Q: What is the history of the fund?
The Sterling Capital Behavioral Small Cap Value Equity Fund is a repurposed fund launched on January 2, 1997. Initially it was a small cap value fund managed in a fundamental, bottom-up fashion. In June 2013, we became the portfolio managers, using principles and tenets from “behavioral finance,” which we define as the study of how psychology influences investment decisions.
As of February 1, 2015, the fund was renamed Sterling Capital Behavioral Small Cap Value Equity Fund.
Q: How is your fund different from its peers?
We like to point to Benjamin Graham, the mentor of Warren Buffet. He was quoted saying “An investor’s chief problem-and even his worst enemy-is likely to be himself, and “Individuals who cannot master their emotions are ill-suited to profit from the investment process."
We start with the position that human beings really do have myopic decision making. A lot of mistakes are caused by fear, greed and ego, so for the astute disciplined investor that creates opportunity and that’s where we come in.
Q: What core principles drive your investment philosophy?
The fathers of behavioral finance, Amos Tversky and Daniel Kahneman, in 1979 did a pivotal piece of research, developing the “Prospect Theory.” They found investors feel pain when a loss occurs two to three times more than pleasure associated with experiencing a gain of a similar magnitude. That leads to investors selling their winners or outperformers too soon and then holding on to the losers in the hopes of breaking even.
With fear or in cases where there is broken or weak fundamentals, the market has priced some companies cheap. That then becomes a value signal and we have been able to deliver attractive returns because we have a disciplined exposure to these value signals. We equate fear with value.
The second aspect that we focus on is greed. The late 1990s saw huge investment gains in tech, media, and telecom stocks with stocks carrying huge valuation multiples. That’s a prime example of the herding effect in play and herding creates a very powerful signal in the market, a price momentum signal.
The third leg of our stool is ego. We particularly focus on Wall Street analysts because we have found they are overconfident about accurately forecasting earnings. They tend to underreact to new information, especially if it diverges from their own view. Analysts are slow to catch up to what a company’s true earnings trajectory is, and this lateness effect is a key to our research process.
Q: Would you describe your investment process?
We take the market cap band of the Russell 2000 Index at any point in time and we call that our universe. From there we use a disciplined screening process to identify opportunities for investment, using a five-factor approach where we apply a score to every single stock in the universe.
We then construct the portfolio in a sector neutral fashion, so it doesn’t take big sector bets over time and we manage the portfolio to a plus or minus 25 basis points weighting using Russell economic sector classifications. We buy stocks that are at the crossroads of having an air of both cheapness from a valuation standpoint, and momentum—where Wall Street is recognizing longer-term price momentum.
We also apply a very rigid process to look across the bottom half of the Russell 2000 Index, which is more micro-cap in nature and fairly expensive to trade from a liquidity standpoint. If we don’t think we can trade in and out of the stock cost effectively using a presumed much higher asset base than we currently manage, then we will pass on the stock even if it looks attractive. This culling out of less liquid stocks gives us a working universe of about 1,700 stocks that have sufficient liquidity.
Next, we rank each of the remaining stocks within our universe into percentiles from 1 to 100. A company ranked 1 is very attractive from its valuation and/or price momentum and/or earnings revision profile. As a result it is likely that it is cheaper than the rest of the universe and/or from a price momentum standpoint, it likely also has more momentum than the rest of the universe and from an earnings revision standpoint, it likely has a more positive earnings estimate trajectory.
Q: What is your research process? Can you give some examples that illustrate it?
First, we try to identify new investor behaviors that are manifesting themselves in anomalies in the marketplace. We also monitor that we are still capitalizing on the existing anomalies using the price momentum, earnings revision and valuation factors on the fear, greed and ego behaviors.
Another phase of our research is analyzing if we are getting an appropriate level of return for the risk that we are taking, where risk is defined as the difference between the benchmark on the individual stock, sector or factor level.
The third leg of the research tool is in trading, making sure we are not driving the stock price up when we are buying or down when we are selling. We assess if we are accessing liquidity in the market as efficiently as we can. The research that we do is less on the individual stock level and more on the portfolio construction, implementation and underlying behavioral level.
Another key differentiator is evaluating individual companies. When we construct our portfolios, we flush out stocks that have become expensive and/or lost their momentum and bring in stocks that we find inexpensive and/or have nice momentum characteristics.
In December, we bought Transocean Ltd., the largest offshore drilling contractors. It had price momentum that was better than the overall universe, was receiving earnings upgrades and looked cheap relative to the universe of energy stocks. Transocean replaced a company called EP Energy Corp. EP Energy still looked attractive from a valuation perspective but the momentum completely rolled over and the composite rank dropped.
Another example would be when we sold Thor Industries, Inc., the recreational vehicles manufacturer, back in December. It had good momentum, but its valuation had gotten middling to rich. We replaced it with Children’s Place Inc., the specialty children's apparel and accessories retailer, which had extremely attractive momentum and value at that time.
Q: Do you have cash in the portfolio?
We always remain fully invested and typically maintain a small cash balance of 1% to 2%. If we sell something, we need to replace that company with another company from the same sector. Our research and experience has shown that we are not rewarded over time for taking either big sector bets or by essentially having a large amount of cash.
Typically, we buy stocks that are in the best 25% of our framework of the combined attractive value and momentum and earnings profile. Once that rating begins to decay and it moves more to the middle of the pack within our universe, that’s typically when we sell. We take those proceeds and reinvest them back into the sector, into something that has a better, more value/high momentum profile.
Q: How has your research process evolved over the years?
The majority of our returns are at the portfolio level, driven by being cheaper than and having more momentum than the underlying benchmark, the Russell 2000 Value Index.
We focus on better trading practices to pick up efficiency, ongoing research in the behavioral sciences and decision making, and ensuring that there is ongoing efficacy to the value and momentum factor. In other words, about 65% to 75% of our returns come from being exposed to value and momentum and the remainder would be idiosyncratic risks associated with the names in the portfolio.
We are continuously researching how we are scoring and building in efficiencies. An example of a process modification based on our research would be an adjustment we made a while back on our longer-term momentum signal. We noticed there is a short-term reversion effect in the market that holds up over time. So, to align the process to benefit from this effect, we adjusted our momentum signal to capture this by installing a short-term five-day reversion component. If stocks are up last week over a five-day period, there’s a pretty good chance they are going to be relative underperformers in the coming week. But the dominant part of what we do that really has never changed over the life of the fund is focusing on value and momentum.
Q: Do lagging or leading indicators impact your investment decisions?
We wouldn’t say that price momentum is purely lagging. It’s lagging with a high probability of being coincident and continuing going forward. The same thing is true with earnings revision. The crucial point is that as the analyst investment community adjusts up or down their estimate for a given company, that action is inherently lagging, and it often tends to be coincident because it there is always a degree of uncertainty concerning future earnings prospects.
Value can represent elements of serving as both a leading and lagging indicator in different situations. For example, buying a stock that does not move much can be viewed as a value trap. As a result, the market might not recognize the inherent value in that stock for a lengthy period of time. Remember we are marrying momentum to our value type stocks, and that typically means that when we purchase a value stock there is likely a little bit of a catalyst already in place in the form of positive earnings revision or attractive price momentum.
On the flip side, we sell after the company has come off its peak a little bit, as the momentum declines.
No single factor or strategy is going to work all the time in all cycles. So there is a mixture of leading and lagging within the portfolio. But the important thing to understand is that over time, because value and momentum are lowly correlated to another, they offer diversification properties and excellent prospects for generating excess long-term returns.
Q: Have value or valuations always been constant?
We invest at the crossroads of where momentum and value meet. That momentum typically represents growth—the marketplace is aware that there are some good things going on with this company or something going on in their sector where it’s pushing the stock higher. Value stocks that you buy today usually appear to be dead in the water, but the goal is the market will figure out what you know today probably two to eight quarters down the road.
We can always find cheap stocks. We can always find stocks with momentum.
Q: How significant is the herd mentality for you?
We capture the herding effect in our work because we think human psychology doesn’t really change. People are going to be overly greedy – as seen in the late 1990s. They are going so to be overly fearful as in the 2008-09 crisis, when they got out of the market and missed the 300% rally that ensued.
We don’t change our stripes, because human psychology keeps giving us the same opportunities over and over again.
Q: How is your portfolio constructed?
The portfolio holds between 200–300 companies at any given time. We find the efficacy of these fear, greed and ego factors ebb and flow, but over time they are all very powerful in generating superior risk adjusted or volatility adjusted excess returns.
Another differentiator of our products is that our process is rules and factor-based, and based on the scoring system. We try to have a laser focus on value and momentum because of the behavioral underpinnings that drives returns.
We focus on small cap stocks, however we do cap a max weight of any individual stock. Whenever we refresh the portfolio, if we have a handful of stocks that still rank favorably from a risk adjusted return perspective, we may still own it but cut our position, as another form of risk control.
Q: What is your sell discipline?
Once the rank for any stock in our portfolio declines to the point there are several other replacement candidates available, then we begin trimming or selling. Typically a stock is held if its rank remains better than 35-40. Remember that its score weakens as its value becomes less cheap and its momentum slows. The replacement stocks typically have a score between 1–15 which denotes a better value or momentum profile as compared to what we sell.
Q: What types of risk do you focus on? How do you manage and contain risk in the portfolio?
For us, risk is two-fold. Underperforming the Russell 2000 Value Index over our time horizon (three to five years), coupled with the risk of extended periods of higher volatility—defined by standard deviation from the benchmark. We try to manage risk through our stock selection and trading. Lastly, we are laser-focused on providing superior risk-adjusted or volatility-adjusted returns over time.
