No. of Recommendations: 13
Last week I went to the Polaris Capital Management annual review meeting at the InterContinental Hotel in Boston. It's always good to hear what other investors have to say, what they're looking at, and where they're finding ideas. I’m happy to say it was worth the trip, because they had a somewhat surprising position in India and pretty vocal takes on India, China, and the overall global economy.

You may remember that I went to the same meeting last year (link:, and that the meeting was an interesting one on a number of levels. The market had recovered at the end of 2008, but was already falling again by the time of the meeting in January, Polaris' funds hadn't done so well in 2008, and the attendees at the meeting weren't in a good mood. This meant the Polaris team spent most of their time explaining their process (bottom-up value, but I'll get into this more in a bit) and why they believed it was still the right process going forward.

This year things were completely different. Fund manager Bernie Horn spent less time talking about the fund's performance (very good in 2009) and was able to spend more time talking about the different ideas in the portfolio and their outlook.

The one regret Bernie had is that the team didn't take in enough funds after last year's meeting. Having been in the audience I'm not surprised. Investors weren't happy. In fairness to Bernie and the team at Polaris I don't think they're alone. Plenty of funds that performed very well for years were in the same boat and I bet some of them weren't happy with the inflows in January, February, and March. Otherwise known as the bottom in 2009. I bet a number of Polaris investors are disappointed that they didn't invest more too.

I’ll walk through some of the major points in the presentation and highlight some of the companies mentioned. The presentation should be up on in about week if you want to look at any of the details I’m summarizing here.

Bernie and the team at Polaris are global (almost international, but there is a small amount of US exposure in the global fund) bottoms-up investors, which means they find companies that are attractively valued and then work their way up through the business, management, industry, and economies the business operates in to confirm if it’s a good investment opportunity. Having listened to the team talk about their process the last two years they give the impression that they’re very quantitative (perhaps 100%) on the front end of the process where they’re searching for companies below certain cash flow multiples and much more qualitative on the management and industry/competitor evaluations. Despite the poor 2007/2008 returns this is a process that has worked well for the team going back to the 1980’s.

A look at 1900 – 2009
After reviewing performance and process the team flashed up a chart showing returns for equities (US and World), bonds (US), and T-Bills (US), and inflation data (US-CPI) for each decade from 1900 to 2009. The last decade (2000 – 2009) was second in the last 110 years where US equity returns were negative, but the first where equity returns were negative and inflation was positive. Some other interesting data points in the chart:

-There were 2 decades of deflation back-to-back 1920-1929 and 1930-1939.
-Equities actually performed better from 1930-1939 then they did from 2000-2009 (ouch).
-There are three decades where equity returns were less than inflation and five decades where bond returns were less than inflation. Four of those five decades came in a row from 1940 to 1979.
-Bonds beat equities in two of the three deflationary decades.

Those points are more interesting to note and think about in relation to the underlying dynamics that drove those decades, but I wouldn’t try to draw definite conclusions or trends from the data.

Ideas and a little bit on India
The bulk of the presentation was spent going through companies that are held in the portfolios currently. Many of the ideas highlighted were successes during the year, but a few were highlighted that still have some promise.

Bernie dedicated one section to US thrifts. It has been one of the worst performing sectors over the last three years, and he believes it is one of the most undervalued sectors in the world right now. Not without risk, of course, but so cheap that the risks are more than priced in for patient value investors. Note, he did concede that there is no way of knowing specific loan exposures, so keep in mind that even with small thrifts you’re trusting management more than anything.

The other sectors discussed were Energy & Utilities, Materials, Industrials, Consumer Discretionary, Consumer Staples, Financials, Healthcare, IT, and Telecom sectors. Too many ideas are in the presentation to go through them all here, but here are some of the names that were discussed include:

Tokyo Electric Power, Allete, Technip, CRH, Imerys, Symrise, Showa Denko, Kone, Nippon Yusen, Cargotec, Taylor Wimpey, Culture Convenience Club, Autoliv, Heinz, State Bank of India, Novartis, Infosys, KDDI, and SK Telecom.

I’ll let the presentation that they’re putting out in the next week do the talking for most of those positions, but I do want to talk about State Bank of India (SBI) a bit, because it ties into our recent visits with HDFC and ICICI.

The Polaris team is very bullish on SBI and its long-term prospects. Sumanta Biswas, the assistant portfolio manager and a BC and Calcutta University graduate, did much of the on the ground legwork on this selection from what I could tell.

For presentation and anecdotal purposes the view of India was simplified down to one where everybody, including the poor, is seeing conditions improve slowly, and everybody involved wants continued improvement and not a step back. Sumanta described this as once you have a little bit of fish or meat in your diet to go with rice you want it more often.

As a -- if not the -- major banking institution SBI is at the center of economic growth in India. After the presentation I had a chat with Sumanta to get a little more info on their take. Although the company is 59.4% government owned Sumanta explained that it’s no longer the big sleepy, government run bank with poor customer service. He stopped at multiple branches and found that service and the offerings were competitive. He believes management has changed its stripes and that since they’re doing more hiring from the top-tier management schools in India the change to a more dynamic SBI is permanent.

I also asked Sumanta if he feels comfortable with the risk SBI is taking. SBI was one of the leaders in offering mortgages with slightly below market fixed rates for the first year or two that switch to floating mortgages. Sumanta views this as proof of SBI getting more creative and aggressive in taking market share, and that this was done deliberately to take retail share from ICICI after they ran into problems with their unsecured retail lending and tightened across the retail part of their business. He did admit that they don’t want to see SBI take this too far, but that they’re ok with the offering as a short-term strategic decision. (note: I think they’ve already made a big chunk of their gains now, but this sounded like an investment they’ll look to return to even if they end up selling most or all of the position in the near-term.)

2010 Thoughts
The view of 2010 was mixed, which is understandable after a very strong final nine months in 2009. Bernie Horn’s conclusion is that 2010 will be more difficult. Investors that can separate good businesses from bad businesses and can value the good businesses properly should still do well (stock-picking ability), but that anybody looking to keep riding a broad wave of gains will likely find life very difficult because in many cases the waves of stimulus have helped low quality businesses rise more than the high quality ones.

The deepest values in the world (using their quantitative screens) are most abundant in Japan and Taiwan, but in both cases they’re in small caps, or in this case micro caps (below $300mm). That makes it hard for them to take big positions. It does mean there might be opportunities for us in GG though, and we’ll be spending some time in this area hunting for bargains. Liquidity (trading volume) might be a problem for US-based investors in these ideas (unless you have access to the Tokyo stock exchange via your broker), so these will most likely show up as wild cards.

Watch out for China!
The team came across as very concerned about China in the presentation session, but chatting with them briefly afterward I got the feeling that they see a very good long-term opportunity, particularly with consumers. The negativity comes from the top-down command driven nature of the economy. They don’t trust all the distortions this creates, such as the housing bubble in Shanghai and Beijing, and while they think the government is doing the right thing by trying to cool the market off, they’re willing to sit back for now and see if the government is successful.

Similarly they’re very bullish on infrastructure demand globally, but worry about the trickle-down effect to these companies too. They noted that every industrial/material company they visited in the last six months highlighted China as the only bright point in their businesses during 2009. In 2-3 years the slowdown in Chinese infrastructure spending could be problematic for steel, iron ore, etc.

The optimism comes from consumer spending picking up once all these distortions are shaken out. They see some improvement already, but think many Chinese are still in saving mode, more than spending mode. Right now I think they don’t see many opportunities here, because most of the opportunities are overpriced or small caps, and Polaris has billions of dollars under management, which makes meaningful positions in these firms difficult.

Inflation vs. deflation
During the Q&A there was a question about optimism for 2010 and the next few years. Bernie Horn fielded this question and said that his optimism was guarded. Never in his life or investing life has he seen this much government stimulus globally. He thinks the stimulus was key to the recent recovery, but worries about what happens as it is withdrawn.

This brought him to the inflation/deflation debate and he thinks we’ll see both, it will depend on what industry you’re looking at. In many industries in the US he sees deflation as much more likely in the next few years even though there has been a flood of capital into the markets. There is simply too much spare capacity in many industries, many well below the 80% - 85% utilization level where price increases start to set in. Until demand catches up with capacity and unemployment comes down a long way from 17% (he didn’t say so, but he’s using the U6 measure of unemployment here) there won't be pricing power or wage pressures. Further out he eventually sees inflation becoming a material problem.

This is part of the reason he included the 1900-2009 look at asset returns and inflation – as a reminder that extended period of deflation are possible. Horn also said the one question he’s asked every company he’s meeting with is: What is your plan if you see three to five years of deflation in your industry?

He still said he’s not sure which way we go from here. He can make sound cases for a very short period of deflation or a longer period that lasts a few years, and he knows plenty of smart people making those cases too. Right now the focus is on how each company fares in either scenario and taking risk out of the portfolio now that many markets around the globe have doubled from the lows in the first quarter of 2009.

Wrap up
The Q&A portion of the meeting was much shorter this year and not a single person questioned why certain investments were made. This was a huge departure from last year when those questions dominated a much longer Q&A period.

Overall it was an interesting meeting and I think the overview of ideas is more helpful investors. They also had product examples out in the lobby to help investors relate to the company’s and I couldn’t help but think of our dispatches, photos, and videos where we do the same.

The team brought up 2008 a few times and it seemed pretty clear it’s still a sore spot even though the 2009 performance was very strong and the attendees didn’t spend a lot of time revisiting the topic. Being frustrated and keeping 2008 fresh in the mind isn’t such a bad idea, I think. There are still plenty of imbalances out there and now isn’t the time to pile on risk, it’s a time to be balanced.


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