Q: What is the history of the company and the fund?

My father, Dr. Frank James, is the founder and chairman of James Investment Research, Inc. He started the firm in 1972, and today we manage more than $6 billion in assets for clients.

My father was an Air Force officer who earned his doctorate from Rensselaer Polytechnic Institute with a dissertation on the stock market. He looked at every stock from 1926 to 1960 and developed the thesis that the random walk theory was wrong; instead he found stocks that are outperforming the market usually continue to outperform the market. In 1972 he established James Investment Research. In its first two years the market fell 50%, and yet our clients still made money. 

We started with a basic theory that stocks do not move randomly; there are paths of inefficiency: and losing money is a very bad thing. Our approach is to take the least amount of risk that does not prevent us from making money. 

Our first mutual fund, the James Balanced: Golden Rainbow Fund, launched in 1991 with a dual mandate: growth and income, and preservation of capital in falling markets. The Fund has a good track record of minimizing losses. 

Q: What were the fund’s worst and best returns since inception?

Our best return was in 1995, when we were up 22.67%. But in the long run it is not what you make, it is what you keep. Our worst return was obviously in 2008 when we were down only 5.5% when popular indexes fell close to 40%.  

Q: How is your fund different from its peers?

One aspect is we actively manage the allocation among stocks, bonds, and cash, based on our risk assessment. The equity component is all capitalization, so we have small, mid, large and even micro-cap stocks in the Fund, and we shift the proportions in each of them to where we see opportunity. Up to the beginning of 2016 we were running 15% or so in small and the rest in large and mid; currently we are up to about 30% in small with the remainder in large and mid. 

Our approach is not to be a clone of any index, in any way, shape, manner or form. We buy stocks based on whether they are bargains or not, based on our proprietary research. We are well diversified by sectors, more equally weighted. We actively manage the fixed income, which includes only investment grade bonds, and we shift among the sectors. In 2008, especially in the fourth quarter, what saved us was we only had U.S. Treasuries in the Fund. They were the only thing that made any money at all. 

Now we have corporates, agencies, mortgage-backed securities, and even some municipal and sovereign bonds. We actively manage each of those areas, with the goal of trying to preserve capital, we have been running plus or minus 50% in stocks, but the range can go up to 80% or down to 20% in stocks. We are not rapid jumpers, though; we don’t go from one extreme to the other. 

Another aspect that makes us different is we do not buy research. We only buy raw data, and we process it ourselves in-house. We do a lot of testing based on my father’s original research—but when we make a decision we can move quickly. 

Q: What are the core principles behind your investment philosophy?

The first tenet is risk reduction, and we do that at every level. In our stock selection, in bond portfolio management and in asset allocation, everything we do is designed to take the least amount of risk that won’t prevent us from making money.

The other principle is that you cannot just follow the crowd and expect to be successful. So we are contrarians a lot of the time, in both asset allocation and individual stocks. As an example, the higher the expectations of future earnings on a stock, the less we like it, because those earnings are already built into the price. But we are not contrary just for the sake of being contrary. If our research says now is a good time and everyone else says it is a bad time, that is an opportunity for us. 

So our process is allocation, selection, and being contrarian supported by our research. By testing things ourselves we turn future probability in our favor and in favor of the investors in our Fund.

Q: What is your investment process? Where do you start and what steps do you follow?

Our investment process has three phases. The first is the allocation phase. We do a yearly analysis that looks ahead at the market, the risks from a macro standpoint, the influences and major trends. In 2008, for instance, we saw an unwinding of the housing bubble, and so we did not own any mortgage-related firms, we only had pawn shops and insurance companies that could take advantage of a troubled market. 

Then on a weekly basis we do a risk analysis of the stock and the bond markets. We have developed about 100 indicators that point to risks in the long term, beyond six months; the immediate term, the next two to six months; and the short term, the next two to three weeks. When the long-term indicators are favorable, we are more bullish, possibly above 50% in stock. The intermediate indicators point to the next likely shift in the markets. And when the one-, two-, and three-week indicators point to higher risk, this means the market should have a little pullback, which could be a good time to buy. We update those indicators every week; our team reviews them and we make a determination about whether to change the equity levels in our balanced portfolio or not.

The second phase is the individual stock selection. There is somewhat of an overlay from a macro standpoint where we may be soft or heavy in some areas. For example, take our view on oil. There are certain levels at which the drillers do well and certain levels where the refiners do well. We have figured that out to some extent and it is helpful as a macro overlay.

In equities, our key driver is to be diversified across the sectors and to have representation in every sector. Again, we do not try to mimic an index. We have our own internal weightings based on macro factors for the sectors, but it is closer to being an equal-weighted approach than anything else.

Within each individual sector we have a weighting in terms of large, mid and small cap stocks we look for within the portfolio. We look at about 8,500 stocks, searching for companies that are relatively cheap and not completely discovered. We also look at what is happening internally in those companies, whether management has ownership in the company and whether they are buying more. But generally we focus on valuation, so we look for lower price-to-earnings, or price-to-book, or price-to-cash than the market as a whole. We also try to find stocks that are somewhat ignored—that’s a large component of what we look at. 

We also look at earnings; we only want to own companies that have earnings. In 1999 and early 2000 the Fund lost a lot of business because we would not buy companies that did not have earnings. So even though we made money in 1999 we weren’t buying all those Internet companies that didn’t have any earnings. And the irony was that in 1999 companies with earnings went down 10%, whereas companies without earnings went up over 20%. 

We have not found a good way to use projected earnings, so we look at historical earnings instead. We do a long-term comparison, say the past 12 months versus the 12 months before that, focusing on earnings momentum we also look at return on assets, and cash flow. We like to see cash flow from operations on an upward trend; when the market goes haywire those stocks tend to not go down as much. This is effective when there is something cheap and has good earnings. 

The question is always, when do you own something and when do you sell it? If it has our two components—if it is cheap and has good earnings—we want to own it. And the other side of it is that when the market goes haywire, which it eventually does, those stocks do not go down as much. 

Another point of consideration with stocks is relative strength. If we find a stock that is declining in the short term but has a long-term upward trend, that is the best time to buy. It’s like baseball, when a great hitter is temporarily not hitting well, that is the time to have confidence, because he is going to get back to normal eventually. The bond side is more about risk; we know we are going to make most of the money in stocks and not in bonds. However from 2000 to 2010, the stock market was basically flat but our fund gained over 100% because we did not have big losses and we made money in bonds. 

Q: Does a company’s ability to pay dividends factor into your selection process?

At times it does. What we look for is a mispricing on dividends. For instance, utilities are paying high dividends today, but our perception is they are expensive on a historic basis, and that indicates to us that they are higher risk. So we would have a lower position in utilities. Obviously over the long term dividends have been a huge part of the overall return in stocks, but unfortunately yields are low today, though I think they are going to be rising. So we do not take dividend yield itself into account directly, but it may be an overlay we would add to the portfolio.

On the bond side, our approach is if we are not going to be in stocks, we do not want to lose money. So we only buy investment grade. We want to be diversified across sectors and the key risk profile we try to address is duration. Every week we do an analysis of the risk levels in the bond market, which are historically interest-rate sensitive. It is a combination of two things: the structure, whether you are more barbell, bullet or ladder type of portfolio, and the duration. We generally go from a duration of about two years to seven years. We are trying not to take excessive risk; we view bonds very much as the safety component, the shock absorber when things happen with stocks, though obviously we will try to make money and have longer durations in a falling interest rate environment. We are in a changed scenario right now where we are at a bottoming in rates; we think they will be heading up and we do not believe there may be great returns in bonds over the next 5 to 10 years. So we are taking a slightly different approach. But it is still a protector of the portfolio. 

We do not give up much overall return but we do give up a lot of downside by having bonds in the portfolio. Most balanced funds have a flat 60/40 allocation but we make that adjustment over time based on where we see risk and opportunity. In 2008, which is an extreme example, we were about 30% in stocks and 70% bonds.

Q: Can you give examples of your research process?

In 2015 we saw oil prices dropping, which was really good for refiners and airlines, and stocks like Valero Energy Corporation and Alaska Air Group Inc. met all our criteria and helped the Fund. They were relatively cheap and had good earnings, prices were rising, and the macro environment was helping them.

The good news was they went up; the bad news was they became a larger part of the portfolio. Then in 2016, when prices started to reverse in the oil sector, it left them a bit high and dry. While they still made sense from the valuation standpoint, they had a huge headwind going against them, so we trimmed back. The airlines have come charging back since then but the refiners not quite as much. But having too large a position in them was just too much risk.

Last year, on the fixed income side, our indicators on bonds changed from being more positive to less positive. So we made specific decisions to reduce some of our holdings in longer-term Treasuries and made the portfolio a little more defensive in nature. We bought Treasury Inflation-Protected Securities (TIPS) and floating-rate securities and shorter term Treasuries, so we lowered the overall duration but at the same time made the mix itself a little more defensive.

On TIPS, we looked back historically to determine an average breakeven level. If what TIPS are offering us as an inflation adjustment is below that break-even level, that is a good time for us to buy them. The environment is starting to fade a little but they have been outperforming this year. So that is one small area where our research has been helpful.

Q: How do you construct the portfolio? What are your benchmarks or diversification approaches?

Our portfolio management team has eight portfolio managers and nine people on the investment committee averaging over 20 years with our company. The team meets a couple of times a week to review the securities we have on our buy list. For instance, if we want something in the energy sector the team will look at the top-rated stocks according to our internal proprietary ratings system and narrow the list down on more of a qualitative basis. Then the team will bring it to the entire investment committee, where every member, from the most junior to the most senior, votes. If the committee votes that it is appropriate and needed for the portfolio, we buy it.

We use as a benchmark probably about half stocks and half bonds, maybe a little cash. The actual stated benchmark is weighted 25% in S&P 500 Index, 25% in Russell 2000 Index, and 50% in Barclays Capital U.S. Intermediate Government/Credit Bond Index.

The most important decision for a stock is when to sell it. Several triggers bring up a stock for review: its strength might no longer be above the market average, and that might be an early warning of a long-term downtrend. Or a significant move in the price of the stock, or a significant outside event like a merger, acquisition, or lawsuit, might trigger a sell decision. Portfolio turnover is in the 40% range. 

After about six months we review the stock and look at our proprietary rating. You want to fish where the big fish are; we know that the top-rated securities are the best performing over the long haul. But if the rating starts to slip, that would trigger a review; if the performance does not match up to our expectations we would try to find something else that might perform better. We’ll bring it to the committee for a review. We might sell it, or say it is now on our sell list and then sell it at an opportune time to get the best price for it. 

We do not buy or keep a stock because we are in love with the company or the CEO. We might love the way they run the business, but we let the numbers do the talking for them. 

Q: What is your definition of risk and how do you manage it? Which types of risk do you primarily focus on?

Our definition of risk is losing money. Lowering our overall risk is embedded in everything we do; in our asset allocation, our sector diversification, our stock selection, our bond duration. It works most of the time, but it does not work all the time. Our risk management is about trying to figure out, when what we have is not working, whether it is something systemic to us or just a normal pattern within the market. That is always the hardest part of investing. 

At the same time there is always a risk that maybe we are on the wrong track, that maybe our processes which have usually worked just are not working any more. So over every two-year period we go back to every component of our risk analysis and of our ratings for stocks, and revalidate every single one. Just to give an example, back in the early 1980s when we first started using computers to help us, quarterly surprise had months and months of carryover; it would predict rising prices for a stock for three to six months. Today, it may be one or two days. So it does not have much value and we do not use it very much. Now we have found alternatives, such as stock buybacks. 

We do not jump from one extreme to another—we use exponential smoothing. We look at what has worked over the past two years, and if it continues to work over the next two-year period we give it greater and greater weight. We continually try to prevent hubris, from thinking ours is the only way and it is always right. 

We believe in continuing to adapt. The techniques may change, but the basic philosophy that drives us is rock solid.