Q: What is the history of the fund and how has it evolved? What is the mission of the fund and how is it different from its peers?
The LK Balanced Fund evolved from a partnership that was in existence since the firm was founded in 1986. Two years ago we converted that partnership to a mutual fund structure. It has been a balanced partnership and now a balanced mutual fund throughout its history. Because of the way we structured the conversion, 100 percent of the partners converted to shareowners and the management team remained the same.
The SEC allowed us to port the performance history wherever we’ve reported it from the partnership to the fund. While the fund has only been in existence for two and a half years, its performance history goes back over 28 years now.
The partnership was initially formed for clients that could not meet the firm’s minimum investment size. We’re primarily a separate account manager at Lawson Kroeker. Inevitably families have smaller accounts or IRAs or children's accounts and didn't have at the time the half million, now currently million dollar minimum to fund a separate account. The partnership was formed as an investment solution for such circumstances.
The conversion to a mutual fund has helped that process greatly. In partnership we could only allow purchases and redemptions twice a year; the mutual fund is daily along with all the other benefits of a mutual fund. We found that it's a great benefit to our existing client’s other assets.
The management of the fund is entirely consistent with the way we managed the partnership, and the managers are the same too. I came to the firm in 1999. Ken Kroeker, one of the founders of the firm, has been a manager of the fund until retiring from fund management this year. Bruce started eight years ago. For a while it was just Ken, then it was Ken and me; then it was Ken and Bruce and me. Now it’s Bruce and me. Throughout its history it has been the same underlying way of investing that we use for our separate accounts.
Currently we have about $26 million in the fund and the firm manages around $500 million.
Q: Why is the balanced fund the right way for investors and how can it help them to achieve their goals?
Most people need a balance in their financial life. Historically the fund has run at about 60 percent equity and 40 percent bond balance. We do have discretion and have used it to move anywhere between 50 and 70 percent equity depending on where the better opportunities are.
We think, and statistical studies have shown, that a balanced product tends to keep investors involved in the market in times of distress while not sacrificing that much in terms of return. We’ve been a balanced proponent since inception.
This product just mirrors the thought that we don't like to have 100 percent equity. If you want to, think of it as a one-stop shop fund for the person who doesn't want to worry about buying ten ETFs and trying to balance them out and do their weightings and who likes hiring a professional manager to do that for them.
Q: What core principles drive your investment mission?
We’re fundamentals-based investors and aren’t driven by technical analysis. For us, it’s getting to understand companies and really treat the purchases we make as an investment in the management of the company, whether they’re bonds or stocks.
We want to own the company for the long term so we want to be comfortable with their business. When we look at different industries we may use different valuation metrics based on what’s appropriate for that industry, but as a baseline it’s a fundamental approach of getting to know the company's income statement and balance sheet and being comfortable with them.
Specifically, being comfortable that the management has the same goals and objectives we would if we were running the company. Then we’re more or less partnering with them by letting them use the capital to grow the business.
Q: So you view yourself as a buyer of the business rather than a piece of stock?
Right. To us the trading of stock that goes on makes little sense; it’s very close to gambling or at the minimum speculating and we’re just not into that. It does tend to lead to periods of being out of step with the market because certain sectors will go in and out of favor. But if we’re holding companies with good solid fundamentals that are growing at acceptable paces at acceptable prices we get the long term benefit.
Q: With that philosophy in mind, do you want to buy high quality businesses that are trading at a good price?
That’s correct; what we’re trying to do. We’re not deep value in the sense that we’re not looking for broken businesses at really cheap prices with the expectation that someone is going to turn them around. The strategy is trying to identify sustainable businesses that are defensible in an ever-changing environment and trying not to pay too much for them.
We don't like to use the word unique, maybe distinctive: distinctive businesses. They don’t have to be different, they just have to be run in a manner that makes economic sense to the holder of their securities. We’re going to hold most of our securities three, five years or longer; some of them have been around for 20 years and historically the fund has had about a 20 percent turnover ratio.
We think that letting the companies do the work as opposed to us trying to guess which way the line is going to squiggle up or down makes more sense in the long term.
Q: Do you decide allocation between stocks and bonds first and then pick securities?
First the allocation. We start with a mental picture that says 60/40 is about where we think a portfolio should be and we’re going to vary from that based on where the current opportunities are.
If the stock market looks a little bit expensive, we may lower that weighting and increase the bond weighting. If the bonds look a little bit more expensive we’ll let that weighting drop and let the stocks go, but we will try to hold it around 60/40 as opposed to swinging from zero to a hundred.
So, historically we haven't got much outside the 50 to 70 percent equity ratio and we do that opportunistically when we think bonds are a little bit pricey. The stock weighting is about 65 percent today because we think stocks may offer more potential return over the next five to ten years than bonds. But we keep the bond position at a level that others may view as too high today simply because we think it does add enough stability to justify having it there.
The expected return on bonds may not be as high as the expected return on stocks but we would expect the volatility will be far less and it will benefit the portfolio in that manner. With regard to the security selection process we don’t own other funds, we buy individual stocks or bonds. We’re not buying ETFs, we’re not positioning the portfolio to go out and buy the drug sector by buying the health care ETF. Instead we’re going to buy Johnson & Johnson, as an example of a high quality company at a reasonable price that we can own for many, many years.
How we get to Johnson & Johnson versus Merck is a process of recognizing that they’re both very high quality companies, and they both have in that industry certain pipelines or certain prospects going forward. We try to analyze the business and which company has better prospects at a more reasonable price. We’ve been on the Johnson & Johnson side for several years but that doesn't mean we’re not always watching the other ones to determine if this one’s been beat up and whether it’s time to look at it and ask if it is worth a switch at this point.
We’re not buy and hold forever; we buy and hold until there is a better alternative.
Q: Please give one more example to explain your research process.
Let’s take Kansas City Southern as an example of a company that we have bought in the past and that we own currently and we’ve had a nice run in. Kansas City Southern currently operates a railroad that runs north-south across the Midwest part of the United States and has rail lines down into Mexico. We originally got involved after the conglomerate separated assets and streamlined the company and at one point also owned the Janus Funds.
The conglomerate sold its other businesses and kept the railroad. It has one of the best lines running north-south and what we really liked was that there was a new port in Mexico being built to allow goods into North America in a more cost effective manner. When we first got involved it was a railroad running north-south with the new port that would increase traffic at a reasonable valuation. The port was built with goods coming from the Far East into Mexico to Dallas and to the Wal-Mart and other end market distribution centers. Goods get distributed throughout the country and you get an earnings boost.
You can’t necessarily predict things like North Dakota developing an oil field and all this oil needs to be shipped. They have lines that run right through there so they’re going to transport oil south and they’re going to pick up sand and other materials used in the fields to frack the wells, They will then ship those north and we will have another boost. Some day one of the larger railroads might buy these guys out and just tie them into their lines.
That’s an example of a company that we get involved in because after a breakup it looked cheap and kind of abandoned and was a reasonably priced business given its prospects. Management executed on its prospects and continues to execute. And because management in our opinion knows what they are doing, it continues to find and develop new revenue streams that allow the company to continue growing. This is a company that we bought in the $30s and is now $115. It’s a little bit volatile because when oil was down they shipped less oil and when it’s up they’ll ship more.
Q: How did this port impact revenue?
It was a significant increase because the Mexican port was not controlled by the Los Angeles Longshoremen's Union so the labor rates are much lower. To get product from China to Dallas, Texas was shorter and much cheaper so that's where the shipping started to go.
The lines run through the auto plant region in Mexico so they’re moving those goods north also. It’s one of the few major north-south tracks in the middle of the country where the majority of the railroads are running East-West. When you think of Union Pacific or Santa Fe or CSX they’re running East-West not North-South.
It's more of a niche business that we really liked and it’s worked out.
Q: Any other example you can share with us?
Costamare Inc., a Greece-based container shipping services provider, is a new company we got interested in about 18 months ago. It concerned our clients when we started buying it. Who buys Greek shipping companies in the middle of the Greek financial crisis?
What we liked about the company was it was largely family-owned, and it had a balance sheet that should allow it to survive the economic downturn and the current weakness in the container shipping business. We’re not top-down in the sense that we’re going to try to predict when the downturn would end, but certainly we thought within the next five years that we could expect the downturn to end and that Costamare could make it through that.
Management has signed some joint ventures with other shipping companies. They’re continuing to build and get their ships under lease with Maersk and other ocean cargo shipping companies at rates that are profitable for them. The best part to us is when we initially bought it we got almost a 6 percent dividend yield.
We got paid to wait at a rate that was more attractive than bonds were yielding at the time and yet we get a company that when worldwide shipping and container rates improve should have incredible operating leverage.
We suspect earnings of the company could expand by a factor of maybe two to three times and we wouldn’t expect the stock price to fall so we have big upside and little downside and a nice dividend while we wait.
What we also liked is that the management or the family is paying themselves primarily with the dividends and not outrageous salaries which we feel makes the dividend fairly secure for the other shareholders. They are the majority shareholders so in that sense we’re at some risk of them making a stupid decision but so far they haven't.
As one of the few shipping companies that entered the downturn with a balance sheet that could survive the economic malaise, they’ve been in a position where they’ve been able to grow their business throughout the decline in containership pricing.
But as soon as we mention Greek shipping with most of our clients they say no, which is again why the stock appears attractive. The point of most return is usually at the point of most pain, so if you can tolerate the pain there may be substantial return. But you have to understand the potential pain and be willing to withstand it.
So far we can happily report that even though shipping rates continued to decline the stock is actually up 20 something percent. I'm okay with that and again we’re banking on and collecting a return on the dividend while we wait for a turnaround in the industry.
Q: What are your stocks selection process steps? Do you review key metrics like return on investments, dividend yield, operating margins or others?
We typically own 30 to 35 of stocks and the stock selection steps are simply identification of the factors you mentioned.
We screen on return on equity and on debt to total capital, and we look for a strong balance sheet. We screen on earnings growth and more importantly consistency in earnings growth.
We look at dividend although that doesn't preclude us from owning it. We like it if we can get it but it's not a discounting factor. Initially we look for the higher-quality companies and we do that by screening for debt to capital and earnings growth. Next we move to how do you value them today versus how they been valued in the past.
For instance, if the normal Price-to-Earnings ratio range of the company has been between 10 and 20 for 10 years and if Price-to-Earnings is the proper valuation metric and it’s been at 20 for 10 years, we’re obviously going to try to buy it between 10 and 12.
We try to buy at the lower end of their historical ranges and we avoid the upper range. If we do not get the price we like, we will watch the company, put it on our monitor list and wait to buy it lower.
When you get into a market that’s up a lot and you’ve got a lot of good companies on the wait list, you get into a position of what’s the next best alternative. We typically own 30 to 35 and the best ones we can find are the ones we’re going to own.
If one stock gets cheaper, we’ll move that one on to the list and take one off but we’re not going to own a stock without it being on the monitor list for a while. Rarely is there a company that runs through here that we haven't been following for years. I’m 50 years old and I’m the youngest and I have been doing this for 30 years since I got out of college. Other team members are between 60 and 90 years old and they are still active and involved in the investment process in terms of identifying great companies.
We have a good understanding of what the companies are and it’s a matter of waiting for the right price.
Q: In the bond portfolio what kind of securities do you prefer?
We limit ourselves to investment grade corporate bonds, U. S. government agencies and U.S. treasuries and we move between the sectors based on attractive yields.
In 2009 you got above average rates on corporate high bonds due to investors’ worries that the world was going to fall apart. We didn’t think the world was going to fall apart, so we didn't go to the U.S. treasuries, we went heavier into corporates.
We traded bonds then but we don’t do that much. With bonds we are buy and hold. However, when an entire sector goes in or out of favor we will go more heavily in that direction. We generally go out to eight to 10 years and let that roll forward in our bond portfolio.
We’re currently of the belief that bond rates could be down here. By down I mean two to three percent in ten-year treasuries for ten years or longer. That's not a common view. That view has kept us somewhat longer than the guys that are really bearish, but shorter than the guys that are really bullish who are predicting the ten-year going to one-an-a-half.
We’re kind of in the middle on our bond side right now. We think that with rates likely to stay lower longer than people think we can probably stretch our duration of our bond portfolio out a little bit.
Q: So generally you have an allocation on treasuries and agencies and then into corporate bonds, but you never go to high yield?
We never go to the high-yield. If we want to take additional risk we would put more money on the equity side. Bonds for us are for stability.
Q: Are you mostly looking for low duration?
We don’t see interest rates going up and up. We’re in the flat, flat, flat category. Because of that our duration would be somewhat longer than the guys that are say rates are going up and up.
Let’s say our duration is about 4.7 now which is longer than we would have if we really thought rates would jump from two to three to four to five percent. If that was our thinking we would want to have a lower duration and wait it out. But we currently think it is going to be a long time period where interest rates remain very low.
Right now European rates are below the United States, which makes no sense to us. Their economies are in horrible relative shape as a continent not to mention the individual countries’ economies and their easing programs will probably continue. U.S. monetary easing is probably declining but still on the books.
None of the governments of the world can financially afford interest rates to double, so they’re unlikely to let it happen. There are few current signs of inflation in the world and commodities are currently getting crushed worldwide. There are more people entering the worldwide workforce so there appears to be no employee wage inflation, so we’re not overly really worried about inflation.
To get much higher rates you need to have inflation and you need to have no more easing. More importantly you need to have governments that can afford higher rates and they can’t afford it right now. I would sense that most governments will do everything in their power to keep rates low for an extended period.
Q: In your opinion is five years or longer a long time?
We’re saying five to ten years. Obviously we’re re-evaluating this all the time as things change but if I had to say today whether rates will be higher or lower than five percent in five years, I'd say we’d predict lower.
Q: You invest in equities and bonds. Do you look at REITs favorably from your asset allocation perspective?
We don’t consider it a separate asset class; we throw them in with the equities. We’ve owned REITs in the past but we don't own any right now, although we do own some lumber companies that are quasi-REITs but not legally structured that way.
Q: What is your portfolio construction process and what role does diversification play in your thinking? How do you leverage your small company size advantage in the market?
Within stocks we like to have representation in all sectors. We’re not required to be represented in all sectors but we’d have to be hard-pressed not to own at least one. But if there are no opportunities we won’t own any.
Historically we’ve been overweight industrials and economically sensitive companies and underweight technology. That probably goes back to our fundamental ability to look out five years and determine whether the companies will be earning more or less or if they will even be in business in some cases for the technology companies. There's a natural bias in our process towards companies that make things. These companies are tangible and long-lived without rapid changes in their product line. As a result, we’d be underweight in technology today and have been for the 15 years I’ve been here and I see that continuing.
We try not be more than two times weighted the index and the S&P 500, although the proper weighting or the proper index to compare us to would be some combination of the Russell 2000 and the S&P 500. In my opinion S&P 500 index is too highly focused on large caps. At all times we have the freedom to move between small and large caps and we’ve used that freedom at some times to be heavier in one sector or the other depending on the opportunity. But at all times we probably have had a much higher weighting than the S&P 500 in smaller capitalization companies.
You could say two thirds S&P 500 and one third Russell 2000. That might be fairer than just the S&P, but when doing sector weights we just look at the S&P for ease. Our ability to move between small and large is different than many balanced fund managers who restrict themselves to owning just the largest cap companies.
We have a lot more flexibility than the competition which is trying to move billions of dollars in and out of the market. They can’t do it efficiently. With a $500 million company we can do it fairly easily. We think that’s an advantage we try to exploit in an attempt to improve returns at a lower volatility or lower risk level than our competitors might.
Q: How do you define risk and what do you do to manage it and then control it?
Our risk definition is not very academic friendly in the sense that it’s not volatility and it’s not what our beta is or anything like that. We try to make an estimate of what’s the likelihood we’re going to lose money on an investment, an absolute loss of dollars. We recognize that all stocks are influenced by the market and we could lose money in any of them. But if you were to hold the security for ten years, what’s the likelihood that you will be underwater in ten years assuming a flat market? We use that as a kind of baseline.
Unfortunately there’s no hard number. The academic world likes to put numbers on everything. It’s our view that stock selection is as much art as it is science. But as you move more and more towards making it scientific, you get away from the ability for the artful selector to pick companies that are actually going to win.
Our underlying definition of risk on the stock side is to ask what our chances are of losing money in this over ten years we might own it. We use ten years because you can compare that to a bond. We compare this to buying a bond that we might hold for ten years, where we’re fairly certain of getting back our principal.
By way of example, if we have an expected return on a Johnson & Johnson bond of 2.2 percent for ten years and a very high certainty we’ll get our principal back. While, on the stock, what are the chances my stock is down over ten years? We would say pretty low to nonexistent and yet we get a 3.5 percent dividend return that we know going in is better than the interest return on the bond. We like that and then it’s compared to other equity alternatives on that same kind of scale.
Q: When do you decide to sell?
There are three scenarios that are fairly common. One is the least pleasant; that’s when we clearly misunderstood what we thought we were doing and the management usually isn’t doing what we expected they would do, so the company isn’t performing and the stock isn’t performing.
The more pleasant reason is if it’s become too big a percentage of the portfolio and we have several names that ran from three to five to eight percent. Therefore we were forced to just sell some because we don't believe that any name should be more than seven or eight percent of the portfolio. If it gets to ten percent, you’re taking an awful lot of risk on a single security and that’s not the point of a balanced portfolio.
So the first reason is it didn’t work, the second reason is it worked too well. The third reason is we have a better alternative.
We do this constantly as we discuss our holdings. If we’ve got to raise cash what’s the name to sell on the top of the list? That’s if someone needs a cash withdrawal or if we’ve got a better name that we want to replace.
We’re not constantly ranking them one through 35, but we always have in our minds these are the companies that have had their run or not had their run or are not performing and need to be replaced. As we identify replacements we move them in and the other out. It’s a replacement sell discipline ongoing in addition to the “oops” we made a mistake or that worked out great.
Q: How is your firm different from other investment managers?
One of the things that make us different, a little bit better in our view, is our structure. We have a group of investment professionals that have been around for a long time who own the firm and we’re going to be around here for a long time.
We’re all shareholders, and our own money is invested in the fund, our retirement plans, so we’re eating what we’re cooking and it’s what we believe in. That’s not always true of some of our competitors. Not being beholden to a large bank or a large holding company really helps and allows us to be different in our selections.
We can and have varied from the indexes over time, which in the short term can be painful but over the long-term seems to have worked out in the sense that you can’t be like an index and expect to beat that index. We don’t see how you can closet index your way to outperformance. Investors will have periods of underperformance to get the periods of outperformance. You'd prefer fewer steps back and more steps forward but it doesn’t always work that way.
Others’ strategies may keep them close to the benchmark but then they’re just competing with an ETF and then you might as well just buy the ETF. We have some spirited discussions about why we should or should not own these companies and in our case it’s what's best for our shareholders.
