Q: How has the fund evolved?
The strategy was established at the end of 2006 as a limited partnership. It was designed for investors who wanted to own a single investment, but with adequate diversification. In 2011 we found that investors preferred mutual funds to partnerships because of the daily pricing and liquidity. As a result, the North Star Opportunity Fund was launched on December 15, 2011. The fund has the flexibility to invest in small, mid, and large cap equities and in fixed income. Brad and I have been managing the fund since its inception.
The primary objective has always been long-term capital appreciation. We seek to achieve this goal through a concentrated portfolio of common stocks, covering the entire spectrum from micro cap stocks to the largest global companies. We also have a fixed-income component, which represents about 20% of the fund. We tend to focus on domestic stocks and fixed-income deposits.
Q: What core beliefs drive your investment philosophy?
We are value investors, looking for out-of-favor companies with high free cash flow yield, protective moats, prudent balance sheets, comprehensible businesses and high-quality management teams, which align their interest to the shareholders. We also need a catalyst that is able to change investor perception. To avoid value traps, when we identify an undervalued security, we always assess the catalyst and how it is going to bring change.
We avoid momentum-driven stocks and companies that we don’t understand. For us it’s important to understand the business, the way it generates the profits, and what the company does.
In general, we stay away from businesses, where commodities are a big element of the profitability, so we’ve had low exposure to metal and energy companies. In these areas, the commodity price is driving the profitability. We think that commodity prices are unpredictable and if we can’t predict the commodity price, we feel that we can’t predict the profitability of the company, so we tend to avoid these businesses.
We believe in mean reversion and that’s part of the catalyst assessment in some of the opportunities we find. When a company has had a certain historic return on invested capital and has gone through a period of lower return, we try to understand the reason behind the lower return. If the issue is temporary and we can be comfortable with it, then we would estimate the mean reversion number to see what the earnings would look like if things get back to normal.
Q: What are the analytical steps of your investment process?
We start with the Standard & Poor’s industry sectors that we want to overweight from a macro-economic perspective. For instance, if we feel that financials are going to do well from a macro viewpoint, we try to find the financial companies that meet our needs. The other criteria we assess include consistent dividend payments, rising net income, sufficient cash flow, and whether there is something exciting or transformational on the horizon that makes the company an opportunity. Then we do our own research to pick the best individual stock in that sector.
The sector determination often comes from a macro outlook. For instance, we thought that the economy was doing better over the last few years, so we were comfortable overweighing financial stocks. The factors that influenced that overweight were the improving economy, the rising interest rate environment and the better economic metrics for financials. Our largest holding was Bank of America because, at the time, it had the biggest value in the group, based on individual analysis of the different financial companies. More recently, we moved towards more defensive names. So, the top-down element affects the types of stocks we own and the sectors we overweigh.
The next step is constant screening for stocks that meet our characteristics on all the available databases. We also go to investor conferences and listen to presentations. We have a bullpen of about 50 different companies and that’s our favorite area for getting ideas. When our macro outlook changes, we go to the bullpen to see which companies and sectors are interesting. That’s where the portfolio additions come from.
On the fixed-income side, we determine the duration from our macro outlook. If we are getting a reasonably good yield, we try to keep duration as short as possible. If are feel comfortable owning the equity of a company based on our research, screening, and meeting with the management, then we make an effort to see if they have fixed income as well.
We believe that the fund offers flexibility by covering an unconstrained universe of investment opportunities. We aim to create an investment with much lower beta and volatility, and to leverage our long-term strength of being value investors.
Q: Could you give us some examples that illustrate your research process?
A good example would be Consolidated Communications Holdings, Inc., the Internet service provider. We ended up owning Consolidated when they bought a company called North Pittsburgh Systems Inc. that we had owned 10 years ago. So, we knew the management team over a long period of time.
Consolidated has grown through acquisitions of other telecom service companies. It has been terrific at finding poorly run or smaller telecom service companies, where it could improve the quality of the offering and the economics of the business, as well as integrate, achieve synergies and provide the customers with better experience.
About 18 months ago they made an acquisition of FairPoint Communications, which was the largest acquisition in the company’s history. Consolidated stock has been popular with dividend-oriented investors for a long time, became unpopular very quickly. In other words, the stock started to drop and weakened to a point where we thought there was a significant misperception. The misperception was that it wouldn’t be able to continue to pay the dividend it had historically paid.
With 10 years of research and frequent contacts with the company, we believe that over time Consolidated will display the positive cash flow it projects. That will make the investment community once again comfortable with the company’s ability to maintain its dividend. As a result, we expect the share price to be revalued back to historic levels.
The reason for the pressure on the stock price is clearly the market concern with the sustainability of the dividend and the proper integration with FairPoint. We have faith that Consolidated can execute well, because we have been following the company for a long time and we have met with the management numerous times. That’s why we considered the situation an opportunity. We follow hundreds of small cap companies outside of the strategy and that’s an example of finding an obvious opportunity and establishing a position in the Opportunity Fund.
Q: What is the catalyst in the case of Consolidated Communications?
The catalyst is the integration savings that the company has already experienced. As these integration savings flow through, reported earnings will improve dramatically. Second, they rebranded, consolidated, and improved the service to the legacy FairPoint customers. In terms of the business, the big catalyst will come not only from the synergies of the integration, but also from the revenues of FairPoint customers. That would cause significant upward re-valuation of the company.
Q: Could you give us another example?
We were attracted to WisdomTree Investments, Inc., an exchange-traded fund sponsor with about $60 billion in assets under management. The two founders have a great track record as investors. They have been making investments and acquisitions in Canada, Europe and other parts of the world.
All these investments were made in different platforms, which dramatically increased the distribution, and that’s one of the catalysts. We expect to see growth coming and, as a result, we believe that the company will get the attention of the market. The shares dropped sharply over the last year, so we think that WisdomTree Investments will provide a good opportunity.
Another example is Janus Henderson Group PLC, a global asset management group. We originally bought Janus before its merger with the Henderson Group. At the time the stock of Janus was extremely undervalued. The growth in assets has been disappointing mainly due to competition from ETF products.
We assumed that assets would stabilize and grow as their funds performed better. Janus also had negative performance fees that were depressing the earnings for four or five years. We knew that trend would be reversed and that was a good catalyst. The next catalyst was their merger with the Henderson Group, which broaden the distribution as well as the scope of their funds. The fund has started to perform better, and better performance attracts assets. So, the story played out exactly as we had expected.
Q: What is your portfolio construction process?
Currently, we invest about 80% of the fund in equities. If our equity allocation falls below 70%, that means that we are particularly concerned about the market. An equity allocation of over 90% signals that we are exceptionally bullish. In term of individual stocks, our exposure typically is 1% to 3% of the fund. An investment of 4% of the portfolio would mean that we have extraordinary confidence in that security.
Our sector exposure depends on our macro view of the economy and the stock market. As a result, we gravitate towards certain sectors or type of companies at different times. We look for the sectors and the companies that we believe are best, based on what’s going on in the world and the economies at the time. Our turnover is typically quite low.
Defining the right benchmark for the fund is difficult because of our investment style. When we have an aggressive allocation, we may look like an aggressive equity fund. Often, we are compared to the S&P 500, which might make sense over the long-run, but in the short-run is not a very good benchmark.
Q: How do you define and control risk?
We accept the inherent risk of owning stocks, where there is no maturity date, coupon, or guarantee. We view volatility as a risk and we believe that most of the volatility is created by trading firms. That’s the unfortunate part of the landscape and we can’t do much to control it.
We control risk by focusing on companies with the highest quality, best balance sheets and management teams. In other words, we believe that investing in well-run and high-quality businesses with prudent balance sheet is the best way to minimize risk. These are lessons that we learned in the financial crisis.
We watch a couple of indicators to see if the overall environment might be deteriorating and we decide the equity and the sector allocation on that basis. We specifically look at the St. Louis Fed Financial Stress Index to see if there is actual stress in the system. When the market went down 10% in late February, after a week that index showed that there wasn’t really that much stress in the system. In such cases we would be less inclined to change our allocation.
Another gauge that we watch is the U.S. dollar. The fact that the dollar has been weakening recently gave us a reason to become more cautious. We have been moving out of some financials and more into consumer staple stocks, which have less inherent risk.
Diversification is another risk control measure. A great way to minimize risk is not to let any positions to dominate the fund.
