#2 – John Gillespie on the Prospector Investment Approach

May 23, 2020

Many equity investors tend to be optimists, counting on their portfolio’s winners to offset losers. Prospector founder John Gillespie has a different philosophy. Mr. Gillespie and his team spend just as much time considering what could go wrong with a stock as they do determining what could go right. Striving to avoid large losses is part of the Prospector DNA, as the team knows it is a critical component to compounding money.

In the second podcast in this series, Mr. Gillespie is joined by Havener Capital Partners founder Stacy Havener to tell us more about the Prospector investment philosophy and approach.

This includes details on:
• The firm’s Private Market Value and Free Cash Flow investment approaches
• How the firm constructed their well-tenured investment team
• Reflections on the Global Financial Crisis
• Characteristics of the different funds

Intrigued? Click on button to listen to the interview (21 min) or read the transcript of the interview below.

(Previously Recorded in January 2020)

Listen to the interview

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Our Founder John Gillespie has always been fascinated by the stock market, but it was a combination of hard work and a bit of luck that led him to work with Jack Byrne, legendary CEO of GEICO. Listen to his story here: Episode #1: Our Story.


Stacy: Welcome back. Today we continue our conversation with John Gillespie of Prospector Partners. In the previous episode John shared his story, including how he went from working at Geico for Jack Byrne, whom Warren Buffett called the “Babe Ruth of Insurance”, to becoming a lead PM at T. Rowe Price, and eventually to founding Prospector Partners over 20 years ago. And oh, by the way, the Babe Ruth of insurance, John’s mentor Jack Byrne, he became Prospector’s seed investor. It’s a great story.  Today we will focus on Prospector as investors.  What do they believe in, what strategies do they offer, and what makes them different than all of the other value investors out there?  In other words, why should anyone care?  Let’s dive back in to our chat with John.

On the strategy side, what do you specialize in?

John: Well, Stacy we’re value investors. I mean, that’s what we do, we’re also company analysts. At Prospector we have portfolio managers, but our portfolio managers are analysts themselves at their core. So, what we do is value investing, bottom up research, and we do the research ourselves in house.  We basically use two different value investing techniques to do our work. The first is private market value. And for us, that means a couple of different things. It can mean tracking what the value of whole company transactions are in different industries and comparing the value of 100% of a company to the value of a minority percentage of the company as represented by the stock price. It can also mean for us taking a GAAP balance sheet, often a complex one, and breaking it down and changing it into a statement of net asset value. So we mark GAAP balance sheets to market, that’s another form of private market value analysis that we do. The second school that we utilize a lot is the school of free cash flow. We believe in free cash flow investing, and basically that means after routine cap spending, after working capital adjustments, what is the sustainable free cash flow yield that a company can generate as compared to its enterprise value and what is the likely growth rate of that in future years. So those are really the techniques that we do, that’s our philosophy, it’s not that complicated but it’s our disciplined set of techniques that we apply over and over.

Stacy: It’s interesting too and I know from previous conversations with you just some of the tie backs to the insurance part of the business and the work that you did there in terms of protecting capital. Do you want to talk at all about that component?

John: Well you know we work hard at protecting capital.  I mean in my experience, most equity investors are optimists and, you know that serves them well and they count on the winners in their portfolio being strong enough to carry along the decisions that maybe weren’t so great and that’s how they operate. We’re a little different, we’re sort of opposite of that.  We spend a lot of time thinking about what could go wrong at least as much time as we think about what can go right. And so, we’re trying to do our risk management by avoiding losers, and I mean I think the key to making money is to avoid large losses over time. And so, it patterns into everything we do, we’re looking for $2 of upside for every dollar downside in our investments but we will not contemplate an investment if we think it has more than 20 or 25% downside. So, having said that, we’re in the business of looking for stocks with 40 or 50% upside and maybe only 20% downside, rather than looking for stocks with 100% upside, but as much as 50% downside you know, those aren’t for us.

Stacy:  You’ve alluded to some of your teammates and one of the things that really differentiates you I think is just the longevity of the team.   Can you talk a little bit about your partners?

John: Sure. Well, we’ve been together a very long time. We have three portfolio managers at Prospector – myself, Kevin O’Brien and Jason Kish.  On average, the three of us have been here together for 20 years. So, you know, It’s been a long run together. Our analyst team is homegrown and home trained. We like that because the way we approach things is really different from most of Wall Street. We find if we bring in more experienced people we have to go through a long process of un-training them before we can retrain them.   And our group I would say has a black belt in accounting.  I mean we’ve got 14 people in the company we have seven CFAs, we have five CPAs, we have five master’s degrees – so we’re very technically capable.

Stacy: That’s great, I mean the 20 years together, there are so many firms that haven’t even been around for 20 years so that’s just amazing.

Let’s transition a little bit. At the start we said you know the idea of this interview is really to talk about some of the things you can’t screen on right? Who you are and why you do what you do and we have this question, we always ask ourselves, which is why should anyone care. What are the problems that you solve for investors?

John: That’s a good question. I mean, I would say we’re striving to deliver good after-tax risk adjusted returns. History suggests we have done a good job of protecting downside in difficult markets. And, you know, that formula, which hasn’t really been the flavor of the month the last 10 years as we’ve been in a bull market just might be timely right now.

Stacy: Great point, Okay so you talked about your philosophy. Let’s take that down a level to the process, and I know your philosophy and process really underpin everything you do at Prospector.  But what would you say differentiates the process there?

John: Again, I do think we look at things a little differently. For instance, compared to most equity investors I think we attack a company’s financial statements backwards. What I mean is that we spend most of our time on the balance sheet, we spend the second most of our time on the cash flow statement, and we spend the least amount of our time on the P&L or the income statement.  And in my sense, my experience, that’s exactly an inverse to how most equity investors do it. And that really sort of sets us apart.

Stacy: That’s a great point.  Just in conversations with investors I think one of the topics that comes up as it relates to your strategy is ’08.  It seems so far away now, but can you talk through what that was like?  How you were positioned, you obviously did very well in that environment, why did it work so well?

John:  Well I’ll start by saying ‘08 was not fun. It wasn’t fun for us it wasn’t fun for anyone and I don’t necessarily want to repeat it.  But having said that, let’s look back.   I’ll use as an example our largest mutual fund, which is our POPFX. The ‘08 experience If you looked at the portfolio from the top down, and you looked at where the sector bets are first of all, it wouldn’t be all that different than it is today. You’d see that our largest sector weighting was in financials where we had over a third of the portfolio and then we had 10% bets in other areas such as consumer staples, technology, and utilities. Now, as I’m sure you can recall, the epicenter of the 2008 crisis was in financial services, yet somehow with an over one third weighting in financials, we were able to withstand 2008, only losing half as much as the market did. How did we do that. I would say there were basically three reasons – one was our financial sector performance was just much, much better than average and the secret to that for us is low leverage. I mean, we do not invest in highly levered companies.  We have a bit of an aversion to leverage and so within financials we love property casualty insurance companies which are levered at 2 to 1 or savings banks that are levered at 5 to 1. This is in stark contrast to money center banks and investment banks, which were really damaged in the crisis which would be levered 25 to 1 or 30 to 1.  So low leverage was the first secret for us.

The second was M&A.  We had a lot of good news in ‘08 through M&A. One of our largest bank holdings was taken over by a Japanese institution in the first half of ‘08.  We also had a large position in a small savings institution in New Jersey that unwound an ill-advised takeover attempt, where we and other investors convinced management that it was not the right move to do and as that deal got unwound, the stock recovered sharply.  So those two things really helped us.  But we barely lost any money in our financial book in ’08.

The other couple of reasons are also things that are consistent about Prospector. One is that we’re overweight defensive sectors.  For us that’s consumer staples which is an area that we have consistently been overweight through our 22 years running money here, and we also had an overweight position in utilities in ‘08 and that makes us underweight most of the cyclical sectors of the economy that are more volatile relative to the business cycles such as consumer discretionary, technology, industrial, and materials and let’s not forget that the crisis of ’08 did cause a significant recession. So those are the reasons why we outperformed. And interestingly the portfolio as it was positioned back then is not so different than it is today.  We still have our largest overweight in financials, we still have about a 10% weight in consumer staples and technology. So, you know, from the top down the portfolios don’t really look that different.

Stacy: That’s really interesting and I know we’re going to talk a little about your outlook on the market in a few minutes here.  You mentioned POPFX, what are the investment strategies you offer at Prospector and can you just give us an overview of each one?

John: So we’ve managed all of our strategies for a very long time. I mean we don’t generate new products at a very rapid rate and all of our strategies are really dependent upon the one common research platform. So, we have just sort of one research kitchen and all the strategies eat off of that research kitchen plate.  What they do is they construct their portfolios a little bit differently.  I think a great analogy would be to say at Prospector, we make our products like different kinds of ice cream. It’s all Prospector ice cream but we offer different flavors.

In the ‘40 Act world, in the mutual fund world we have three products. 

We have a long short fund called LS Opportunity Fund (LSOFX). We’re the sole sub-advisor to this ’40 Act fund and it’s a long-biased fund with both long and short stocks; it has a beta of about point five and we’re seeking to generate absolute returns that are attractive on a risk adjusted basis.

Secondly, we have what’s our largest mutual fund today which is the Prospector Opportunity Fund (POPFX).  This is a long only fund; it’s got an orientation towards small and mid-cap companies. It utilizes our private market value and free cash flow techniques. It averages a beta of around point eight. And again, we’re trying to generate solid risk adjusted returns on an after-tax efficient basis.

And finally we have a third mutual fund strategy called the Prospector Capital Appreciation Fund (PCAFX). That again is long only, but it’s different in that it uses fixed income to help dampen volatility and mitigate downside. There we typically have a 75 to 80% allocation to equities, and that portfolio runs a beta of about point seven five.

Stacy: That’s helpful.  And all of those strategies are fairly concentrated in terms of the holdings, or what does that look like?

John: We tend to have, depending on the portfolio, anywhere between 75 and 110 holdings.

Stacy:  Great, let’s spend a minute on capacity, if you don’t mind.  It’s a question many investors have, especially as you alluded to one of the strategies having a small to mid-cap tilt. Can you give us some insight into capacity, and you can either do that (I know there’s one research platform) – so you could speak to it at just firm level or at the strategy level, however you think about it.

John: Sure. So, first thing I would say is that we’re nowhere near capacity in any of our products today, as far as I’m concerned.  And let’s just talk about the three that I referenced the long/short, the POPFX small and mid-cap and the PCAFX which is more of the balanced fund. I think each of those strategies could comfortably run a billion dollars. And I think the next time we would sit down and really have a hard internal conversation about capacity in each of those products would probably be at the billion dollar level and considering today as a firm we’re running just a bit north of 800 million that tells you that we have a lot of room to run. The other thing I would just mention about capacity is that it really depends on what are the market conditions, you know when you reach certain asset thresholds. So if we’re at a billion dollars in POPFX for example, but we’re in an environment where there’s lots of ideas coming out of our research platform and there’s plenty of liquidity in those ideas, well that would be an indication that well maybe we shouldn’t pause and close the product then. On the other side, if you’re at a place where there’s few ideas and you’re feeling rubbed by liquidity concerns in the few ideas that you have, that’s a much more powerful reason to tap the brakes and stop attracting assets

Stacy: That’s a great point and I think from an investor’s point of view, you know they obviously hire you to generate alpha for them, and your commitment to sort of protecting that, especially for the early adopters who’ve been with you for a long time there’s that whole debate about whether a fund manager is an asset gather or an asset manager, and I think it’s refreshing to hear the commitment to maintaining that ability to generate alpha.

How about the mutual fund conversation –  I know you went through the three mutual funds, you obviously have other vehicles.  What was the decision to launch mutual funds?  Why did you do that?  It’s obviously a different business with its own set of challenges, what was the impetus for that?

John:  Well, first of all we had experience.  I mean I had run mutual funds in my prior life at T. Rowe Price my partner, Kevin O’Brien had run mutual funds in his prior life at Neuberger Berman. So, we had the experience so it was demystified for us.  But we did it for a couple of reasons. First of all, it was to diversify our client base.  We had run basically an institutional business prior to that and we thought that it made sense to diversify our client base. The second thing is we really wanted to accommodate a lot of inquiry that we had from friends and family of our institutional clients to have vehicles at smaller minimums with daily liquidity that they could access for these smaller pools.  So those were really the two drivers behind the decision to enter the mutual fund business.

Stacy: That’s great.  And what are the other vehicles that you offer?

John:  Well, we do have partnerships in our hedge fund business. Again, same story as with the mutual funds.  We have a common research platform and we just have a couple of different portfolio constructions.  We have our all cap long/short fund Prospector Partners Fund and Prospector Offshore Fund. We have a pure small cap hedge fund called the Prospector Small Cap hedge fund. And then we have a strict market neutral fund called the Prospector Turtle fund where the beta adjusted exposure on a daily basis is always between 0.1 and minus 0.1.  Additionally, we offer institutional separate accounts.

Stacy:  Great and actually this is a question I should have asked, so I’m going to, which is, if I’m an investor and I’m looking at partnering with you are you and your team invested in these strategies?

John: Yes, we are.  As I mentioned earlier, we manage a little over $800 million in assets at Prospector. I think $150 million of that $800 million is our own money that we’ve accumulated over our 22-year history here, and we’re invested in all of our products as well.  So, internal Prospector people are significant investors in each of our products.

Stacy: Thank you to John Gillespie for providing more intel on Prospector’s value investing principles, as well as their flagship strategies. Also, how refreshing to know there are still managers out there who believe in capacity constraint and investing alongside their clients.  Asset managers versus asset gatherers – high five to that.  Listen to more of our conversation with John Gillespie, or learn about the Prospector team by visiting the Prospector website.


Our Founder John Gillespie has always been fascinated by the stock market, but it was a combination of hard work and a bit of luck that led him to work with Jack Byrne, legendary CEO of GEICO. Listen to his story here: Episode #1: Our Story.