E X C E R P T E D F
SEPTEMBER 24, 2018
THE FOLLOWING REPORT IS EXCERPTED FROM
THE WALL STREET TRANSCRIPT
MONEY MANAGER INTERVIEW
FRANK MARTIN
Martin Capital Management, LLC
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 M O N E Y M A N A G E R I N T E R V I E W

Taking an Aggressively Defensive Approach as an Absolute Value Investor

F R A N K M A R T I N , M A R T I N C A P I T A L M A N A G E M E N T , L L C

FRANK MARTIN, CFA, is the Founder and Chief Investment Officer at Martin Capital

Management, LLC. Mr. Martin has 45 years of investment industry experience. While a

partner at McDonald & Company, he founded McDonald Capital Management in 1987; he

acquired and changed its name to Martin Capital Management. Mr. Martin holds a B.A. in

Copyrighted material: For reproduction permission contact Kenneth Wolfrath (212) 952-7400
investment management from Northwestern University and an MBA with honors from

Indiana University at South Bend. Mr. Martin is on the boards of various charitable

organizations. A prolific writer, he is the author of two investment books.

SECTOR — GENERAL INVESTING He who doesn’t, pays it.” So that’s kind of our mandate and living
(AHP511) TWST: Could you tell me a little bit about the firm? out that mandate over the 50-plus years I’ve been in the business.
Mr. Martin: Yes. We’ve gone through a number of Our two worst years were 2002, when we were down 8%,
evolutions in our history, largely due to our fixation on being an which of course was followed by an uptick of 22.3% in 2003, and
absolute value firm. That style, as you know, is occasionally in favor then, our second worst year was 2008, where we were down 7%,
but often out of favor, and so we’ve which again was followed by an
had some pains related to that in uptick of 20.9% in 2009. Now that,
terms of the Founder not being Highlights of course, sounds well and good,
willing to compromise on what but that also means that we missed
constitutes being responsible in an Frank Martin discusses Martin Capital Management, the tail end of bull markets. And
environment that’s not necessarily LLC. Mr. Martin is an absolute value investor. Mr. obviously, the one we’re in currently
conducive to buying absolute value. Martin doesn’t want to suffer significant has been a doozy, and by some
So we were managing as much as drawdowns, and unlike relative return investors, measures, it’s the longest ever.
$700 million in 2008 and slightly he has to consider market risk. He also wants to What’s particularly
more at the end of 2009. We avoided buy stocks when they are selling for half of their painful to an absolute return value
the bear market substantially. But intrinsic worth. Mr. Martin talks about the risks he’s guy like me is that it became
there’s been — as I’ll note concerned about in the current environment. prohibitively expensive early. By
somewhere else in the conversation These include overvaluation, the aggregate debt March of 2013, it was 22 times
— there’s been a most trying time and the future clearing of malinvestments in the the CAPE, which is Robert
for people like us since 2009. market. Right now, Mr. Martin is being aggressively Shiller’s cyclically adjusted price/
Well, I’ve been doing this defensive. He has 90% of his assets in cash and is earnings ratio, and that ratio
a long time, actually since 1966. running a book of S&P put options. reached 27 times in 2015 and is
And because I believe that the Companies discussed: Netflix (NASDAQ:NFLX); currently 32 times. And then, if I
reason we’re an absolute return Facebook (NASDAQ:FB); Alphabet may continue on this subject?
investor is because we know (NASDAQ:GOOG); Eastman Kodak Company TWST: Sure.
significant capital drawdowns will (NYSE:KODK); Xerox Corp. (NYSE:XRX) and Mr. Martin: The ratio
occur periodically. They simply Goldman Sachs Group (NYSE:GS). obviously gets some criticism. And
play havoc with long-term returns, it also is frequently referred to in
and we both have heard the Albert terms of what the average CAPE is.
Einstein quotes about the theory of I just mentioned we’re 32 times,
compound interest being the most powerful force in the universe. while the average is about 16.5 times. We give that average,
And as it relates to what I do more personally, there is another however, very little weight, because when mean reversion occurs,
quote, that’s not as famous, and that is again from Einstein, and he the pendulum very infrequently stops at equilibrium.
says, “He who understands it,” that is compound interest, “earns it. And what’s even of more concern to me personally as an
 M O N E Y M A N A G E R I N T E R V I E W — F R A N K M A R T I N

investment manager is the amount of time the CAPE has spent now and that you’re concerned about?
below 10 times. From 1917 to 1925 — and let me note parenthetically Mr. Martin: I’m not sure everybody is as concerned
that in the Martin Capital Management 2014 Annual Report that I about these risks as some of us in the distinct minority are. For
wrote is a history of the secular valuation of the market going back example, overvaluation, which I just talked about in terms of the
to 1900. So these numbers are pretty familiar to me. CAPE or any other metrics. I mean, you can use a market cap to
GDP, you can use Tobin’s Q ratio, and you get to about to
the same place, but because valuation is not a timing tool,
“So we don’t want to have significant drawdowns in the people give a short shrift, but ultimately, it’ll get you. And
value of our client accounts, in part because they often so that’s a risk that I consider huge.
Other risks that are not talked about that much
precipitate irrational behavior. The last thing we want to because I don’t think most economists have had reason to
hear is ‘get me out.’ So the mandate is more rigorous I be schooled in them — the biggest one, of course, would
think than a relative return mandate because they’re just be the aggregate debt, whether we’re talking domestically
picking stocks and not concerned about market risk.” or globally, and that, to quote Nassim Taleb, is sort of a
potential black swan as debt continues to expand. Most
people would have thought that, after the financial crisis,
we would have become much more concerned about
From 1917 to 1925, we had a CAPE of less than 10. aggregate indebtedness. The numbers only crept up to new highs,
During the summer of 1932, of course in 1943 and 1950, and inconsistent with the kind of reaction people would have to a
surprisingly to a lot of people, largely due to the high inflation financial bloodbath like in the 1920s.
and interest rates, it was below 10 quite a bit of the time from So there’s another risk that is of concern to only a handful
1975 to 1985. Now, as Bob Shiller calculates it on a month-end of us, and that is I see and my fellows see that the secular peak was
basis, it hasn’t been below 10 times since. It did fall to 13.2 really in 2000. And that resulted from an increasingly accommodative
times the end of March 2009 and, even then, was back to 20-plus Fed since Alan Greenspan stepped in after the 1987 crash. Then,
by December of that year. Greenspan changed the market’s dynamics, and the risk-on trade
So the final thought on CAPE is that at market peaks of really got wings as we got into the 2000s. And so the Fed stopped
2001 and 1929 and 1966, 2000 and 2007, and perhaps today, the potential fallout from the dot-com collapse by driving interest
nobody imagined that the ultimate secular lows would see a CAPE rates to 1% in 2003, and then of course, post-2008, they’ve kept
below 10 times. And if you use 10-year average S&P earnings interest rates at essentially zero until December of 2015.
today, you come out with about $86, so you can do the math about So we’ve had sort of an artificially induced bull market, a
what 10 times $86 would be. We know the immutable laws of bubble in real estate and then this current phase that nobody wants
finance, and we suffer from acrophobia. to call a bubble. Yet post-2009, I don’t believe with the Shiller
TWST: Maybe you could define absolute value and getting down to a little over 13 times in March of 2009 — I have
absolute return for the readers. believed, and I’m looking really bad right now — but I believe that
Mr. Martin: Yes. Absolute is one part of the two-word that did not represent a great secular bottom, that the Fed came in
definition, and that means that we don’t want to suffer significant and pre-empted the market from clearing the malinvestment,
drawdowns. So our competitors would be considered relative leading up to that time. And so that cleansing lies out somewhere in
return. If a relative return manager is assessing his own performance, the future. And that’s a pretty scary prospect.
and the market’s down 50%, and he’s down 40%, he thinks he had TWST: What about your concerns about valuation?
a good year. An absolute return investor who was down more than Mr. Martin: Well, that’s just in addition to the black
10% and the market was down 50% thinks he has an awful year. swan financial risk related to indebtedness, to heap an overvalued
Now, whether he can be aggressive enough to think he could market on top of that just doubles the risk.
actually be in the black, that’s another point. TWST: How about GDP growth? Is that another
So we don’t want to have significant drawdowns in the concern?
value of our client accounts, in part because they often precipitate Mr. Martin: Yes. I would like to speak briefly about that
irrational behavior. The last thing we want to hear is “get me because there seems to be a disconnect between corporate profits
out.” So the mandate is more rigorous I think than a relative and GDP growth. And obviously, corporate profits are ultimately
return mandate because they’re just picking stocks and not the justification for the level of stock prices. I mean, stock prices do
concerned about market risk. As an absolute return, we have to not fluctuate independent of corporate earnings, but those corporate
be preoccupied with market risk. profits themselves are irrevocably tied to the economy, even if by a
And then, the second half of the term, value, is that we’re bungee cord. And I think that reality is kind of overlooked in today’s
looking for a dollar selling for $0.50. So we can’t touch the glamour instant-gratification investment environment.
stocks of today because we find it difficult to value them, and we don’t Now, to be sure, companies that, say, make up the S&P
think they’re selling for half of what they are intrinsically worth. engage in various forms of financial engineering that enhances their
TWST: And you mentioned market risk. Did you want per-share results without necessarily requiring an increase in the
to talk about risks that you think investors are concerned about underlying profitability of the businesses, and oftentimes at the
 M O N E Y M A N A G E R I N T E R V I E W — F R A N K M A R T I N

expense of long-term financial stability. So that link is kind of to find stuff that’s absolutely cheap. So I’m stymied here.
important, and while we’re on corporate profits, I think this is kind Now, if you’d like, I might talk a little bit more about the
of a novel twist as it relates to what’s going on today because there’s general impediments to growth, which are largely related to low
a lot of talk about share buybacks likely to reach $1 trillion this year, productivity, and that will get us in the direction you’re going I think.
and at the same time, people are talking about low capital TWST: OK.
investment. With the tax cut, we thought it was going to stimulate a Mr. Martin: So tying this back to corporate profits
lot of investment spending; that hasn’t happened. ultimately cannot grow faster than GDP, and we know that the
engine ultimately drives corporate profits. GDP has
been faltering. So it grew at 3.2% from 1970 to 2006,
“But today, with the exception of the FANGs, it’s hard and the rate of growth has dropped by 50% from 2006
to find sectors in the market that are desperately cheap. to 2017, down to 1.6%. And what we’ve done, what
And again, remember, I’m an absolute, not a relative, Bob Gordon and I have done, is try to take out some of
the extraneous stuff that would allow us to think about
return investor, so I can find some stuff that’s relatively the long-term trends and to avoid too much of the ups
cheap, but it’s hard to find stuff that’s absolutely cheap. and downs in the business cycle.
So I’m stymied here.” Each of these measurement periods, whether
it’s 1970 to 2006, or to some extent today, although it’s
lower, we try to find a measurement period where the
unemployment rate was around 5%. Now, obviously, it
And I think there is an explanation, and I give Bob was less at the end of 2017, but it’s close enough for government
Gordon of Northwestern, who’s written extensively on the subject work. So here we are in the late innings of this externally
of the slowing growth in the United States, all the credit. But capital stimulated business and credit cycle. And I think the prospects for
spending, and that’s net investment relative to the business capital an uptick in GDP growth, despite the 4%-plus number for the
stock, shrunk to a rate of 1.5% from 2010 through 2015, and it’s second quarter of this year, are clearly dim.
continued, and that’s half the long-term average. And it’s that slump And the prospects for GDP growth beyond the current
in investment that has become a prime suspect for the slow growth business cycle are really related to the low growth in productivity,
in productivity. But Gordon argues, and I’m in the same camp, that which accounts for about half of the decline in the growth rate of
causation could run the other way. And that is, slowing growth leads GDP. Another 30% is attributable to the declining labor force
to declining investment. And that’s simply based on a well-known participation rate, which you and I both know is partially due to the
tenet in growth theory, and that is that the equilibrium in capital to retirement of Baby Boomers and then also sadly a decline in prime-
output is a ratio that’s constant. age labor force participation. The final 20% of that 100% is traceable
So the long-term decline in GDP growth is largely due to to the decline in population growth, which has a whole lot of subsets.
slower growth in population and hours worked per person, and And if I can stay on this subject just a minute longer, I think
which leads to decline in the growth rate of capital and ultimately a the structural impediments to that mix are, for the most part, daunting.
decline in net investment. So what I’m saying is that net investment, But Jerome Powell in his speech at Jacksonville last weekend offered
which is concerning to some people, is really passive. It’s dependent what he thinks may be a silver bullet that could save the day. Now, by
on what GDP does, which then gets down to the corporate way of background, Powell hinted that there’s a chance that history
boardroom and the question of whether CEOs are being rational for may repeat itself, and he’s referring to Greenspan’s decision in the
spending shareholder cash on buybacks without regard to price in mid-1990s when Greenspan concluded that the economy’s productive
financial engineering. But what seems to be quite rational in what capacity due to the digital age was increasing at a rapid pace. So he
they’re doing is their reluctance to spend more on capital assets actually resisted calls from his colleagues to raise interest rates to
because the GDP growth just doesn’t support it. prevent overheating and ultimate inflation.
TWST: Now, given some of these trends that we’ve Now, Powell went back and said before that there was
been talking about in the economy and the market, is there a another episode, where an error was made, and that was in the 1970s
certain strategy in terms of what sectors might be of interest to when there was overconfidence about the so-called natural rate of
investors or maybe even what they might want to avoid? Are unemployment, the level to which joblessness can fall without sparking
there certain criteria that they might want to look at when inflation, which is a little bit of a question today. And that mistake
they’re looking at sectors? obviously led to double-digit inflation by the end of the 1970s. So what
Mr. Martin: Well, the short answer is, a rising tide lifts all Powell said, and I quote him, “It is difficult to say whether or when the
ships. And we both know from the late 1990s that we truly did have economy breaks out of its low-productivity mode of the past decade or
a situation that was atypical. In that, it was a bifurcated market. So we more,” but he then adds this condition, which I think is significant, “as
had some really cheap mundane companies and some really expensive it must, if incomes are to rise more meaningfully over time.” So Powell
information-age companies. But today, with the exception of the is aware that if we don’t have growth in productivity, we’re not, in the
FANGs, it’s hard to find sectors in the market that are desperately long run, going to have growth in incomes, and it’s going to complicate
cheap. And again, remember, I’m an absolute, not a relative, return a system that’s already badly skewed toward too much concentration of
investor, so I can find some stuff that’s relatively cheap, but it’s hard wealth in too few hands.
 M O N E Y M A N A G E R I N T E R V I E W — F R A N K M A R T I N

TWST: When we talk about opportunities, are there
certain situations that investors might want to look at, such as
startups that are moving to IPOs or companies that might be
considered too big to fail? Are those things that investors might
want to watch carefully?
Mr. Martin: Well, I’m not sure how I’d bet on a too-big-
to-fail institution, because if we get into that position, which would
probably most likely be financially related, bailing them out doesn’t
strike me as an opportunity to make a whole lot of money. It’s more
about trying to come out of that, unless you’re buying obscure debt
that a fellow like Seth Klarman knows is undervalued. So I think
it’d be hard to make that fit my absolute return requirement, which
is buying the dollar for $0.50.
“Now, this digital revolution, certainly as a study in industries in the service sector, such as education and health
contrasts, changed office procedures in all industries, because wages have risen in general, they have benefited
but it’s had less of an effect on the everyday life of from that spillover effect.
consumers around industries that involve what we call
‘physical transformation,’ such as manufacturing,
construction, mining, utilities and transportation, as maybe some previous generations, but once they do
well as industries in the service sector.”
TWST: What about so many of these companies and
others that have begun as startups with a few people working
on them and eventually move to an IPO? Are there just too
many risks with those?
Mr. Martin: Obviously, the VC — venture capitalist —
guys will tell you that you’ve got to spread your risks. We’ve had
limited but successful experience in the venture-capital arena. But
we have no access to direct investment in some new venture where
we could make spectacular returns. By the time we would have
access to it, it would be when it goes public, which is probably the
worst time to buy it of all because that’s when someone else sets the
price, and they don’t set it for your advantage, they set it for theirs. investment nightmare. The idea that you could pay any price for a
Now, I might just digress for a minute to talk about the
effect of technology and what some people consider the fourth
industrial revolution, and that’s, from this point forward, the effect
of technology on corporate activity and ideally corporate
profitability, and as if that could be a place to look for value because
there are many people who believe — and I’m not necessarily fully
onboard — but many people believe that just as every time in the
past we thought we had reached the ultimate in innovation some
new wonder popped up during the great industrial revolution from
1870. Post-1970 is certainly a case in point. New innovations,
which nobody thought about in advance, emerged out of the space
to become staples of modern-day life.
So Gordon, if anything, is criticized for maybe being a
little shortsighted as to what the digital world can ultimately
produce. Although I will say, in Gordon’s defense, his concern is not
so much with the rate of innovation in this digital age but in the
applicability of those innovations to significant improvements in
productivity. There are certain industries that are just not amenable
to automation. It takes the same number of musicians to play a
Beethoven string quartet today as it did in the 19th century, for
example, as an extreme example. So I think if we were to go down
that path a little bit, it might be helpful.
TWST: Sure.
Mr. Martin: So when I look back at the very short third
industrial revolution from 1996 to 2006, it doesn’t measure up
anywhere near to the productivity growth that was in the second
industrial revolution, which is, say, from 1870 to 1970, because those
early inventions had a profound effect on every aspect of human
existence. Now, this digital revolution, certainly as a study in
contrasts, changed office procedures in all industries, but it’s had less
of an effect on the everyday life of consumers around industries that
involve what we call “physical transformation,” such as manufacturing,
construction, mining, utilities and transportation, as well as
care, which have not had much of a gain in productivity, but
TWST: You mentioned technology. One
thing that comes to mind is how the Millennial
generation so far hasn’t been investing as much as
get involved with the market, do you think that their
understanding and comfort level with technology in
their own lives will get them more interested in
investing in it as a sector?
Mr. Martin: Well, to some extent, I think the popularity
of digitally based companies, from Netflix (NASDAQ:NFLX) to
Facebook (NASDAQ:FB) to Google (NASDAQ:GOOG) and the
rest, is some evidence that somebody is seeing a lot of future value
in these businesses. But as you and I both know and looking at
history, once some idea gets that kind of acceptance, not only with
the Millennials but even I hear it with older people, its days are
usually numbered because no beanstalk ever grows to the sky.
And if you and I go back to the Nifty Fifty in the 1970s,
a simple concept pushed to an extreme became an economic or an
company that had long-term growth potential — well, along
comes Eastman Kodak (NYSE:KODK), Polaroid, Xerox
(NYSE:XRX) and the like, and many of the Nifty Fifty faded and
ultimately closed their doors.
I remember going to see Polaroid after its heyday in Boston
and hearing about the dream that the company was about to become,
and that of course never came to fruition. Who would have guessed the
number of digital photographs that are taken? I think a number I saw
the other day was something like a trillion-five photographs taken in
— I can’t tell you the time period — versus hundreds of thousands back
when it cost $0.50 a picture. But you look at that, does that increase
productivity? It increases consumer satisfaction.
TWST: Is there anything we didn’t talk about,
either about your approach, the firm or some trends out
there, that you care to mention?
Mr. Martin: Yes. I’d like to talk about the conundrum
in which a manager like MCM has at this moment in history. And
that is given what we think we know and given the risks that we
believe are there, while not fully appreciated by others, we have
 M O N E Y M A N A G E R I N T E R V I E W
no prudent option but to be utterly defensive, and I am aggressively
defensive in that, in addition to having 90% of our assets in cash,
I am running — I can’t say it’s a hedge portfolio because we’re not
hedging anything — but we are running a book of S&P put
options, which is exactly, if you look at my second book, A
Decade of Delusions, Chapter 10, what I did in 2007. I bought puts
on the investment banks of Goldman Sachs (NYSE:GS), Bear
Stearns, Lehman, Merrill Lynch, and then I also picked up
Chase, which didn’t prove to pay off, but because my partners
wouldn’t go along with it, I personally had a huge 2007 and 2008
experience. And whether I’m going to be able to replicate that this
time around with the S&P puts is obviously unknown.
We’re not only playing full lock defense, but we’re
betting on the downside because, as a value investor, it’s my view
that if you find a dollar selling for $0.50 — let’s say the S&P sells
for $0.50 on its valuation dollar — you buy it. On the flipside, if it’s
selling for $2, you buy puts against it. And so all you’re betting is
that mean reversion will ultimately take place. And I think there’s
an adage that I believe strongly in, and that is, if a person is willing
to take a number of small losses in the expectation of a large gain
from an asymmetric bet, that guy can own the world.
I’d just say, most investors don’t like to be nickel and
dimed — we pay about 2% of our assets each year. We just
started last September, but we expect to spend 2% of assets a
year in premiums on put options. And that’s money gone, and we
reduce that cost to carry because we’ve done some trading within
the options, but let’s say it runs to 1% to 2% a year, and that’ll
continue until such time as the market heads meaningfully south,
and because the Black Scholes model badly prices a longer-term
option, on which Warren Buffett has written a great deal, there’s
a huge opportunity here.
As I mentioned earlier, if you got $86 in S&P earnings on
a 10-year average basis and you go to 10 times, that’s below 1,000 on
— F R A N K M A R T I N
the S&P, which is a far cry from where it is today. So that’s a fall of
about two-thirds. Well, the options that we own would, if it were to
fall that far, which I don’t like to talk about because that seems
extreme, which certainly it is, that would be a payback of greater than
50 times on your money based on today’s option prices. Thus, if you
have 1% of your portfolio committed and it has a 50 times payback,
you’ve protected your corpus — your cash — dollar for dollar, and
you’ve had a 50% gain on this asymmetric bet. So you find yourself
in a bear market, maybe when prices are really depressed, with more
money, by 50%, then you started with at the top of the market. I mean,
that would be the ideal. But to sort of wrap this up, that’s the extent
of our aggressiveness on the downside.
What I see facing most investors, one that is avoidable I
might add, is that the short-term thinking that’s dominated the way
people invest today has resulted in a mismatch between the time
taken to compensate someone and the time it takes to be comfortable
that he’s not making a reckless bet against a rare event. So today,
people have every incentive to be myopic about the risk of a major
revaluation of equities because they’re paid on the basis of short-
term performance. And so I think we’re living in this la-la land, and
it’s like a turkey who lives 364 days thinking that life is great, and
then, the day before Thanksgiving his world changes unalterably.
TWST: Thank you. (ES)
 
FRANK MARTIN, CFA
Founder & Chief Investment Officer
Martin Capital Management, LLC
131 E. Franklin St.
Suite 14
Elkhart, IN 46516
(574) 293-2077
(574) 293-2153 — FAX
www.mcmadvisors.com