Q&A With Martin Sass: Investor Talks Airlines, Pharma and Alts. Managers

Dec 10 2014 | 7:39am ET

Martin Sass, founder and chairman of the $7 billion investment manager M.D. Sass, may technically fall into the ranks of a high flying hedge fund manager, but his investment strategy—and his outlook—are steadfastly down to earth.

Mr. Sass—or Marty as the Brooklyn native prefers to be called—recently spoke with FINalternatives editor-in-chief Deirdre Brennan about his best bets for 2014, why he is bullish on alternative asset managers (well, at least one big one), and his optimistic outlook for the U.S. economy in 2015.

What were your best bets this year?

The biggest winners have been in the airlines group—American Airlines and Delta—and they remain major positions. We have been in these stocks since the middle of last year, but so far this year American is up 103% and Delta is up 72%. Those have been two top performers and leading positions in our funds.

To give you a little color on these names, we saw early last year that the airline industry was going through a massive transformation as a result of decades of turbulence in the sector. Then there was tremendous consolidation and restructuring, and it left the industry with three carriers that dominate the U.S. market. These three so-called legacy carriers—American Airlines Group, Delta and United–have over 80% of airline traffic in the United States. We chose to go with American as our biggest position by far, but we also hold Delta. We believe these stocks will continue to be attractive. The fundamentals are attractive, earnings are growing at a significant rate and I think they will come in at above consensus forecast, with American, in particular, helped by the decline in the price of jet fuel since it doesn’t hedge and has no fuel profit sharing.   

Other very strong performers have been in the healthcare area. The two biggest winners have been Actavis, which we’ve owned for five years and have made six times our money on (it is up 58% so far this year) and Shire, which is a Dublin-based pharmaceuticals company.

Actavis is still a major position. We bought it five years ago (when it was Watson Pharmaceuticals, which later acquired Actavis) at $44 a share, the stock is currently trading at $264. We bought it just before Lipitor—which is the biggest selling drug in the world—was going off patent and Watson had the rights for the generic form. We also bought Mylan as a play on a wave of generics that we thought had a lot of legs.

Actavis has made several acquisitions over the years. Most recently they announced the acquisition of Allergan, which was in a battle with Valeant, and this gave Actavis a tremendous opportunity for a friendly takeover. This deal will make Actavis the sixth largest pharmaceuticals company. We think the company will show sustainable double-digit earnings growth and will consistently beat analysts’ estimates in terms of earnings.

Turning to your new ideas, are there any stocks that you have bought recently that you are particularly enthusiastic about?

We recently bought Apollo Global Management—one of the leading alternative asset managers in the world—at $22 per share after it declined 25% (at one point this year it was up as high as $36.5 per share). It, along with other alternative asset managers, have been poor performers in the market.

One of the things we look for is an opportunity where investor perceptions lag reality, and I think that is the case with Apollo. I think one of the great areas of growth in the financial industry is in alternative investments, and one of the leading alternative asset managers in the world is Apollo (with $164 billion in AUM). It is a top tier private equity performer. It has had net IRRs [internal rate of returns] of around 29% in its private equity funds, and it has the strongest growth in asset raising in the alternative industry—about 32% compound annual growth in AUM since 2004. Apollo made an acquisition about a year ago that I thought was very smart. It acquired Athene Asset Management—which is an insurance company which provides fixed annuities. Athene gave the investment, which is $60 billion of assets, to Apollo to manage. That is a form of permanent capital.

These companies are misperceived in the market because there are two ways in which Apollo reports its earnings: One is called economic net income (ENI), which reflects mark to market and mark to model accounting for earnings. Because of the way in which that accounting methodology works when you are in a harvesting period of selling more than you are buying, you are reducing your assets, so it negatively impacts earnings, and that causes a decline in the economic net income and investors are focused on that, improperly in my opinion. Therefore, they trashed the stock.  

The opportunity is that the underlying value of the business has not diminished but is actually improving. I use a metric which is much more relevant which is called distributed earnings, which is the real cash flow of the business. I’m a religious advocate of free cash flow that actually gets distributed to shareholders. They are paying out these distributed earnings to shareholders and I estimate that just the cash distributions will generate a 9.5% yield over the next 12 months based on the current market price.

I think both economic net income and distributable earnings will be going up nicely, and it is selling at less than 10 times those earnings, so now is a great opportunity to purchase a leading alternatives manager with expertise in the credit space.

What did you get wrong this year?

The only thing I look back on with regret is that we owned any energy related stocks. Shame on me not to have sold these stocks for a nice profit early in the year when oil was up to $115 dollars a barrel. Fortunately, we didn’t go all the way down with them but we did give up profits and trimmed out positions significantly. We woke up late…like in October (laughs).

What is your outlook for the stock market as we enter 2015?

I continue to have a positive view of U.S. equities. I think we are in this goldilocks environment in the United States where we have sustained economic growth, low inflation, relatively easy monetary policy and low interest rates. Price to earnings ratios are only slightly above their historical average, they’re 16.6 times our estimate for earnings for the S&P for 2015. I think continued earnings growth should drive the overall market in 2015, but I think it will only be a modest rise. There is a possibility that as people become less frightened about the market (despite this bull market, fear has been a factor in keeping people away) multiples may go higher, but I’m not counting on that. What would be rational is that stocks go up in line with earnings.

There is an opportunity to do much better by selecting a narrow group of stocks, which is what we are focused on. We’ve consistently beaten the market since inception by sticking to a strategy of buying stocks that are growing much faster than the market [in earnings and cash flow] and that are trading at large discounts to intrinsic value. The names I’ve mentioned so far all meet those characteristics. If you look at the average stock in our portfolio, the earnings are up 40% in 2014 versus 2013; the S&P is up 9% in earnings this year…We estimate our portfolio stocks will grow 20% in earnings in 2015, and another 18% in 2016. We are growing rapidly and I don’t think you’ll see that for the overall S&P, which will grow single digits.

I also think we are going to have a more challenging environment. This year we’ve had a pretty strong market, so it wasn’t that challenging despite recent choppiness. But I think we will see more choppy markets in 2015. Some of the macro factors are going to kick in like the fed rate hike. People know it is going to happen, but when it happens it will still cause a little bit of a hiccup in the market. I don’t think it will change the overall secular trend of being up, but I think it will cause a selloff.

Overall, there is decelerating growth in China, Europe is teetering on recession, Japan remains ugly, and things are going to get difficult for all of these large oil exporters. Those kind of macro forces are going to make things choppy, and of course valuations are not as cheap as they had been, but the trend remains up. Our economic outlook is for continued sustained growth here in the United States, and I think we’re the best game in town.

You recently gave a large donation to your alma mater, Brooklyn College, to endow an investment academy. Why did you decide to fund financial education?

I came from a modest background—I put myself through college and lived in a basement in Brooklyn…What I wanted to do [with the endowment] was to help inspire students who come from modest backgrounds like I did. I wanted to do something that would give them valuable, hands on investment knowledge. I thought that by endowing a hedge fund, mentoring the students and having them manage the fund, they would get something unique that they couldn’t get in a classroom.

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