Errol Rudman started his investment career as a transportation analyst with Smith Barney & Co
Errol Rudman started his investment career as a transportation analyst with Smith Barney & Co. In 1970, he formed Rudman Associates to manage the assets of one Midwestern family. Rudman Capital, the successor to Rudman Associates, is one of the oldest U.S. equity-oriented hedge funds under continuous management. Despite an 18% net annual compound rate of return over the last 25 years, the firm is relatively unknown, particularly outside the US. The firm manages approximately $400 million in a domestic fund, an offshore fund as well as separate accounts. Errol Rudman spoke to HFN publisher, Antoine Bernheim, in late October 1999.
Profile of Errol M. Rudman
Born: New York City
Education: Oberlin College, BA in Economics;
University of Chicago, MBA; Chartered Financial Analyst
Family: Married, 4 children
Last vacation: Southampton, NY
Last book read: "The Joy of Sports: End Zones, Bases,
Baskets, Balls and the Consecration of the American Spirit" by Michael Novak
Favorite quote: "I want to thank the good Lord for making me a Yankee". (Joe DiMaggio)
How he best describes himself: I pride myself as being intellectually curious, insightful, and willing to take
contrarian positions. I am very interested in the people
around me and those with whom I invest. I believe that
having a sense for the core, relevant issues, allows me to
bypass the obvious and already understood opinions. I
listen carefully and have enough confidence to pursue the
issues that I feel are important
Q. Could you describe your investment philosophy?
A. We are cash flow investors. We base our analysis on factors that are going to result in an acceleration of cash flow or a slowing of cash flow generation. We look for what we call catalytic changes: a new product, a change in government regulations, mergers/acquisitions activity or a change in the competitive environment in an industry that may generate increased momentum in cash flow.
As we focus on cash flows or the lack thereof, we are attracted to different areas of the market. We buy companies that other people may qualify as high multiple or low multiple or value stocks. We do not try to superimpose an investment style on our portfolio, but look for criteria that indicate that an individual security is overpriced or underpriced. We understand that the market may like certain sectors or certain types of companies at any given time and we are mindful of that, but we are not sector rotators. We are looking for changes of an evolutionary nature that will extend over several years as opposed to weeks and days. Short term trading is not important to what we do.
We do not benchmark against any particular index. We strive for absolute returns and are not afraid to move to cash, if we feel circumstances warrant.
Q. Could you describe your research process ?
A. Our research is very fundamental. We use trade sources; if we are looking at a medical company, we may talk to doctors, scientists. We also use Wall Street. We use the tools that most professional analysts use. Several of us are Chartered Financial Analysts or accountants, and we try to understand the financials, understand the industry.
Q. Could you describe your approach to hedging?
A. We actively short stocks when we think that a company isstrategically or cyclically or financially in a position that it cannot get out of. We are not interested in valuation shorts as we do not feel that we have any expertise in deciding that a given earnings stream should be selling at 50 vs. 100 times. We typically have liquidity requirements and a stop-loss discipline for our short positions. In addition, we systematically buy put options on the market. We spend half of one percent to one percent a month as a kind of calamity insurance with the hope that the performance of our long positions will far outweigh the cost of our put options.
Q. How do you control risk?
A. We control risk in a variety of ways: first through an in-depth knowledge of our companies. When something goes against us, we discuss it very thoroughly and decide whether the stock has overly discounted anticipated events. Second, we have shorts. Third, we use index put options and futures. Fourth, we generally limit the size of our initial investments to no more than 5% of our capital and no more than 25% of any given securities' average trading volume. Finally, the bulk of our portfolio capital is invested in liquid securities with free float in excess of $1 billion and average daily volume over $10 million.
Q. Could you describe the typical structure of your portfolio?
A. We have guidelines regarding sector selection and concentration. No single sector should exceed 25% of the portfolio. We rarely let a position go over 10% of our capital. Typically, we have 30 to 40 positions of 3% to 4% of our capital for the longs, somewhat less for the shorts. Our net invested exposure has ranged from -20% to 110%. We generally cap leverage at 150% of gross equity.
Q. Could you give an example of a couple of stocks you like?
A. Shaw Industries (15 ¿) (SHX) is the world's largest manufacturer of residential and commercial carpeting. We believe that most investors have missed important changes in the carpet manufacturing industry and Shaw Industries specifically. Our thesis is that recent industry consolidation will translate into improved pricing power towards customers and suppliers. In addition, partial upstream vertical integration and new non-petroleum supply sources will lower exposure to fluctuations in oil prices.
Shaw's management continues to lack credibility because of ill-conceived and poorly executed expansions overseas and into retail in the mid-1990s. International operations have been sold, and Shaw's industry share is increasing as it revives dealer relationships that suffered during Shaw's own foray into retail. Approximately 75 percent of Shaw's sales are to the replacement market, which is not related to new home sales. Moreover, Shaw should be able to leverage its distribution capacity and dealer relationships into new faster growing segments of the floor covering business, such as tile and hard wood.
Shaw is deploying its cash flow to repurchase shares. When the industry experiences a slow down in sales, Shaw's inventory reductions will release additional cash, which will be used to fund further share buybacks. As Shaw grows its market share and leverages its fixed costs, we forecast that free cash flow will exceed $2.40 per share in 2000 (implying a price of seven times free cash flow), and will continue to grow strongly. This level of cash generation plus growth, combined with a propensity to repurchase shares, is a powerful investment story.
Amgen (78 3/8) (AMGN) is the largest and most profitable biotechnology company in the world. Amgen has two drugs, Epogen and Neupogen, each of which generates over a billion dollars of annual revenues, and a rapidly expanding pipelineof exciting phase II/III products. The most significant of these pipeline products is NESP, a long-acting version of the company's top-selling Epogen. Epogen (under various brand names) is currently prescribed to dialysis, pre-dialysis and cancer patients for the treatment of anemia.
We are tracking three under-appreciated drivers for NESP. First, NESP will increase the barriers to entry for competing versions of Epogen in the dialysis and pre-dialysis markets because of improved dosing convenience and superior economics. Second, Amgen will be able to sell NESP into faster growing treatment markets, which were out-licensed to Johnson & Johnson in the 1980s. These markets are exploding as high dose chemotherapy gains increasing support among oncologists. Third, and least recognized, is that Amgen will have the opportunity to dramatically expand the applications for NESP by demonstrating the importance of anemia management in many new disease settings.
Amgen has several other products in late-stage clinical testing with innovative mechanisms of actions. The most prominent of these products are Abarelix (prostate cancer and endometriosis) and IL-1RA (rheumatoid arthritis). Amgen's high profitability and strong balance sheet allows the company to maintain a steady share buyback program. These financial resources are also major strategic assets in an industry that is highly dependent on the capital markets to fund research. More than 200 biotechnology products are in the clinic, including 80 in Phase III clinical trials, all competing for limited capital. Amgen clearly has a major informational advantage over many potential buyers, and the company is devoting substantial resources to its in-licensing activities.
We believe that Amgen is at the beginning of a multi-year transition from a specialized and highly profitable biotechnology company into a new mainstream pharmaceutical company. The company's sales have the potential to double or more over the next few years.
Q. Could you describe how your organization functions?
A. I am a little older and have more experience than the others, so I function as a team leader; I make the assignments and define research priorities. Generally, one or two people work on an idea and try to find out specific details about a company to fill in the puzzle. My analysts develop recommendations which I consider as I make investment decisions. Inthe end, I am responsible for all investment decisions.
Q. What are your goals for the future?
A. We have enjoyed a high compound growth rate over the years and we hope to continue our successes. We invest primarily in larger capitalization companies, and the skills we have demonstrated enable us to manage substantially more assets.