Q: Would you provide an overview of the company and the fund?

With its global footprint, Lazard Asset Management currently manages nearly $178.5 billion across a broad class of assets. Nearly two thirds of assets under management fall into global, international, and emerging market funds. 

The portfolio team at the US Small-Mid Cap Equity Fund relies on the input of analysts from all over the world in our research process. This worldwide resource helps us in developing a global perspective, because about 28% of revenues in our benchmark, the Russell 2500 Index, originate outside the U.S. 

Q: What are the advantages of investing in a Smid-cap fund as opposed to investing in small-cap and mid-cap funds?

What we like about the Smid-cap segment is the deeper liquidity. It is getting tougher and tougher to trade small-cap stocks, whereas the Smid-cap space, which is a broader asset class including larger mid-cap names, lets you move up the market cap trail and avoid some of the illiquid microcap names that small-cap managers have to deal with by definition.

Another distinct advantage of Smid investing is that you can also participate in the mid-cap market segment, which has been such a strong performer as an asset class, especially in the last five to ten years. 

This ability to hold onto winning small-cap stocks without having to sell when they hit an arbitrary point in time, as they enter the mid-cap segment, is a great advantage. The flexibility in being able to hold onto your winners as a company is graduating and maturing from $3.5 billion to the $8 billion level is a huge plus for funds like ours.

Q: What is your investment philosophy?

Our investment philosophy is rooted in relative value investment discipline. We strongly believe that higher financial productivity eventually leads to larger value creation. Thus, we think that the investment opportunity lies in assessing the relationship between financial productivity and valuation. 

Since productivity drives valuation over time, we think there is more predictive value in security selection than there is in predicting macroeconomic trends on a consistent basis. Our investment process looks for one company at a time in order to build a portfolio of companies that meet our valuation and financial metric criteria.

We look for companies that generate high levels of financial productivity; high return on capital, return on equity, operating margins, and cash flow yields. Generally, these portfolio candidates fall in the market cap between $800 million and $3.5 billion, and we may have some names above and below that but we are cognizant of our benchmark. 

Q: How do you transform this philosophy into your investment strategy and process?

Our investment strategy is designed to find companies trading at a significant discount to their intrinsic value. While value can be measured in various ways, we are constantly looking for companies with an inherent growth profile and unrecognized future earnings growth. 

As far as our investment process is concerned, we rely on our U.S.-based team of sector specialists, who are individually responsible for a specific industry or a group of industries. We utilize both their expertise and proprietary screens in identifying a list of companies for further analysis. 

What is interesting about our corporate culture is that, in the research area, the career path at Lazard does not necessarily lead to portfolio management. One can achieve managing director status as an analyst, which is a career path in its own right, but not everybody is expected to become a portfolio manager. That allows our analysts to gain their experience, be comfortable in their own skin doing what they like to do, which is essentially quality research.

Q: How do you generate ideas?

Most of the ideas that we drive through, and which end up in the portfolios, are a result of our analysts’ screening on a daily basis. Meanwhile, the portfolio manager will also screen and provide some ideas to see whether it is worth doing any further research on them. All of the screens are individually built and tailored to each specific industry. They also function as both valuation and productivity screens. 

To help us narrow down what is a large universe of investable stocks, we limit our idea generation within the Russell 2500 Index. Moreover, when we apply the liquidity criteria to the list of companies in the index, we are able to eliminate between 500 and 700 names. In addition, we are not going to invest in companies that are not profitable or do not have a clear path to be profitable. We will also eliminate some additional companies where we do not see that valuations can expand in the near future. 

In general, we prefer companies with strong balance sheets and a team of seasoned managers at the helm. Through our modeling, we try to identify companies whose streams of earnings are currently undervalued by the market. Also, we prefer to look for companies with strong and consistent cash flows. We actually believe that tracking cash flows rather than earnings serves as a more accurate indicator of the financial health of a company.

In summary, our process is designed to identify companies that have identifiable and consistent revenue streams along with proven productivity and profitability advantages over their peers.

Q: Are you a growth or a value investor?

We are not a growth investor or a deep value investor. When we use the term “value” to describe our strategy, we mean a disciplined approach to investing. We have a disciplined approach to what we are willing to pay, but we are still flexible enough in understanding that each industry is different and valuation metrics across industries differ accordingly. 

As long as we believe that there is an understatement of consensus estimate for future earnings, we may invest in more expensive multiple types of stocks because we believe the growth trajectory is greater than what the market estimates; therefore, it is not quite as expensive as it may seem. We look for relative value in companies, meaning our estimate of a company’s earnings growth potential is higher than the market estimate. 

When we start developing our investment process and building our models out, we make intelligent estimates to revenues and margin assumptions. As we drill down more, we find situations where we believe there are undervalued earnings streams. Those names make us excited and we can have a lot of confidence in them as long as our predictive metrics support the thesis. 

Our models do not look longer than 18 months as it gets harder to model future earnings stream beyond this time frame. Although our target price for each stock fluctuates with the news flow and quarterly earnings, some names get in the portfolio and stay in there for quite a while. We refer to these as compounders—names and situations where the investment thesis is not broken and where we see productivity gains going forward.

Q: What is your research process and how do you look for opportunities?

As mentioned earlier, our research platform is deep and diverse and we have 22 investment professionals covering wide range of sectors. We rely on our analysts to sift through a multitude of names and zero in on few companies. Not only does this process require diligent monitoring of all the publicly available information in regulatory filings, but it also involves doing interviews with management on a regular basis. In addition to that, we read various sell-side research.

Our analysts use all the input to prepare proprietary and forward-looking income statement and balance sheet models for each company that we are potentially interested in. That will give us a picture of whether or not this company may have some hidden earnings that are not being appreciated by the Street.

As the models begin to look attractive to us, we start on our investment thesis, which is simply a prediction of the news flow and its impact on stock prices. At this point we can build a risk-reward profile using base, bear, and bull case scenarios. After all the work is done and the risk-reward profile is set up, the discussion then graduates to whether this is a stock worthy of investing. Should it be an investable name for us, and more importantly, should we commit our client’s capital to this stock?

When we have a name that has an attractive risk-reward profile, we get serious about the stock. That is when I scrutinize stocks one more time and grill analysts to develop my confidence level for each potential candidate. The stock is likely to be added to the portfolio if that confidence level is high and we are comfortable with the type of business they are in, with our modeling; and with our investment thesis in terms of predicting news flow and its impact on the stock. 

To sum up, our research process is driven one stock at a time. We look for opportunities with companies with repeatable business models and recurring revenues. The revenue profile of this kind helps us in understanding the value of the company on an ongoing basis. 

While we feel that cash flows are a strong indication of a company’s health, we do not draw lines in the sand. We are prepared to invest in companies that are not making money now but have identifiable catalysts that could help the business from turning around to profitability and improving cash flows and capital positions. 

It is important to mention that we have to be able to understand accounting. If there are any red flags that come up with that, we will just move onto the next name. We do not get involved in anything with dubious accounting.

Q: What is your portfolio construction process?

We run a relatively concentrated portfolio given the investable universe, and we hold between 70 and 90 names. A typical position size is between 1.2% and 2% of the portfolio. The difference between 1.2% and 2% comes down to the risk-reward profile. 

Looking at our current positioning and the relative scenarios involved, we will manage position sizes according to that on a daily basis. As a result, nothing gets to be much more than 2%, or even 1.9%.

We look at stock-by-stock risk and we are not willing to put more than 35 basis points at risk in any one particular name. When we start seeing that 35 basis points of downside risk, we will go ahead and trim or sell that position. Provided that we are comfortable with the investment thesis, with our high conviction level, and there is two-to-one upside-to-downside ratio, we will go ahead and buy that position. 

In contrast, what causes us to sell a position is a change in our investment thesis. This may be that we are getting something wrong or we may not be getting the news flow right. It could be a change in the management team or the management strategies that we did not anticipate. We will also sell the stock if it has accreted so much that we cannot justify the downside risk in holding it, or we do not see much more upside, even as we rework our numbers and come up with a new price matrix. 

The portfolio turnover tends to be between 75% and 110%, which is reflective of our 12-to-18-month time and investment horizon. Consistently, about one third of our turnover is from trims rather than outright sells of positions.

We feel that the breadth and depth of our research platform does allow us to participate across industry sectors, and we are certainly diversified across industry sectors. It is a bottom-up process, so occasionally the smaller sectors may not have any representation. This is not because we do not like the sectors, but mostly because we are not finding relative value in those particular names. 

As the bottom-up process allows us to be representative across the industry sectors of the Russell 2500, it will obviously lead to overweight and underweight positions in specific sectors, depending on what we are seeing at that point in time. We drive our performance, for better or worse, through stock attribution rather than through sector allocation.

Q: How do you define and manage risk?

We define risk as permanent loss of capital, meaning losing money for our clients. We can live with volatility but when we see greater downside potential, that is what we call risk.

Our risk management is based on three independent levels: stock level, portfolio level and macroeconomic level. The risks on a stock-by-stock basis are risks to that specific name. It may be an interest rate hike, a change in management, or an unforeseen geopolitical risk.

Every month we have a group meeting, led by a senior manager, where we discuss a variety of risk aspects ranging from macro and factor risk and correlation risk, liquidity risk and any other imaginable metric. These monthly meetings allow us to make sure that everything is in-line and that we are cognizant of any hidden correlations or macroeconomic risks. Our ability to understand how the portfolio is positioned overall helps us avoid unintended risk concentrations.

Our next level of risk oversight involves our most senior management from Lazard, our risk oversight committee. Each fund team meets with the committee at least once a year. More frequent meetings with the committee could be a signal that there is a problem in a portfolio. Fortunately, we have not had to do that yet.