Money Life with Chuck Jaffe: Interview with Nael Fakhry

Chuck Jaffe: Nael Fakhry, Portfolio Manager for the Osterweis Growth and Income Fund is here. This is the Money Life Market Call.

Welcome to the Market Call, the part of the show where we talk with experienced money managers about how they do their job, what they look for that determines their buys and sells, what they see happening broadly on the market, and how they put all together. Making his debut in the Market Call today, Nael Fakhry, Portfolio Manager for the Osterweis Growth & Income Fund. If you want to follow along at home, ticker symbol on that, OSTVX. You can go to Osterweis.com. Or you can follow the link that we've got set up in our show notes and on our guest page where you find Nael, that will get you also directly to information on the fund.

Nael Fakhry, welcome to Money Life.

Nael Fakhry: Thanks for having me, Chuck.

Chuck Jaffe: We always start with methodology, particularly important when we are talking with someone we haven't had a conversation with before. Help us understand what the methodology is, what it is that's going to make your buys stand out that you're excited to buy them, and what it is that you're going to generally leave for everybody else?

Nael Fakhry: Sure. On the equity side, what we're looking for are what we call "quality growth" companies. We define quality growth companies as having really three characteristics.

The first is the company has to have a durable competitive advantage. What does that mean? It typically means that a company operates in an industry that is attractive, the structure is attractive, it's an oligopoly. Sometimes even a duopoly, sometimes even a monopoly. The company has something that protects the business. It could be network effects, it could be scale, it could be a brand, it could be some sort of technology advantage. Often, what we find are financial attributes that really reflect that durable competitive advantage.

The company will price in excess of cost. It'll have high and/or improving returns on invested capital. It won't really on too much external debt, it won't be too levered. The margins are attractive. All of that is to say that the company has attractive financial characteristics, and the output is significant and growing free cash flow. If we find a company that has a durable competitive advantage, is operating in a good industry, has all these attributes we've talked about, and they'll tend to generate lots of growing free cash flow. We think that is the first leg of the stool of what defines a quality growth company.

Secondly, it's a company that has a real reinvestment opportunity so it can drive future growth. Often, there will be secular tailwinds in the industry. Things in technology like the Cloud, obviously. Or, AI, you hear a lot about that these days. Near-shoring. There can be secular tailwinds within health care, for example. The company is able to reinvest and drive future growth, that's the second leg of the stool.

Then lastly, it's a well-run company with good governance. What that means is the company, the management team is well-incentivized. They're incentivized along a lot of the same attributes we just talked about. Like returns on capital, for example, free cash flow per share. And, the management owns shares in the company, they're incentivized to get the shares up. If a company has a good board as well, that rounds out the governance in our view.

We are looking for these quality growth companies when it comes to the equity side of the portfolio. They tend to have this durable competitive advantage. They can grow at or above GDP because of the reinvestment opportunity. And they're well-run. When they come in at an attractive valuation, that's when we try to strike.

Chuck Jaffe: I've got to ask an interesting question, because I talk to managers all the time who are growth managers. Over the last couple of years, as what most people call factor investing has become a bigger and bigger deal. I talk to some managers who are quality managers. But quality growth does not quite sound the same as the guy who tells me, "I run a quality fund." Anybody who runs a growth fund has their own flavor.

Is quality a factor to you, or is it just an element? In other words, if somebody was trying to evaluate you, and looking at somebody who has quality in their name, would they expect you to be performing similar to that or different?

Nael Fakhry: It's a good question I think a lot about. That's why I started by defining it the way we define it, because I think some managers will define quality in very different ways. They are just going for growth. They want a ton of top line growth. The profitability and the free cash flow can come way down the line. I think there are some very successful investors who've done a great job managing money that way, and it's a perfectly reasonable way. It's not the way we do it.

We're looking for quality, in terms of yes, we want the growth. But as I said, it's growth at or above GDP, which is not a huge threshold. But the point is these are dynamic businesses that are growing. They tend to grow faster, significantly faster than GDP in our case, but they tend to also be very profitable. They're usually companies that have proven themselves out. They're not really opening up a brand new market.

Valuation also matters in our case. I think that's another distinction, versus what other quality focused investors ... Versus other quality investors out there, we definitely care about valuation. It's an important element of when we make a decision on the buy, and it also affects how we think about exiting a position.

Chuck Jaffe: Given that, how good an opportunity set does this market present? Because I recognize that you are not necessarily top-down buyers where you're saying, "Oh, I need to have great market conditions." But we've got a market that's near record highs. It has been momentum-driven much more than fundamental-driven, so momentum is less about quality. The growth, even though as you said, above GDP, but growth, everybody's worried about slowing.

Is this a good time or a bad time for you to be able to find ... Is it easy or hard right now for you?

Nael Fakhry: It's very idiosyncratic. It's dependent on the opportunity by sector, really. We tend to invest in companies where we've done all the work upfront. We know that this company, perhaps this industry, is a good industry or company to be in, but there's a near-term headwind.

I'd point to a company like Hershey right now. Hershey is obviously the largest, well maybe not obvious to everyone, but it's actually the largest chocolate company in the U.S. It has a little over 40% share. Then you have Mars, which is privately owned, it has a little under 30. Those two companies alone have 70% of the U.S. market. Then, you add in Ferrero and Lindt, and you're at about 85% of the market in the hands of just four players.

As it relates to what I was talking about earlier, basically a four-player market. Very little private label penetration. But near-term, they've had headwinds because cocoa prices have spiked very significantly. For a number of reasons, related to weather, perhaps global warming as well. It's created some disease in the crop. That's really compressed margins. It's going to really hurt margins next year, and the stock has sold off very significantly as a result.

But this is a company that we think has a very durable position over time. A lot of the attributes I talked about, in terms of very high returns on capital, attractive margins, pricing power for sure, very modest leverage, it has all of those attributes. Growing dividend, that's another factor we consider. But it's going through a temporary headwind, so the valuation has come in very significantly, for a business that has a long-term track record of growth, organic and inorganic, within a great industry.

That's completely untethered to the market that we're in. We're looking for those idiosyncratic opportunities when there's a cloud over the business for what we think is a quality growth asset, and we buy it. But I would agree with you that, generally speaking, valuations are high. It's a tough market, I think, to be finding these opportunities in. You really have to look for these stories where there's some sort of temporary setback. You have to be able to prove out that it is temporary to really make the call to invest.

Chuck Jaffe: Hershey (HSY) which by the way, is in my portfolio. That's obviously an example. What's another example, another poster child for the methodology right now?

Nael Fakhry: Another one, AutoZone we could talk about. This is one we'll probably talk about a little bit later. That company, it's an auto parts retailer. They and O'Reilly really dominate the market, along with Advanced Auto Parts and Genuine Parts, which is the NAPA brand. Stocks sold off earlier this year because, basically the industry was under pressure from a pricing perspective. They had taken pricing, during the supply chain, and they weren't really able to take pricing more recently. Because of so much pricing that was taken and the consumer's soft, and there's also a little bit of softer demand in general. You have both weaker traffic and weaker pricing, so that has slowed growth this year for AutoZone and O'Reilly.

But this is actually a really high quality business. This is a business that has gross margins of over 50%, EBITDA margins of 25%, really high returns on capital of 40%. They actually have negative working capital, meaning suppliers are actually effectively funding the inventory. What they're doing is supplying auto parts to people who need to repair their cars, do periodic repairs, to get to basically live their lives. This is a really high quality business. It pulled back, and it was trading at about 17x earnings. To us, that was a really good opportunity. The multiple has expanded a bit here, I still think it's attractive. But it doesn't have the discount that it had earlier. That, I think is emblematic of the type of company we're trying to buy and the valuation we're thinking about.

Chuck Jaffe: Quickly, what makes you sell? Once you found the kind of company you want to buy, what's it going to take to move you off of it?

Nael Fakhry: A couple things. Ideally, we want to own these companies for years. Many of our companies, we have owned for years, even 10-plus years in some cases.

But what would get us to sell is a really extreme valuation. If we're right, we're buying companies at a discount. Then, the market recognizes that the issue they're facing is temporary, so the multiple expands. The multiple can get pretty high, and that's not going to immediately get us to sell. But if it gets really egregious, we will sell, and we've done that. I think that's an important discipline. When we talk about really egregious, we're saying 40x or higher, it starts becoming really hard to justify in our minds.

But the other part is the story has changed. Perhaps the industry structure has changed, so it's not as a good a business as it used to be. Or there's just a better opportunity out there. That might lead us to potentially trim a position, rather than outright selling it. Because there's still significant upside, but it's not as attractive as it once was, and we think there's something else out there. It tends to be a low turnover approach, where we own really good businesses and time is our friend.

Chuck Jaffe: Now we're going to get your Quick and Dirty take on some stocks my audience is particularly interested in.

Speaker 3: Quick and dirty.

Money doesn't grow on trees, you know.

Chuck Jaffe: No, it does not. But it does grow in mutual funds, and Osterweis Growth & Income is all about growth. Its ticker symbol, OSTVX. You can learn more about the firm and the fund, and Nael Fakhry, their portfolio manager, by going to osterweis.com.

You know how Quick and Dirty works. We're going to jump straight in. Since we mentioned AutoZone, AZO. Well, Joe in Parker, Colorado wants to know about Genuine Parts Company, that is the NAPA business as you pointed out. Its ticker symbol GPC.

Nael Fakhry: As I mentioned, we own AutoZone, which is the dominant player along with O'Reilly. Like I mentioned earlier, the industry is facing some near-term headwinds, in terms of a soft consumer and some pricing. Although, the pricing appears to be abating, and they're getting the historical pricing they've usually gotten.

Genuine Parts, it's a bit of a weird mishmash of a company, in my view. It's an industrial distributor in a little less than 40% of its business, and then a little over 60% of its business is the auto parts retail business that's comparable to AutoZone and O'Reilly. That's, again, NAPA. Even within NAPA, it's a little bit unique. It's both owned and franchised. Only 35% of the stores are owned, and 65% are franchised.

The industry is attractive because you have highly complex parts, and it's an immediate need. E-commerce has trouble penetrating here. Plus, it's often consultative. You go in, and you have some issue replacing something. You're going to go in immediately, because you need to use your car. The person at the store often can help you. Like I said, AutoZone and O'Reilly have these really attractive financial attributes. Meanwhile, Advanced Auto Parts, which is another big player, it's actually really highly levered. They just announced last week, or maybe two weeks ago, they're shutting down 700 stores. They have razor-thin margins, about 2% op margins on the remaining business. That should leave a lot of room for Genuine Parts, and AutoZone, and O'Reilly.

The issue with Genuine Parts is that they have much lower operating margins. They're about 8% EBIT margins on the auto parts business. The industrial distribution business is about a 12% margin business. I think it's structurally challenged because they have this franchise model, and there are inefficiencies in how they basically procure and then distribute parts. Meanwhile, AutoZone is, I would argue, best-in-class. It's got these near-term headwinds. They're shifting to more do-it-for-me, which is the growing part of the business. They're investing very aggressively in their supply chain, they're investing international to grow. They're just returning the excess capital in the form of buyback.

One really interesting statistic with respect to AutoZone is they've actually bought back over 100% of their shares since they started buying back shares in 1998. They're just such a massive cashflow generator, in spite of reinvesting in their business to drive growth, that they have bought back all the shares that were outstanding back in 1998. The shares that are still outstanding are just related to new shares that have been issued to management actually as incentive over the years.

Chuck Jaffe: When it comes to Genuine Parts, GPC. Yeah, it wasn't so much a crashing forecast, it was a hold to a sell. By the way, if you're looking for the buy, it is, again, AutoZone, AZO.

Music: Baby, you can drive my car.

Chuck Jaffe: Our next request comes from Morris in Bradenton, Florida, and Javier in Wilmington, North Carolina. They want to know about Terreno Realty Corp, it is TRNO.

Nael Fakhry: We don't own Terreno, but we own EastGroup, which is a very similar business. Like the business because there is growing demand for industrial real estate, and both Terreno and EastGroup own industrial warehouses in last mile in-fill markets, where there's actually flat to declining supply generally. Meanwhile, demand is increasing because of e-commerce, on-shoring, near-shoring, population growth. That creates pricing power. In fact, about three to four percent escalators on their existing properties.

These companies have all paid growing dividends. EastGroup's paid a growing dividend for 32 years. Terreno's been paying growing dividends, growing actually over 13% since becoming public in 2011. These are companies that are actually really modestly levered, at about 3x in both cases. The valuations are cheap right now, because of rates being where they are. We expect demand to re-accelerate next year, valuation on Terreno is about low-20s, EastGroup's 19x on FFO per share. 3%-plus dividend yield.

Chuck Jaffe: It's a buy on Terreno, TRNO. In there also, a buy on East Group Properties, EGP.

Speaker 3: What is this obsession with real estate?

Chuck Jaffe: Well, you just heard why you'd be obsessed with real estate. Our next two requests come from Les in San Diego. The first, Accenture, PLC, ACN.

Nael Fakhry: It's the largest IT consultant globally. We think that scale is what gives it its durable competitive advantage. They can do the strategic consulting upfront for an IT project. They can then do the implementation, if it's a software implementation for example. Then they can actually outsource it, because half the business is outsourcing and half the business is consulting. There's really no other consultant with the scale that Accenture has that can do all of that.

Meanwhile, there's that growth that, between the organic growth they have and then acquisitions, they can then expand margins because they have a little bit of pricing power. And they have increased scale, so you can get low double-digit earnings growth and free cash flow growth. Trades at about low-20s multiple of free cash flow on next 12-months estimates. We think the secular tailwinds are also attractive. You're not making any one bet on any one company winning or losing. They're just taking a tax on growth in IT demand.

Chuck Jaffe: That's a buy on ACN, Accenture.

Speaker 3: That's why we should buy now.

Chuck Jaffe: Les' other request, Home Depot, HD.

Nael Fakhry: It's a company that, it's a great business, they're in a duopoly with Lowe's. Together, if you include Sherwin as well, those three players are about half the market for home improvement in the U.S. Scale is the durable competitive advantage in the case of Home Depot. It enables them to procure at lower cost, they have the best locations. They also have a brand that's unparalleled.

Now obviously, the problem right now is that demand is depressed after the massive increase in spend during Covid, rates are higher than they were historically. They've been making some acquisitions to expand their access to the pro market. That seems reasonable.

The only issue is that the valuation right now is a bit stretched. It's at about 26x the next 12-months earnings. It's growing low to mid single-digit earnings for the next few years. I would say great business, waiting for a better time to own it. We've owned it historically, don't own it now.

Chuck Jaffe: Good company, not a great stock right now. Since it's quality growth, and you have to have it at the reasonable price, the price is not there.

Speaker 3: Why don't you go back home, give it some more thought?

Chuck Jaffe: You want to just wait a little while longer on Home Depot, HD.

Our last request in the limited time we have left comes from Greg in Shortnose, New Jersey. It's Alphabet, or Google, GOOG.

Nael Fakhry: They have a monopoly in search, obviously. That monopoly and the government has confirmed they have a monopoly in search, and that dominance just grows every single day, the more we search. But they also have Android, which is the largest mobile operating system. They have the largest video platform, YouTube. They have the largest browser in Chrome. They have Gmail and Maps. You're completely locked in. That scale and their network effects, really protect the business.

They also have a really growing cloud business. It's a $45 billion run-rate business, growing 35% a year. Actually, pretty profitable now with approaching 20% margins. The business is generating a ton of cash. They buy back stock. They recently initiated a dividend. It trades at just 19x for a company that's still growing earnings in low double-digits.

Obviously, the antitrust overhang is real. We think that they're going to have to change their relationship with Apple. But we're not sure that there are other remedies that the DOJ is going after them for on the search case are really going to play out. There's also the ad tech case, and there are other cases out there. We think ultimately, these cases will be resolved through both a settlement, and maybe some modest behavioral changes. But a lot of that is priced in, in our view.

Chuck Jaffe: So we finish on a high note. That's a buy on Google, or Alphabet, GOOG.

Speaker 3: When you buy here, it's going up.

Chuck Jaffe: That's what we hope for everybody. But we have come to the end of our time with Nael Fakhry. Nael, this was great. Thank you so much for joining me. I hope we get a chance to do this again sometime.

Nael Fakhry: Thanks for having me, Chuck. Really enjoyed it.

Chuck Jaffe: Nael Fakhry is Portfolio Manager for the Osterweis Growth & Income Fund. OSTVX, the ticker symbol. Osterweis.com. A longer link or hotlink if you want, in our guest page and on our show notes, gets you directly to information on the fund.

We will come back, let you know where Nael agreed or disagreed with some recent guests, and we'll set you up for the rest of the holiday week, no turkeys here, as Money Life rolls on and comes to the conclusion next.