April 9, 2009
SouthernSun 1Q09 Commentary
While studying a range of scientific information lately in an attempt to more accurately grasp the economic impact of a number of governmental programs, including the Government of India’s outcome budget from the Ministry of Power, I fell upon the following term, which I must admit, was previously unknown to me. An extremophile is an organism that lives and thrives in environments that are considered uninhabitable, from places with high levels of toxicity to boiling hot deep sea volcanoes. And, although not in the strictest form of this definition, we sense that we have a more empathetic appreciation these days for the aforementioned organisms and their environmental challenges. After many ups and downs over the past few decades, through the Asian flu, recessions and the tech bubble, to earlier more subtle versions of the housing and credit bubbles, we must say that the past six to nine months appear to have unleashed a lifetime’s worth of toxicity on domestic and global banks, credit and housing, on a domestic and global scale, not to mention on our own portfolio businesses and the portfolio they collectively represent. Further, our research, which includes a substantial number of visits with our portfolio companies’ leaders, as well as global policy makers and academics, currently suggests to us that the toxicity and its residue may not go quietly into the night.
We believe that business operators face a credit and regulatory landscape that may well remain unusually difficult to navigate for quite some time, as citizenry and governing bodies joust for position and possession.
In recent days, during our team’s time in the field (one of the key elements of our charge and commitment over the past twenty plus years), we have become confident that noteworthy decisions are currently being made and campaigns initiated by many of our portfolio companies’ leaders. In time, we believe this may create vital added shareowner value. To this point, we believe our job, as we have described before, is to aggressively operate within the discipline of our process. This, of course, does not mean that every specific decision will be correct; rather it should more often favor the best one possible, given what we can know at the time - so that over time1 - our clients’ assets grow.
That being said, over the short run and with respect to our Small Cap composite, we do wish we had something contemporary and profound to say to you about our underperformance for five of the past seven months and our over performance for the other two and how that has, at least for the moment, so barbarously impacted our clients and our own accounts - but alas - we do not.
In an effort to avoid repetition and promote brevity, we believe that, between our interim commentary published several weeks ago and the firm’s quarterly conference call, you should be in possession of our latest thinking on most issues. Of course, new pieces to the puzzle are analyzed and evaluated daily and there is no guarantee that what precedes or follows may not be rightly classified as a bore.
We are pleased to say, very circumspectly, that we are finding encouraging signs amid the rubble in both our current businesses and in a number of prospective portfolio additions that we have been evaluating for some time now. In spite of significant headline difficulties, the current financing and operating environment appears to present at least three possibilities:
1) attractive low equity valuations may prove modestly positive for a number of our companies who are experienced at identifying and rationalizing bolt-on acquisitions, and/or
2) an opportunity to increase market share as a result of staying power strategies allowed by balance sheet strength and/or continued innovation and design amid competitive retrenchment, and/or
3) strategic initiatives to consolidate and streamline processes – not quite as likely to have occurred when capacity demands were at their peak – that may yield cost savings, efficiencies, and competitive advantage when demand returns.
One may dutifully ask at this point and in this setting - how does SouthernSun go about evaluating themselves, apart from investment performance, with respect to adherence to the firm’s stated investment philosophy and process? This is, of course, a fair question but might be difficult to answer in full in this short communiqué. Over the past twenty years, one of the pillars of our investment approach was gleaned from a book, The Modern Researcher, by Columbia University Professor, Jacques’ Barzun. We believe that consistent and effective research must involve at least five virtues: Honesty, Self-Awareness, Logic, Love of Order, and Accuracy. Over the next few quarters, we hope to highlight these virtues beginning with Honesty and Self-Awareness today. To begin, for example, you may recall from one of our previous newsletters a quote from Alexander Solzhenitsyn where he suggests, “it is not because truth is too difficult to see that we make mistakes…we make mistakes because the easiest and most comfortable course for us is to seek insight where it accords with our emotions – especially selfish ones.” We believe that this valuable appraisal, among others, informs (continually evaluates) our discipline (process).
To further highlight this point, psychological research and even now some animal behavioral research, indicates that, when faced with “information overload” (not uncommon these days and in particular in the investment arena), humans and some animals repeatedly choose what they know, as what they have experienced in the past works to their own best interest.2 Many times, the most difficult daily and weekly challenge our analyst team faces is itself. Discipline does not suggest a lack of freedom from new ideas but quite the contrary. It encourages new ideas by providing a reference point from which one might reliably determine the quality of those ideas. SouthernSun has weathered many a calamity. We clearly believe that a rigorous application and examination of our process, which takes into account these and other ideas, quantitative and qualitative, have proven to be advantageous to our clients over time.
Recently, and relying on the fact that we cannot study the future to find our bearings, I decided to re-read through a number of my old letters to clients over the past twenty years. While reading, many of the events that encircled each letter were relived. What we were thinking during the S&L crisis or just days after the events of 9/11. All of these, when coupled with a wide range of other emotive thoughts, have proven useful. I was reminded anew that our no-nonsense approach to research and our relentless focus on our portfolio businesses has been, and continues to be, one of the cornerstones of our investment research approach.
Also chronicled is our effort to consistently communicate with our clients about the importance of understanding that it is not one particular business that is paramount - any one name could be replaced by another. Rather it is the process used to determine value that must remain reliable. It must then be a true statement that businesses in the portfolio will come and go and to comprehensively communicate the context which lingers and which we retain around them is unrealistic at best. On the other hand, communicating SouthernSun’s process is straightforward, consistent, and traditionally the most helpful to clients. Unfortunately, or fortunately as the case may be, my exercise was unsympathetic in the historicity of how certain views proved very close to our conjecture and how others did not. It seemed quite clear that, amidst the range of outcomes, we were, in print, our own greatest critic - particularly when judging the coherence of our actions with how they corresponded to our general and specific propositions and investments.
Ending with a few chuckles about how old I felt while reading what was written in my 30s, two of my more serious conclusions are as follows: 1) that although we have certainly been far from perfect, much, when any, deviation from our due diligence, valuation and portfolio construction process has been quite limited during good and bad environments and for what is now enough time to reasonably forge balanced judgments about such things, and 2) the disjunction of specific information, perception of that information, and marketplace behavior (meaning and substance of, and resultant action on information) may always provide the necessary conditions for opportunity and sedition. Hence, it would aptly follow that our investment approach is thus established over time in verification and self-examination.
Finally, our firm-wide objectives and the outstanding team we have assembled to execute them remain steadfast. In aggregate, our team has already logged tens of thousands of miles, traveling about the United States and around the globe, over the first three and one half months of 2009. One of our primary intentions while in the field is to understand the scope of the issues our businesses are facing, their vulnerabilities and opportunities, and ask ourselves how SouthernSun, for the benefit of our clients, best might respond – bit by bit – piece by piece.
As always, we appreciate your trust in our firm. You may be confident that, as we proceed forward, we shall apply the philosophy and process that have been in place for the past two decades. We look forward to reporting to you again in July, and until then….
Best wishes,
Michael W. Cook, Sr.
CEO & Chief Investment Officer
SouthernSun Asset Management
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