Q: What is the history of the fund?
The BMO Mid Cap Value Fund was launched in 1997, and our team, which has been managing institutional Mid-Cap Value assets since 2000, took charge of the fund in October 2016. The fund currently has approximately $210 million in assets.
Our investable universe consists of the 700 names in the Russell Mid-Cap Value Index. The companies that fall into the mid-cap value category range from about $3 billion up to close to $30 billion.
Q: What core principles guide your investment philosophy?
We have two core beliefs. First, that company fundamentals ultimately determine stock prices; and, therefore, companies that have improving fundamentals, attractive relative valuations, and improving investor sentiment are most likely to outperform over any market cycle.
And second, that a systematic evaluation of company fundamentals is the most effective means of consistently outperforming the market. By combining both fundamental and quantitative analysis, we believe that we are positioned to achieve consistent performance over time.
Q: What is your investment process?
Our investment process is a bottom-up approach with the goal of maximizing returns while controlling portfolio risk. Our process employs three primary inputs: return forecasts, risk forecasts, and an evaluation of current market conditions.
The first input requires forecasting returns for every company in our investable universe. We accomplish this by utilizing a proprietary model that captures a diversified set of investment characteristics for each company. The model analyzes companies by considering three broad buckets of characteristics.
The first bucket analyzes the fundamental attractiveness of each company. The second bucket analyzes the relative valuation of each company. The third bucket analyzes the companies based on investor sentiment and ownership characteristics.
The second input is a comprehensive risk assessment, both at the individual name level and, more importantly, at the portfolio level. We do this by utilizing five different risk models, as well as performing a fundamental assessment of every company in the portfolio.
The third input is an assessment of current market conditions. We determine that by using a proprietary tool called Market Monitor to identify unusual market relationships and identify any portfolio exposures that needs to be adjusted.
There are approximately 20 total factors in our model that each measures a different characteristic of a company, from which we create a ranking. The model is designed to look ahead 12-18 months. We have found that the top quintile has a hit rate in the 55% plus range. On average, the companies that rank well in our model are going to outperform and meet our objective of outperforming the benchmark by 200 to 300 basis points a year over a full market cycle.
Q: What role do catalysts play in your investment process?
We don’t look specifically at catalysts because we think that we capture that within our modeling process. We look for improvement in fundamentals. We are not going to buy a stock hoping for a catalyst to happen; instead, we make investment decisions based on visible improvements in the company financials.
Moreover, our modeling process looks at investor sentiment, which includes price momentum. So we try to buy a stock as it starts to go up as opposed to a stock that’s been going down for a long time. We look for stocks that have either lower levels of short interest or companies where the amount of short interest is declining.
Q: How would you describe your research process?
We use a combination of quantitative and fundamental metrics, rather than doing a deep due diligence into each company. Our fundamental analysis involves looking through regulatory filings, utilizing Wall Street research, and occasionally talking to the company management. This allows us to validate our model results and confirm that what our model finds attractive makes sense. We are acutely aware that our stock ranking models aren’t perfect and we need to look to see if there is something about a company that we are missing.
We scrutinize SEC documents and analyst reports to find things like large customer concentration, regulatory hurdles, or other risk that the company is facing. For instance, if we are looking at a pharmaceutical company and they have a drug coming off patent in the next 18 months, we try to determine how it will affect their sales and earnings.
Q: How is your portfolio constructed?
The portfolio contains between 60 and 80 names at any one time. Generally, up to 25% of the names in our 700-name investment universe rank as potential buy candidates. If they drop below the 35% rank level, that’s where we’ll be looking for a replacement.
Our investment objective is to maximize return at an acceptable level of risk. To manage risk, we maintain individual holding maximums of 3%, but most of the names in the portfolio are under 2%. We also have constraints on the overall portfolio such as sector weightings of plus or minus 5%, relative to the benchmark, and industry weighting of plus or minus 3%.
We use five different risk models and our objective is to measure our portfolio risk exposures in many ways. In addition, we diversify our risk exposure to make sure we are not getting too much exposure to any one risk factor.
Q: What is your portfolio turnover range?
Our portfolio turnover ranges from 50% to 70%. We trade roughly once a month and when we decide to add a name we are normally planning to hold it 12 to 18 months.
The way our model is constructed limits the rate of changes in the rankings. We don’t see big, quick changes. So, a company that ranked well yesterday will continue to rank well unless there is a significant change to the fundamentals of the company.
Q: Do you have a price target when you sell a stock?
We do not use specific price targets to make sell decisions. We would normally continue to hold that stock until its relative ranking declines to a point where it’s no longer attractive and can be replaced by one that is more attractive.
We would also sell a stock if it violates our portfolio constraints, or for reasons of risk. In evaluating the portfolio, if we were facing an exposure larger than acceptable, a name with an undesirable risk exposure could be sold from the portfolio to provide a better balance.
Q: How do you define and manage risk?
We view risk management as being an important aspect of our overall strategy and risk assessment is integral to the construction of our portfolio.
As I mentioned earlier, we do use five different risk models. There are a variety factors that the models take into consideration, as well as different time periods. We want to make sure that the risk exposures that we choose to accept in our portfolio is where we have an informational advantage.
Our informational advantage is primarily through our modeling process. That is because we have the ability to look at all 700 companies in the universe on a daily basis and measure them all in the same way. The fundamental analysis that we do is as much a risk mitigation tool as it is an alpha generator. The area where we do not necessarily think that we have an informational advantage is in accessing beta. We can’t tell if the market is going to go up or down in the next year; therefore, we are not going to take a big bet on beta.
When the price of oil collapsed in late 2015, early 2016, energy companies were negatively impacted. But from our model, it was clear that certain banks in Texas and Oklahoma with big exposure to oil companies also traded in the same direction. We also saw that certain industrial companies linked to the energy complex sold off. Using our model, we were able to identify exposures in the portfolio that we might not have identified by using just a fundamental risk model.
Q: What lessons have you gleaned from the financial crisis?
We made some changes because of the financial crisis. In late 2009, we felt we needed to become more nimble and adaptive. Subsequently, we built a proprietary tool called Market Monitor. The tool utilizes over 40 years of data that allows us to identify unusual relationships within our mid cap universe.
We spent time trying to understand what was driving those relationships, whether those relationships were likely to revert to the mean; and more importantly, how our portfolio would perform during that mean reversion. The resulting understanding has allowed us to alter portfolio exposures to protect against the potential headwind, or to take advantage of a tailwind and generate additional alpha.
We have been actively using this Market Monitor since 2011 to enhance our performance. It now gives us a better chance to outperform under any market condition and add consistency to the portfolio’s return. It was one of the reasons we performed well during the market rally in the second half of 2013 when the Federal Reserve began its tapering operation.
In 2016, we identified a number of higher risk and cyclical stocks that were cheap relative to the market, as well as some defensive stocks that had gotten expensive. Using our model, we adjusted positions in the portfolio to make sure that we were on the right side of that trade. And when risk began to outperform in the second half of 2016, our performance did particularly well relative to our peers, who had positioned more defensively in early 2016.
Q: Do macro factors play a role in your modeling process?
Macro factors are not explicitly taken into account in our modeling process. Where they come into play is through our Market Monitor. That’s where we will normally evaluate the impact of macro factors, assess our portfolio exposure, and make appropriate adjustments.
