Brandywine Global: 'We buy when there's blood in the streets'

I recently visited Brandywine Global Investment Management, the $56 billion wholly-owned, independently-run Legg Mason unit that employs 200 bond- and stock-pickers and support staff at Cira Center, next to Philadelphia's Amtrak station (branch offices in Toronto, Montreal, San Francisco, London, Singapore). Four senior managers shed light on the business. An edited transcript:  

Patrick Kaser, managing director, Large Cap Value: We're an industry with a lot of Type A's. Brandywine as a firm does not tolerate jerks, does not tolerate the competitive type A's throwing around their elbows internally, thinking it's an 'I win, you lose' outcome...

If you want to look like everyone else, do the same things as everyone else, your performance will never be any better than everyone else... I use behavioral finance, where psychology and investing meet. There have been studies done that if you give people 20 data points to make a decision, their decisions are no better than if you give them 3 data points. They are often worse. But their confidence is higher...

We tend to gravitate toward free cash flow. You can't spend a dollar of EBITDA. We look at return-on-equity and return-on-investment capital. Ultimately we look at balance sheets. Very old fashioned. We have yet to own a company with no debt that went bankrupt. If you are producing free cash flow you can pay your bills.

What people now call "Deep Value", distressed or turnaround companies, that's generally not Brandywine. We may miss some opportunities, but also a lot of risk and volatility. We're buying the profitable companies that are good businesses. We want to own good businesses.

We owned a fair amount of USAir, it's now American Airlines. And Delta. How are they doing with that oil refinery in Trainer, Pa.? Are they really losing money? It's very interesting. The single biggest thing that would indicate more is going on than Delta lets on, is that their cost for jet fuel is 10 cents lower than anyone else.

They aren't showing it through the refinery numbers. They are showing it through fuel costs. Fuel is one of the biggest drivers of airline costs. After capacity management.

Go back to 2008 when they were losing billions on $100 oil. Now they are making billions on $100 oil. It shows you how much has changed. 

What about Comcast? The cable companies are interesting. They had no cash flow, until they stopped spending on capital expenses. 

Comcast we don't own now because of the price. Wifi is the big talk when it comes to cable. We're told they are preparing for a much bigger nationwide Wifi rollout than anyone knows. (But the timetable and benefits of this are unclear.)

When Verizon Fios enters a market, it's much worse for cable companies than they let on. We own Verizon. Verizon is like a legacy-GM-type company with a big pension liability -- plus a great wireless business that drives the company. We own the stock.

Will Google buy Verizon? For Google to take on the pension debt, I'm not sure that's their style. Google's Motorola experiment did not go so well.

What else are you in? Toyota, BP, JPMorgan, Citi, KKR, Blackstone, GM in a big way. Cisco, Merck, Novartis, Pfizer. Energy, tech and financials.

With what assumptions? We assume oil stays between 90 and 110 absent some weird geopolitical event. Oil matters for auto prices. If we thought oil was going to 150 we'd want a different weighting. 

We're pretty bullish on autos. In the U.S., the average age of cars is 11.7 years. That's the oldest it's been. So we're bullish on U.S. automakers and auto demand. This has all kinds of positve fall-ons for the economy.

We're also bullish for housing. Our employees in their mid 20s want to live in the city. But as soon as they reach mid 30s and have a kid, whoosh. (He points toward Villanova, and smiles.)

Adam B. Spector, marketing chief, operating committee chairman: Philadelphia is a great city; it might not be the center of the asset management business, but it is a place where the work-life balance is attractive. By locating here we've been able to compete for people. We spend time on managing the culture and think about it. It's paid off for us. The turnover is really, really low here.

Being in this building is huge. We have employees in Manhattan and in D.C. who come to work here every day. On the train line it's so easy. That's the reason we moved to Philadelphia (from Wilmington) is because of the access. Even in Wilmington, we've always been a bit of an Amtrak culture.

Why Brandywine owned more bonds than stock: You had the crisis. In 2008 the bottom fell out of equities. For five years no one would buy stocks. Everyone wanted bonds. Our bond business took off. We had stellar numbers there.

Almost all our fixed income is global. It had appeal to U.S. institutions; non U.S. institutions; the retail market. It offers diversification relative to core bonds, at a time when U.S. rates are low. You had great performance, and natural demand, in these sectors. Within the retail market, it's an uphill battle vs ETFs and passive (index) investing.

Now stocks are back: We've seen the equity business return over the last nine months, and we've raised significant (new accounts). There's a real resurgence in people looking for active large cap stocks. Passive (index funds) are cheap, but it's quite possible to outperform them. The market is not totally efficient. Look at the 30 largest stocks. You'll see a 30 percent differential in their performance in a year.

In a lot of realms, when somethng doubles in price, you're likely to buy less. In this industry, people buy more. It's crazy.

Abroad and at home: We have clients in more than 20 countries, and we follow events and companies in 40 countries. We might only be in a dozen at any one time.

Our recent theme is 'the risk of success.' A lot of investors worry, What if this goes wrong? We're saying, 'Look at the coordinated global effort to save the world, post-crisis. The numerous interest-rate easings. What if these guys got it right? What happens to asset values, U.S. stocks, credit spreads, currency values?' That wasn't priced in. The negative side was priced in. Italian spreads have come down. The Irish banks have come back. It worked. The central governments got it right.

So we're all done deleveraging? Look, Mexico is exporting to Asia... Really low currency rates or interest rates tend to spur economic activity. And high rates can stall an economy. Those are more likely to (revert to the mean) in a bond market, than in an equity market.

Some clients are neighbors: Most of our assets are outside the Philadelphia area, with 40 percent coming from outside of the U.S... The City of Philadelphia, Penn State, Drexel, Curtis Institute, Merck, SEI, these are typical locally-based customers.

David F. Hoffman, managing director, fixed income: I worked for Dick Boylan when he headed the (Provident National Bank) trust department in the 1970s (after graduating from Williams, with a degree in art history, and Haverford School.) I joined Brandywine in 1995.

Here, your job is to make money. Not to look like the benchmark. Not to manage tracking error. Building a business was a much harder struggle than I thought. And it's grown much bigger than I thought. 

Nobody was intersted in global bonds in the mid-90s. The dollar was strong. We didn't want to compete with Pimco and Blackrock and be a core bond manager. There wasn't that much opportunity; when you're little, that's hard to do. So we decided to be global in our approach. There's always somewhere in the world to make money.

Of course, bond benchmarks are driven by who issues the most debt. Why would you want to necessarily lend more to companies who are more indebted?

By contrast, stock indices are a meritocracy. You become a biger part of the index when you are successful. Like Apple... Most equity managers have great records because they bought a couple of stocks that did very well.

With bonds, there are lots of countries in the world that have $20 billion or more in issuance where you can buy bonds with a reasonable level of liquidity. And you have many economic cycles and valuations and political changes to select from.

We invested in the European convergence. Then we bought Italy and Sweden and Australia and different markets that had become cheap. We hedged pre-Euro.

The world began to think global's okay. We have a very non-benchmark-like strategy. First couple of years was a huge education effort. Get consultants to understand benchmarks just exist, they are not a guide for how to invest. We get paid to think. Investing, the right way, gives us pleasure. That's why we get up in the morning.

Consumer lending: What's happened in the last few years is very strange. Young people have taken on exponentially more debt (through student loans, which) you can't get out of in bankruptcy. It has a very troubling prospect for growth in the U.S. economy. It makes it harder to buy your house.

Excess debt is a noose around your neck. You've borrowed from the future. You have to spend less than you earn. Right now the cost-of-carry for consumer debt is low. Rates are low. The U.S. consumer has deleveraged. But a lot of the deleveraging was through foreclosures and bankruptcy.

Young people are less interested in taking on house debt, or auto debt. Which is why the student loan thing is fascinating. I have 3 kids, 19 to 23. There's a huge thing of 'Why buy when you can share?' PhillyCarShare.

The U.S. is one of the least urbanized countries. We built a national infrastructure on cheap energy. Car companies were powerful.

Everyone else has expensive energy. It drives demographics.

Most of our money now is in sovereign debt. We had a lot of residential mortgage CMO debt in 2009. That's de minimis now, though we are beginning to buy some European mortgage debt.

Our strategy is to buy when there's blood in the streets, when spreads are really wide and you are paid to take credit risk, and to provide liquidity when no one has it.

When spreads are narrow we get out of corporate debt. We may lose a little return for a year or two. We'd rather not be there for the next apocalypse.

Are you expecting another apocalypse soon? We're not predicting one. We will buy corporate debt when it's really cheap, and corporate debt is not cheap right now.

We still have reasonably healthy economic growth and liquidity. The Fed is keeping the system awash. Corporations are pretty healthy. They are buying back stock. They have a pile of money. Earnings as a percentage of GDP is the highest in a long time.

Is that sustainable? Good question! Will corporations start hiring a lot more people? Or keep it tight and keep profits high and just hire (skeleton crew?) They are not overly optimistic on employment; they are not getting aggressive in hiring. They want to keep their profits. Labor is on the defensive globally. And there is still excess capacity. In the U.S., we still have a lot of underemployed people and people who have dropped out of the labor force.

Deflation is the natural state of capitalism. New technology brings good deflation: you can buy more for less. But when there's lots of debt, central banks do not want deflation. If you don't want deflation, you need to put more money in the system. And that leads to a bubble, somewhere.

We have long duration bonds. It's an unusual situation: for U>S. Treasuries and other sovereign bonds, the long end of the yield curve is steep. We think it's too steep. We saw that rates would probably go down with quantitative easing, because that leads to lower rates, not higher rates.

The biggest risk if you are a bond manager today, you're still at near-zero interest rates (for shorter-term debt). Savers have been hurt badly. Spanish mortgages offer a much higher margin of safety. They may not smell that good. But they are cheap. Brazil has a 13 percent yield, with the currency exchange we think that is cheap.

Value investing is always buying things where there are problems. 

In our investment process, we separate information risk and price risk. Just before the tech bubble, there was no information risk; everything was wonderful. But in early 2000, as we learned, you were paying way too much for that privilege (dot.com boom).

The market was right in forecasting that the Internet would fundamentally change our economy; it was wrong in how it priced the change.

(What do you like around the world, and not?) India didn't build infrastructure for 40 years. They are ready. We don't own Russian bonds. We won't buy Ukrainian bonds until the country is stable. Brazil, we bought bonds in 2002 when Lula was elected. Rates were 25 percent. We said, he's a Socialist, but this is priced for Communism. And it worked. In spades.

Henry F. Otto, managing director of the quantitative equity group: There are lots of people out there doing fundamental company research. We take advantage of their work. There are behavioral biases. No matter how hard you research, there is a tendency to fall in love with companies and think they will be good forever. Or to hate companies. That's what creates value opportunities.

Our focus is on what can we do to take advantage of those behavioral biases. We like to know what the Street is saying. Markets have changed dramatically. They are changing faster than they have in the past. But those behavioral biases haven't changed. We build that into our products.

How markets reacted in the 70s is just as relevant today. The last five years, we have had a tremendously strong equity market. What happens after a tremendous five-year run? The answer is historically that the market is still positive. But performance  is not as strong historically after a strong time period.

Perhaps offsetting that, the five years prior to the last five were terrible. In some ways, we are back to trendline. For the last 10 years, we are still below average. 

People still very much remember the financial crisis. The market was down 50 percent. For most people that has a real impact.

The markets bounced back. If you can make it through the down-50-percent, it's an indication why you want to be in equities. That's the only place you get equity returns.
 
It's a good thing, the more people are worried and skeptical. If eveyrone expects the market to go up, that may be the worst environment. If there's a lot of concern and fear, that's when it's a good time to invest.

I'm here 25 years becausewe have a tremendous amount of independence. The firm is very open about, 'Let's try new things.' That's how we've grown. (His group now manages $6 billion.) We're as large as we've ever been. (Hoffman is chairman of Brandywine's executive board. There no chief executive for the group. "We manage ourselves as an old time investment partnership," an autonomous unit of Legg Mason, says Spector. "The profits are shared.")

Each group has been the most profitable in different years. We don't always make decisions with great alacrity. But we tend not to make dumb decisions, when you have to get seven people to agree.

We're constantly developing more powerful tools, putting more data into our models. It's all about looking at the pattern in the past and into the future. The more data we can get, the cleaner, the more kinds of information. (It helps to have Penn and other colleges close, he adds.) We keep track of the academic research.