CNBC Pro Talks: Jim Lebenthal on why going back to the fundamentals will make you a better investor 6/7/24

0:01This is CNBC Pro Talks, where we go one on one with Wall Street's top investors, smartest traders, and rising stars. We find out what makes them tick, what makes them money, and how you can follow in their footsteps.

0:19Hello and welcome to CNBC Pro Talks. I'm Dominic Chu. We've got a very special guest for this month's interview, and that's Jim Labenthal. So welcome to the show, Jim. And all you halftime fans know him as Farmer Jim, but let's give him more of a proper introduction here. Jim is now currently a partner at Sarity Partners, where he's a member of the firm's investment committee. He also manages the U.S. equity portfolios for their clients. Now, for this Pro Talk, we want to dive a little deeper into the world of fundamental analysis and how to use it to make better investment decisions. But before we get into the details of all these earnings revisions and peg ratios and price to sales and DuPont analysis and everything else, we're going to talk a little bit about nuclear submarines and molecular biology.

1:07And that's because before Wall Street, Jim used to be an officer, if you didn't know this, in the U.S. Navy, leading crews on attack submarines for weeks at a time sometimes. And before that, he studied molecular biology at Princeton. So a renaissance man, if you will. It's in this science-minded approach to the stock market that we're going to kind of dissect and delve a little bit more into today. So Jim, again, thank you for being with us. It's great to have you here, man. It's really great to see you. I always enjoy my time with you and I don't get enough of it, frankly. So thank you for taking the time today.

1:44Thanks to you for taking the time to do this with us. And we've done some ProTalks already so far in this new kind of iteration of our ProTalks franchise. We've covered a number of topics. We've talked about Buffett and his philosophy. We've talked about technical analysis with Katie Stockton And this is where we kind of want to go with this conversation is the fundamental side of things, because these are all tools, right, that investors have and traders have at their disposal to kind of talk about things. So let's start there. Let's talk a little bit about this idea of what fundamental analysis is and why you think it's critical to your investment process and why investors need to embrace the fundamentals.

2:26Sure. Dom, you gave me such a warm, embracing introduction, and I appreciate that. And it actually helps inform the answer to your question. Because the way I look at investing is putting building blocks in place to construct an investment thesis that I can get behind and that I believe will make money for myself and my clients. And those building blocks and that terminology implies engineering. It implies engineering of the sort that I once was 30 years ago aboard nuclear submarines. I was actually a nuclear engineer for seven years. And it also implies a certain degree of science that is implied by the biology that I studied at Princeton.

3:13It implies a way of thinking that is very embedded in who I am. Now, I don't mean to take away from the artistry that goes into investing. And you mentioned a legendary investor like Warren Buffett. Certainly, there is art in his ability to look at an investment and see not just the engineering fundamentals, but also that je sais quoi that makes it a great investment. There is art involved in this as well. But I always start from the fundamental building blocks of what makes a good investment. So it's this science-minded approach, right? There's actually a scientific method. There's this kind of methodology that you go through to kind of evaluate a problem, theorize about what a possible solution could be, test for it, and then kind of do that iterative process.

4:06The fundamental side of things is about understanding the inner workings of any particular company or investment. What made you, I guess, feel as though that was the best way to look about or look into how to invest as opposed to, say, other methodologies? You mentioned some of it just now, but I'm curious, are you a fundamentals guy? Has that made you more of a value guy, a growth guy? What exactly do you look at? Well, Dom, great question. This may be a little bit long-winded. I'll try to keep this short. But even before college, before Navy, I grew up in New York City, and I was third generation in a family municipal bond business.

4:51So my grandparents actually started a municipal bond trading and retail shop in the 1920s. My father, my aunt, and uncle worked there from the 60s, 70s, 80s, 90s. And so I grew up in this world of finance. And I realized at an early age, and by early, I mean 12 years old, that the stock market was a place where you could put your brain power to work and make money for yourself. And eventually, I extended this into my clients. But there had to be some analytical framework that goes with this. Now, I take away a lot from technical analysis, momentum, things like that. It adds to the heart of what I do, which is fundamental analysis.

5:34And fundamental analysis can be looked at as saying, I am a part owner in any business whose shares I own stock in. So it's not just a collection of letters in a stock ticker. It's an actual business that I'm owning. And I want to think like a business owner or even a business operator. Why do I own those shares? I own those shares for the fractional ownership of the cash flows and earnings that come from them. Now, you can see me diverging a little bit from the technical analysis that many investors adhere to, and I very much believe that technical analysis can be helpful in the short term in determining entry points and exit points from a stock.

6:16But that decision to enter or exit a stock comes down to the fundamentals of do I want to own this business? And that means, do I think it has cash flows and earnings that are undervalued relative to its current share price? And by undervalued, that can mean based against other benchmarks of similar companies, or it can mean what it would go for, what the company would sell for in a private market third-party transaction. Now, as I said before, there are building blocks that are used to build up this fundamental investment thesis. And there are many of them in this discussion to decide how and when we dive deeper into those.

6:57But I'll tease you before I send this back to you with one aspect. One thing you asked is, or you hinted at, is, yes, I am a value investor. Why am I a value investor? Well, at an early age, in my 20s, as we discussed, I was stationed aboard nuclear attack submarines. And the very basis of nuclear attack submarines is that you go out from port, you submerge, and you are not contacted for the next two months and sometimes. I mean, literally, you cannot send a transmission out because that will enable your perceived enemies to detect you if you send a transmission out. On the flip side of that, you get very little information in.

7:39So you don't know who's winning the World Series and you don't know which stock just beat earnings or missed earnings or is doing well or doing badly. Consequently, my investment theses have to be long term, or at least they did in the 20s. And I still carry that with me today. my investment theses have to last years, not just be beholden to one quarter's excellent or not so excellent results. So with that as a hint of where we're going with this, at your cadence, Dom, I'll go into some of the deeper dive, no pun intended, of what these building blocks are. Yeah, I like it. I see what you did there, Jim.

8:22I want to follow that because you just opened the door for that part of the discussion about value versus long term versus growth versus quarterly and everything else. There are some traders and investors out there these days, Jim, who will argue that the current environment that we've been in, and maybe even one that's been in place arguably since the depths of the COVID pandemic back in the spring and summer of 2020, has been that of a V-shaped recovery higher that's been nothing but momentum and nothing but growth and nothing but kind of like this seemingly, you know, just skyrocket higher in many stocks and certain ones in particular.

9:05Now, there may be fundamental cases for some of these stocks, but it's hard to argue with the fact that for many names out there that have seen the highest returns, There are some who say that the fundamentals have been put in the rearview mirror, that now it's just all about growth and momentum. So take us through your philosophy about how a value guy like yourself views this current market and whether or not your views feel at all antiquated to you, given the fact that everything is so focused on things like momentum and relative strength these days. Dom, great question. And I will admit there are plenty of times that I use or I feel, to use your word, antiquated.

9:50And I wonder about the relevancy of being a fundamental value-oriented investor. I take comfort from many sources. David Einhorn recently commiserated, this is the famous hedge fund investor with a strong value bent. David Einhorn recently wrote about this in a newsletter to his clients, decrying passive investment as sort of, I guess, leveling the distinction between good stocks and bad stocks. I am not in any way going to whine or complain about the strongly held opinion that value investing has been out of favor for quite some time. And I mean, it really has been out of favor for longer than since the pandemic.

10:37Growth stocks have really been outshining value stocks. I've got a couple of examples that we'll get to to illustrate why value matters. But I will say there is an end game for a value investor, and it ties back into what I was saying about fundamental analysis and being an owner-operator of a company. If you do your analysis right, and if those cash flows are coming in at or better than your expectations, eventually those cash flows come back to you as a shareholder. They come back in the form of dividends and share buybacks. Now, I realize fully that that may seem a little tinny or maybe not as attractive as, say, NVIDIA, which has gone up, I don't know, you'll have to tell me, Dom, 800 % in the last year and a half.

11:28I mean, it's been a phenomenal result. but to the patient long-term investor who has closed the hatch in his submarine, has made his peace with the stocks that he owns. He or she should feel comfortable resurfacing in a few quarters, or dare I say, maybe even a couple of years, and realizing that the net income from these companies has risen, that their dividends have risen, and that their share buybacks have actually created a condition in which with no effort on your part, you own a more concentrated share of those cash flows and earnings. And folks, I will tell you, and Dom, I'll tell you as well, and you know this, in the long run, what I just described matters a lot.

12:14All right. So let's talk about the long run versus the short-term volatility. You mentioned that you don't like being beholden to every quarter's worth of data, that you're still looking at this kind of long-term view of things, you wonder sometimes about whether or not investors or traders out there, traders maybe take a little different view depending on the type of trader you are, if you're kind of day or scalping or whatever else, but investors certainly have to take a longer-term view. How does a fundamental-based investor like yourself balance that longer-term view, the going down for weeks or maybe months or years at a time without any kind of communications in or out with the world in the submarine, how do you balance that with some of the short-term volatility that we see often these days?

13:05And I use volatility loosely because a lot of our audience maybe knows that volatility is seemingly non-existent these days by certain measures, right? If you look at the VIX or anything else like that, there doesn't seem to be a lot of it. But that doesn't change the fact that there is noise out there. There is stuff that you kind of have to maybe tune out. What are the things from a long-term standpoint that you focus more on? And what are the short-term noise aspects that you try to tune out? Yeah. And it's a great question, Dom. You put your finger on the exact word that I would use, which is noise.

13:43And there's another word that goes along with noise, which is signal. So in engineering terms, there is the ratio of signal-to-noise ratio, and that's where you're trying to find out what matters. What's the actual signal? And distinguish that from a wide array of noise that may be drowning it out. So the signal-to-noise ratio is very important. Now, in my lifetime, there's been an evolution because noise comes from information. There's just a lot of data coming in. And the evolution in my lifetime was that when I was much, much younger, information was hard to come by. I mean, I hate to date myself, but, you know, before the Internet and when the phone, you actually use the phone to speak to people, information was key.

14:31I remember people, and this is a true story, who would fly out to JFK to get the earliest print version of the Financial Times to find out what's going on in Europe. They'd fly it off the plane. as opposed to today, obviously you get that online with no problem whatsoever. The issue today is there is so much information, it's ubiquitous, it's available to everyone, that it's hard to figure out what the signal is. So it used to be the signal was precious. Now the signal is just buried in a lot of noise. Now, to answer your question, you have to decide what really matters. I'm going to give you an example of what doesn't matter and what does matter in my opinion.

15:14As we're speaking today, there was a pre-announcement from an airline company. I'm not going to pillory the company in particular, but their earnings are going to be roughly 10 % less this quarter than expected earlier before the pre-announcement. Okay. All right. That's not a good piece of news. Stock is down whatever, 8%, 9 % in the pre-market. That is, in my opinion, noise. They didn't quite get the ticket pricing that they wanted, But if you look through the details, the passengers are clearly traveling and their fuel prices are under control. What would matter to me, what would be a real signal is if they were saying, you know what, passengers aren't traveling or fuel prices are skyrocketing.

16:01That would indicate that there's something in the economy that's going awry that I would have to pay attention to. So again, that sort of pre-announcement, hey, it's not a good piece of news, but it's not likely to last. What is likely to last, what is likely to matter, in this case, is the strength or lack thereof of the economy. And that's why, on a weekly basis, I'm paying attention to the initial weekly jobless claims. It's a very real-time, very frequent indication of employment in the United States, which is going to be the driver of whether people are traveling or not. And by travel, I mean both personal travel, discretionary travel, and business travel.

16:43Those initial weekly jobless claims matter more than whether this particular airline priced its tickets appropriately during the last quarter. So you have to decide as an investor, what's your signal, in my case, initial weekly jobless claims. And what's noise? In this case, the fact that this particular airline decreased its earnings expectations by 10%, still profitable, by the way. And I don't own the stock, so I'm just taking in this information. We mentioned before a little bit about this idea that there's a fundament, there's tools, there's all kinds of tools to put together. We had broached the idea of the differences between fundamental analysis and technical analysis.

17:27how do you borrow some of the tools from both of those to craft the type of investing that you do from a value style standpoint? So probably one of the most important things that you think about as a value investor is what is the right price to pay for a company? You may be able to identify a great company, a great business, but is it priced attractively in the stock market for you to make money. And where you start with that is to look at the price relative to earnings. I think this is the most basic valuation tool and everybody knows it. So the price to earnings ratio matters a lot. I tend to focus more on the next 12 months than on the prior 12 months.

18:09What's history is history. It's water under the bridge. But OK, so you've got earnings estimates for a given company and you compare that to the price and it gives you a price to earnings multiple. That is step one. Now, that price-to-earnings multiple cannot simply exist by itself because I can certainly, and we all can find cases where a low price-to-earnings multiple is a stock that you want to stay away from because it has no growth prospects. On the contrary, you might actually want to buy a fairly high-priced from a price-to-earnings multiple point-of-view stock because the growth rate of that earnings is much greater.

18:48And that's where probably what is my favorite tool comes in. It's called the PEG ratio, which simply stands for price to earnings over growth rate ratio. The growth rate in this case is the perceived growth rate of earnings over the next few years. So as an example, if you had a stock that has a forward price to earnings multiple of 15, and the forward growth rate over the next three to five years in earnings was projected to be 15%, you'd have a peg ratio of one. You'd have the 15 multiple divided by the 15 % growth rate gives you a peg ratio of one. Now, again, I'm simply giving you a number, the peg ratio.

19:33How does that peg ratio compare? Well, generally speaking, a value investor is going to feel pretty comfortable with a peg ratio that is close to one and maybe in that range of one to two. When you get above two, you're generally getting into the very high growth, very high multiple stocks, where the slightest variation in earnings as they're reported can dramatically affect the stock. Now, that doesn't mean that those stocks are bad investments. But folks, I want you to understand that I invest not only my own money, but clients' money. And when a stock goes down, I have to answer to those clients.

20:13And by the way, I feel an obligation to answer to you, the viewers of CNBC, whenever I make a recommendation and a stock goes down. So I want to be very careful about the volatility that goes into a stock. And that volatility can often be tied to a high peg ratio. So the combination for me of a moderately priced price to earnings stock with a moderately priced peg ratio, again, that one to two range, can be a very attractive place for me to look for good stocks for us to invest in. You can combine those fundamental building blocks with other building blocks, like price-to-book, which is a measure of the value of the company versus the net assets that it has on its balance sheet, or dividend yield, which is a way it's important for value investors, particularly in light of how value investing has kind of languished the past several years.

21:15it's important that you get paid if you have to wait for a stock to finally unlock its value. And a dividend yield can help you do that. So those are four building blocks that we put together in fundamental value investing, price to earnings ratio, peg ratio, price to book, and dividend yield. There are others as well, but those are the top four that I use, Dom. Jim, this is interesting because you've laid out all the formulaic ways, right? That these are almost like you take inputs, you put them through a machine, and it kind of tells you an outcome and you compare that outcome on a scale, right?

21:57And you measure it against a benchmark. And that gives you an idea of whether something is either over, under, fairly, not fairly valued. This sounds like a construct. that is ripe for disruption when it comes to things like machine learning and artificial intelligence. And the reason why I bring this up is because I recently had a conversation with a professor, an adjunct professor who now teaches finance to college and graduate students. And one of the things that he joked a little bit about, or maybe made some tongue-in-cheek comments about was this idea that they've been able to use certain AI technologies, generative AI, that sort of thing, to literally ask a machine to crunch all of these different types of things that you're talking about, literally from a quarterly report or an annual report.

22:57In other words, you take a quarterly report from the SEC, you feed it through a machine, and that machine will tell you every single ratio and even conduct strategic porter analysis, right? Strength, weaknesses, opportunities, and threats, and that sort of thing. Do you feel as though fundamental analysis is one of those things that can evolve with or be disrupted by artificial intelligence and machine learning? And if so, how quickly do you think this thing will permeate through the markets and fund managers over the next several years? Dom, I certainly think artificial intelligence can and will have a dramatic impact on investing.

23:38But I do need to draw a distinction here. So far, what I've been discussing with you are simply numbers. They're the numbers of what the price to earnings multiple is, what the peg ratio is. And for years, there have been data analytic tools that have allowed investors to screen, that is the verb that's used, screen for certain stocks that meet the criteria, whether it's whatever that criteria may be. By the way, that criteria may be far more than fundamental analysis. It may be technical analysis. It may be showing me what stocks are in a downtrend or what stocks have a 50-day moving average that has recently crossed below a 200-day moving average.

24:19There are any number of permutations of data. Again, going back to the signal-to-noise ratio, So artificial intelligence may be very good at determining what's the signal or driving out the signal from the noise. But where I think human interaction is going to come in is defining what that signal actually is from all of that noise. And what we haven't gotten into so far is some of the softer tools that go into building this construction. So I spoke about hard tools, whether in the metaphor of a bridge, hey, I've got concrete, I've got steel. In the metaphor or rather the application of value investing, I speak about these metrics like price to book or price to earnings.

25:04How you put these all together needs a little bit of artistic flair, whether it's building a bridge or in the case of investing, you have to do some of the softer analysis. And that means calling up and talking to managers of the companies that you're going to invest to glean from them, not just in their spoken word, but how they speak, whether they believe the prospects of their future are bright or dim. It also involves talking to competitors, customers, suppliers of the companies that you want to invest in to find out from them how they think about the company that you're choosing to invest in.

25:44These are some of the softer things that I think we're probably a little ways away from artificial intelligence getting into. But I do think eventually artificial intelligence will be able to tease out some of these softer analytical elements that go into constructing the bridge. But to answer your question, yes, if we're just talking about numbers, just talking about metrics, that's a no brainer for artificial intelligence to come in and screen and give you a list of stocks that meet your criteria. All right. So you've talked about the tools, some of the harder ones and some of the softer ones, the science and the art, the engineering aspect and some of the other artistic elements of that.

26:27But I'd like to kind of maybe get you a little bit more into a discussion about some of the basic tools and ways that investors, the retail investors and individual investors in our audience can use to further their studies or their entry into fundamental analysis or learning more about it. Were there books, resources that you thought were helpful for you in kind of making you a better fundamental investor, Jim? Um, that's, that's a really good question. There are, of course, the, the tomes that you're supposed to read, the intelligent investor, a random walk down Wall Street. You know, going back to the signal to noise ratio, I am a voracious devourer of news, of current news.

27:17And this comes from various people who have trained me over the years who, in turn, were voracious devourer of news. This may seem counterintuitive to what I'm saying about determining the signal from the noise. But if you read a lot of what's going on in current events, you can figure out what the market is most focused in on, what matters most to the market. Now, I'm going to give you an example that, I don't know, maybe this will seem counterintuitive. But if you go back to 2022, the Fed was raising rates tremendously. And all people could talk about was how this was going to impact the stock market, the economy.

27:57There was going to be a rise in joblessness. There was going to be a recession. And that's what all the newspapers and all the media, TV, everybody was talking about, market strategists, et cetera. What was lost, and I actually think was the signal underneath this, was the fact that the government was actually putting in place tremendous supports for the economy in terms of infrastructure spending and incentives to re-onshore the supply chain, which in fact is what has mattered over the last few years in keeping the economy out of recession, despite the fact that the Fed raised rates by 525 basis points in a little over a year.

28:39My point being on this is being a, as I said, voracious devourer of news will tell you what the market is focused on and it will help you to decide if you agree with what the market is focused on or if you think the market's getting it wrong and the signal is somewhere else. CNBC Pro Talks is a monthly interview series that's part of CNBC's premium subscription service, CNBC Pro. To hear the full Pro Talk interview, including specific stock picks and investment strategies, listeners can subscribe to CNBC Pro at cnbc.com slash pro talks. That's also where subscribers can submit questions for upcoming guests, or pro members can email those questions to askprotalks at cnbc.com.