinds of magnitudes, that’s where you see the retail investor disappear for a while, sometimes a long while, until they get some confidence and start coming back into the market, hopefully by then as a value investor. By that time many of the institutional investors have picked their spots.
Was that a good time for value investors, once the dust settled?
We certainly bought a lot of financial stocks in that period, and that turned out to be a very good decision. People always talk about asset mix: your balance between equity and bonds. Well, when you hit a market like that it takes care of your asset mix pretty quickly all on its own. All of a sudden you’re underweight equity. And you know, that goes back to what I was talking about earlier, that to a great extent the fixed-income side of what we’ve managed has been somewhat of a tempering influ- ence to the volatility on the stock side. Although we have a wide variance of returns because our clients have different objectives and different risk tolerances, we were down only about 12% in 2008, which wasn’t too bad. But a lot of that can be attributed to our exposure to fixed income.
That’s incredible risk management. Did you exit any positions during the financial crisis?
We ultimately bailed on one or two, unfortunately close to the bottom [laughs]. But for the most part we stayed the course because that’s what we’re paid to do. The difference between a professional investor and a retail investor is having the fortitude to stick with your knitting. I’ve always said that the worst mistake that I see retail investors make is to become value investors when that’s popular, and then all of a sudden become growth investors when that’s popular. You get whip- sawed on making changes between macro-economic sector rotation and micro-economic stock selection. That’s where most people go wrong. Quite frankly, going from value to growth is a continuum; it’s not like they’re separate.
Is there ever a sure thing in the market?
A number of bank analysts over the years have always made the argu- ment that if you had just bought bank stocks your whole life, you would have done very well over time. Whereas I think our response as portfolio managers is that diversification is a key to managing risk. You might not have a great deal of diversification, but certainly different industries at different times and in different environments are going to react differently. We saw that in a 2008 — the financial firms were extremely hard hit. So I think that’s not a place for people to really hang their hat.
You studied actuarial science and you’re a CFA holder. Does math play a part in the markets?
No, not really, because I think, with all due credit to my competitors, there are some extremely competent investors out there that didn’t come from a mathematical background or even a science background. Investing success, like any other discipline or profession, is achieved through the rudimentary core knowledge that you need to know. It’s in the application — how you think, your discipline, and whether you can stick with that discipline.
What advice do you have for investors starting out in the markets?
Well, if you go to my website, I have a suggested reading list buried somewhere in there. There must be a list of 20 or 30 books or more for beginning investors or novices to more sophisticated investors. I don’t think that every investor out there can read Security Analysis by Benjamin Graham [laughs].
Is this an opportune era for investors?
Let’s face it. We’ve just come off a 30-year bull market for bonds. I don’t think the next 30 years is going to be a bull market for bonds. We’re going back to a period where maybe we’re going to see more performance in equity markets. One can argue today whether or not equity markets are overvalued or not, but I think if you were to look over the long-time horizon, we’re going back into that kind of environment where they have to be.
What we’re seeing in the bond markets today is very artificial. What I see happening in the world is a race to the bottom. People are trying to devalue their currencies against the strength of the U.S. dollar. That’s beginning to affect U.S. manufacturing, and at some point the U.S. is not going to take lightly everyone devaluing their currencies to this extent. The degree to which they can is limited, particularly when you get into negative rates. People will take a negative rate because what they’re paying for is liquidity and insurance. But that won’t last that long. With the number of countries that are now doing quantitative easing, this is something that the world has never seen before. And I don’t know how this experiment’s going to end. But usually when governments start out on these experiments, by trying to take the cyclicality out of the business cycle, it doesn’t end well.
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