Michael Sprung has successfully managed money for more than 30 years and even unprecedented market volatility is not about to change the way he does business. It’s that kind of discipline that has more clients than ever seeking the services of Michael and his team at Toronto-based boutique firm, Sprung & Co. Investment Counsel.
SmallCapPower.com: Michael, you manage investments for high net-worth individuals at Toronto-based boutique firm, Sprung & Co. Investment Counsel. Right now we’re seeing a remarkable amount of volatility in the markets and that’s probably worrisome for at least some of your clients. What are you telling them to assuage their concerns?
Michael Sprung: We have a range of clientele and, yes, some of them are very concerned with the volatility that we’ve seen in the market. A number of the clients, certainly those that have arrived sort of post-2008, came in rather shell-shocked from that environment and then to see it continuing this year after two relatively good years following 2008, is causing some concern.
The bulk of the money that we manage is in family trusts or it’s family oriented money, so the investments are long-term in nature. The portfolios we manage tend to be, for the most part, balanced portfolios. A few are at the extremes in terms of aggressive equity but the vast majority of funds we manage is in balanced portfolios. We try to assuage their fears with the fact that a portion of that is in fixed-income investments. Most of the fixed income that we manage is probably in three years and under and so it is not going to be affected so much by a change in interest rates. This provides some stability in the portfolio. So although we’re seeing some volatility on the equity side, it’s being dampened by the large short-term position on the fixed income and cash side.
Furthermore, because of the nature of the clientele, we don’t tend to be in the high beta area. We’re always telling clients that if the market is up 30%, we might not be but when the market is down we tend to be not down anywhere near as much. And, over the years we think we come out ahead. And because the clients are relatively long-term focused, I think they’re very accepting of that philosophy. They aren’t so concerned with the sort of quarter-to-quarter fluctuations that you might see with more aggressive investors or even on the institutional side.
SmallCapPower.com: I would think that that would attract even more clients in the current market conditions.
Michael Sprung: Actually, we are having more enquiries this year than we’ve had before. But we attribute some of that to the fact that I founded this firm at the end of 2005, so we’re at the point where we’re getting to be a known presence out there.
SmallCapPower.com: Do you expect the volatility that we are seeing now to carry on throughout the rest of the year? And perhaps deep into 2012?
Michael Sprung: I think that’s almost a certainty. Right now, with the economic conditions that we’re seeing in the world and the worries over the high sovereign debt levels, particularly in Europe, but to some extent in the United States as well, investors are very concerned. In the 30 years I’ve been managing money, I don’t think we’ve seen an environment that has taken us quite as close to the precipice as this one has.
Another aspect of that volatility is that investors generally seem to be clamoring for any good news. And so when there’s some good economic data regarding the market, then the market really goes too far on the upside. And the opposite effect is happening when the news is bad. I think that we’re going to be in that sort of trading pattern for some time.
SmallCapPower.com: If U.S. economic growth recedes in consecutive months, do you expect to see another round of quantitative easing or some other measure of economic stimulus?
Michael Sprung: Well, we’ve had quantitative easing phase one and phase two. The initial response helped stabilize things. The second response? Not quite so much. I think what we’re seeing is diminishing returns on the quantitative easing side but, should we see the U.S. slipping back toward recession or deflation, yes, I think we would see more quantitative easing. But I think the market’s not going to be very happy unless we get a fiscal response as well. And one of the main problems that we’re seeing in the U.S. right now is the political gridlock and the inability for them to co-ordinate on fiscal measures that would help alleviate the situation.
SmallCapPower.com: You talked earlier about the asset mix that you have for your clients and the fixed income in that mix. What are some other investment vehicles that are providing a measure of economic safety for your clients right now?
Michael Sprung: Well, I don’t think that we’re unique in this circumstance, but certainly since 2008 we’ve tried to emphasize more and more high dividend-paying equities with good balance sheets and maintainable payout ratios so that those dividends will last. And that’s causing the portfolio to be somewhat more concentrated in things like the larger Canadian banks, for instance.
SmallCapPower.com: Bank stocks are certainly providing good value right now, too.
Michael Sprung: Yes, we’ve seen a recent pullback in the banks where we probably have room to be adding to existing levels.
SmallCapPower.com: Among the Canadian banks, are you leaning toward some institutions more than others?
Michael Sprung: We certainly like Bank of Nova Scotia (TSX:BNS); it’s a bank that we’ve always admired for its extremely strong credit discipline. Over the years that I’ve followed the bank, which has been quite a few, Nova Scotia has always been noted for being very tough on credit. So when the economy goes bad and loan losses go up, they tend to be less affected. And they’re probably the most internationally diversified bank without a great presence in the U.S. where we’ve seen some problems occurring for banks like the Royal Bank, which just recently sold off their retail operations in the U.S.
We also like the Bank of Nova Scotia for its management. They’ve been expanding their wealth management area, a sector where they were a little bit weak before. Otherwise, we look at that as being a more stable bank.
We also have exposure to the Canadian Imperial Bank of Commerce (TSX:CM), which, over the years, has certainly stepped in its share of potholes. But over the last few years, under current management, I think they’ve gone a long way to de-risk the bank and, on a profitability basis, they tend to have a higher return on equity than the other banks. Their dividend yield has been very good. And so we look at it as one that has probably not only the dividend yield providing income but, because it’s perceived as a riskier bank, it’s traded at a discount and might have a little higher capital gain potential.
And I guess more recently, in the last year, we’ve been convinced that the Royal Bank of Canada (TSX:RY) was going to do something to correct some of the problems that they were having in the U.S. And so we’ve taken on exposure there, because if you went back a year or so, (the Royal always commanded a premium valuation but more recently that premium has disappeared.)it was selling at a fair discount relative to its normal stance within the banking group. And we thought that there would be some reversion to the mean once they started to take steps to correct that. Those would be our biggest three.
SmallCapPower.com: On your Sprung & Co. website you talk about your firm’s approach to investing and in particular choosing equities using a value-based method. That approach requires finding undervalued companies, mostly through research. But it’s probably not all that difficult to find value in the market right now. How are you choosing between undervalued company “A” and undervalued company “B,” for example?
Michael Sprung: You bring up an interesting point. As value investors we all try to estimate, using our own individual methodologies and processes, the intrinsic value of a company at a given point in time. We’re asking: what is the share price relative to what we perceive the intrinsic value of the company to be? There are lots of factors that go into that but it boils down to: What are you paying for what are you getting?
So when you’re comparing two plausible investments that both look like they could be net additions to your portfolio, you want to buy the one that offers the most. We use a methodology called the IGR, which was a methodology for comparative investments developed by American Airlines back in the 1970s. That method breaks things down into four quadrants and so in cases where stock “A” has a higher return on equity (ROE) but you’re paying a lower price for it – lower price to book value – then that’s obviously superior to the other investment. Conversely, if it has a lower ROE but you’re paying more in terms of price to book, the other investment is probably preferable. It’s the two in between that cause you problems. And what we try to do there is say, OK, over the projected time horizon or business cycle, we think that this company is capable of earning this level of ROE, so what are we paying for it? Generally we use a three- to five-year investment horizon. And in cases where you’re getting less ROE but you’re paying less, the question is: Are you paying enough less? Conversely, if you’re paying more but getting more, how much more are you paying relative to the other? It really comes down to mathematically figuring out between two investments is the payback period within your investment time horizon.
SmallCapPower.com: If this volatility continues, as you believe it will, could we see some dips in the market where you’re seeing stocks trading at less than cash?
Michael Sprung: Very occasionally you see that. You probably see that happen more in the small-cap area than you do in sort of the mid- to larger-cap area. It does occasionally happen but I don’t think there is ever going to be a situation where there’s a prevalence of companies selling for cash or less than cash.
It’s generally an overlooked situation or it’s a situation quite often where maybe you don’t really want to own the underlying business model anyway.
SmallCapPower.com: Would you recommend that some of your clients sit with a high percentage of cash in their portfolios in order to take advantage of some drastic market dips?
Michael Sprung: We are there, actually. Relative to our investment policy statements, we are skewed a little bit more toward that cash and fixed income than we are the other way around. And to the extent that what we have in cash and fixed income is all such short term it’s very easy for us to raise funds to take advantage of opportunities. And I think it’s important, actually, in this kind of environment to have a position where you are able to capitalize on those opportunities.
SmallCapPower.com: Some of your clients are invested in precious metals through various investments. What are some of your preferred ways to give your clients exposure to precious metals? And, in your view, what percentage of a portfolio ought to be in precious metals?
Michael Sprung: As value investors it’s always hard to justify the multiples that you see in the precious metals, particularly the precious metals securities. However, I think that there is room for exposure in this kind of environment, particularly with what we’ve seen happening with gold, and to some extent silver, whereby both metals are being used as a currency hedge against the potential of devaluation of currencies.
We typically would have between 2% to 5% of our exposure in precious metals. It’s probably a little bit higher than that now with our clientele. And our exposure is primarily through some of the large-cap gold companies. Goldcorp Inc. (TSX:G) and Barrick Gold Inc. (TSX:ABX) would be our two biggest.
We like Goldcorp because it’s a low-cost producer. We like the production profile going forward with the properties that it’s owning and developing so we can see an increase in production there. And Barrick is the largest producer in the world; it’s basically the benchmark. And that seems to suit our clientele quite well. That doesn’t mean that we wouldn’t look at some things like Agnico-Eagle Mines Ltd. (TSX:AEM) that also has the potential for production increases over the next few years with its properties. And - at the right price - Kinross Gold Corp, (TSX:K) but we have tried to invest in gold companies that operate in areas with what we perceive as lower political risk than, say, Africa, where Kinross has a lot of exposure.
SmallCapPower.com: Glencore, a Swiss firm that is essentially the world’s largest mined commodities trader, is buying cheaply priced base and precious metals equities as the froth comes out of the market. In fact, Glencore recently launched a bid for the shares of Australian nickel miner, Minara Resources (ASX:MRE), that Glencore didn’t already own. If Glencore is buying and it knows mined commodities better than most any other company on the planet, shouldn’t the average investor follow a similar strategy?
Michael Sprung: As a general rule we’re not likely to follow the herd. What you say is fair, as commodity traders Glencore probably has a view as to what they think the price of the underlying commodities are going to do and they’re trying to invest in equities that have leverage to those changes in commodity prices. My observation would be that when you see mining companies making large investments, sometimes that tends to be when the markets are frothy, when they are cash rich. But at that point prices also tend to be high. I think when markets are particularly strong in a given commodity group, that’s usually not the best time to buy for a longer-term investor. You’re usually better off trying to invest in mining companies when they aren’t so much in favour; when you’re buying them at a much lower multiples to what you perceive their longer-term profitability to be.
SmallCapPower.com: Are there any mined commodities that you’re somewhat bullish on at the moment?
Michael Sprung: I think long term, with the emerging markets and with the demand coming from the development of the emerging markets, we’re pretty bullish on most of the commodities. We just think you have to be very careful as to where and when you invest. We had had a fair amount of exposure to base metals a year ago. We basically minimized that exposure more recently with the market pullback. But with the pullback in some commodity prices, we’re certainly looking at getting back in again.
SmallCapPower.com: Did you replace your base metals equities with rare earths or precious metals equities?
Michael Sprung: No, we didn’t. No, we just took some profits when they became available. A good example, would be HudBay Minerals Inc. (TSX:HBM). We had bought it at what we perceived to be a pretty low price. I think it was around $10 or $11. And within a relatively short period of time it had run up to around $18 and we took some profits there. More recently we’ve seen HudBay correct again.
SmallCapPower.com: When you buy equities are you buying them all at once or are you using a dollar-cost averaging approach?
Michael Sprung: We tend to take an initial position, which could be, depending on the market cap of the company, a 2% or 3% position. And if we see the price come off after we’ve purchased it, we re-evaluate our original premise to determine if we should be looking at adding more. And we may beef that position up to a 3% to 5% position.
SmallCapPower.com: With large gold companies generating a lot of cash flow right now from gold being in excess of US$1,700 an ounce, and silver miners seeing their margins increase this year as well, do you think that we’re going to see more consolidation in the precious metals space?
Michael Sprung: Oh, very much so. I think in the last number of years we’ve seen far more junior gold companies come to life than we saw in the in the previous 20. And I think that’s largely a function of the fact that US$1,700 gold makes a lot of the older and abandoned mines profitable again. So we see a lot of small-cap companies starting up and those that actually do some exploration are turning up new veins that are really looking interesting. In those cases, those small companies are really looking toward the mid-size to larger companies to come along and say, “OK, that’s attractive to us and we’ll buy that.” I think we’re going to see a lot more M&A activity in the precious metals sector than we’ve seen in a long time.
SmallCapPower.com: You tend to deal more in the large-cap space, but are there some mid-cap and small-cap names that you’re following now?
Michael Sprung: In most of our client portfolios we don’t really get into the small-cap mining space but there’s a number of small-cap names that those clients with a little higher risk tolerance could look at. There’s Scorpio Gold Corp. (TSX-V:SGN), Sage Gold Inc. (TSX-V:SGX), Soho Resources Corp. (TSX-V:SOH), to name a few. There’s a number of them out there. I think the danger for the smaller retail investor is that you really have to know the credibility of the players behind these small companies, what their track record has been, where they’ve come from, as well as have some understanding of the history of the properties that these companies are exploring.
SmallCapPower.com: What are some investment themes or ideas that you believe are about to have their time in the spotlight?
Michael Sprung: That’s a good question. Where are we finding value today? I think that we tend to be bullish on the longer-term prospects for energy and we certainly have seen energy prices come off considerably in the last little while. I think that people who are investing not only in the large-cap, but even into the small- and mid-cap area in the energy sector, should be well rewarded in the next cycle.
SmallCapPower.com: Do you have some parting thoughts for us?
Michael Sprung: We always try to apply our investment discipline on a consistent basis. And that is very difficult for the average investor out there because they get so caught up in the noise of the day, you know, what they hear in the media or on television. And there tends to be this herd instinct to go with that. One thing we’ve always said is if you run with the herd you’re likely to get trampled.
SmallCapPower.com: Thank you, Michael, for talking with us today.
Interview Disclosure: This interview was conducted by Brian Sylvester on behalf of SmallCapPower.com. Mr. Sylvester and/or his family may own shares of the companies mentioned in this interview.
Michael Sprung, Sprung & Co. Investment Counsel, and/or their clients may hold positions in the stocks mentioned in this interview.