Q: What is the history of the fund?
This mid-cap mutual fund launched on September 17, 2003 although we started working on the strategy a couple of years prior to that. For our quantitatively managed funds we back test the strategies as far back as five decades. The goal of all of our quantitative funds is to outperform their relative benchmarks with a lower risk profile.
We look at historical factors and investment criteria, and we believe the methodology for each fund allows it to stand out from the competition, while providing attractive risk/reward profiles. We want our shareholders to be able to weather the ups and downs of the market.
This fund differs from its peers because of its investment methodology. Our investment process is clearly defined and wholly transparent. We believe investors want to know exactly how their money is being invested, and that is why we disclose our strategy, in its entirety, in the prospectus. We want every investor to not only know what is held in the fund, but also understand the parameters for its construction. That means we do not change our process because of media headlines, short-term fluctuations in the markets or emotions. We stick to our proven investment strategies in all types of market conditions.
Our mid-cap fund, with a concentrated 30-holding portfolio, offers diversified exposure to the mid cap marketplace, but without being the whole marketplace. We aim to outperform the index, and when you get a larger, less concentrated portfolio, you may wind up picking names that may not be the strongest or best ideas. Nobody really wants a fund manager’s 285th best pick.
With 30 names you are diversifying a good deal of the risk away. In addition, we do not use cash to try and time the markets, meaning the fund is fully invested at all times, with less than a 5% cash position.
Q: What is your investment philosophy?
Our philosophy is to invest in growth stocks that are reasonably priced, and that means we have to employ a consistent and repeatable investment approach. We know markets are volatile and not always favorable, yet we stick to those parameters over market cycles.
The quality of the growth that is attractive to us consists of companies that have increasing year-over-year revenues and that subsequently transfer increasing earnings to their shareholders.
One of our key criteria is the price-to-sales ratio. A lot of analysts concentrate on earnings, and while we do look at that, we take a little longer-term approach. We look at the annualized increase in earnings without worrying about the short-term fluctuations in the business as much as the long-term implications.
When looking to add companies to the portfolio, we will not buy anything with a price-to-sales over 1.5. That is our value threshold. We look at multiple sources to verify data accuracy and use a very strict cut-off for inclusion within the portfolio.
Q: What is your investment process?
We start with a database of roughly 9,500 public companies, screening for domestic companies whose market capitalization is between $1 billion and $10 billion. We believe these companies have more defensible market positions than their small-cap brethren, but exhibit better growth prospects than many large-cap stocks.
There are roughly 1,600 companies between $1 billion and $10 billion in market cap. So once we have the basket of stocks, we start whittling down the potential stocks for inclusion by looking for companies with a price-to-sales ratio below 1.5. We then look at companies with increasing earnings and positive stock price momentum for the three and six month periods. All stocks that pass these screens are then ranked on 12-month price appreciation. At the end of the process we are generally left with between 100 and 200 companies that meet all of our investment criteria.
The reason we use the price-to-sales ratio as our valuation metric is because ultimately sales cannot be manipulated the way earnings can be, and we think it provides a clearer picture of the company’s value.
We look at the sales number but we also want to make sure that the annual earnings are higher than the previous year. We are looking at a 12-month rolling basis as opposed to quarter-to-quarter. The 12-month trailing number has to be higher than the previous 12-month trailing number, but it does not necessarily have to be a positive number. It can move from -$0.30 to -$0.20, it just has to be going in an upward direction.
The next thing we look for is positive stock price appreciation over a three- and six-month period. If it is negative in either of those periods, a stock is eliminated from potential inclusion within the portfolio. We are looking to see that money has been flowing in or this company has been operating well in the marketplace and it is taking them higher over the short-term and medium-term.
What we are basically creating is a funnel where we are slowly eliminating stocks that will not meet our criteria. Once we get through all of those screens, stocks are ranked and we select the top 30 stocks based on 12-month price appreciation. We allocate 3.3% to each of those individual stocks and we will generally aim to hold it for at least one year and one day to push everything towards long-term gains.
When we rebalance the portfolio we utilize the inverse of our buy criteria as our sell criteria. If a stock does not meet any one of the criteria for any reason, it is subsequently eliminated from the portfolio and we replace it with a company that meets the criteria. If a company continues to meet all of our criteria at the rebalance, to manage some of the risk we will take the gains off the table and pare it back to its original 3.3% weighting. For example, the initial allocation is 3.3% and if the stock price increases 100% to 6.6%, we will take that profit off the table and reallocate it amongst the other companies so we are not getting overly weighted in an individual holding.
We constantly monitor companies’ 8-Ks and any company that is restating their financials gets re-evaluated immediately. Should the restatements show that the company would have been precluded from selection, it immediately gets removed from the portfolio and the capital is reallocated.
Q: What is your research process and how do you look for opportunities?
This particular fund is purely quantitative, so we do not meet with management. We do listen to the conference calls and read the 10-Ks, 10-Qs and proxies; however, we do not use this information to form the basis for our selection criteria.
One recent addition to the portfolio is JetBlue. The company has done a great job of positioning themselves for future growth. We think they have a competitive cost structure advantage that will be essential to their success, and they continue to build a profitable and defensible network. Despite our positive take on the underlying business, what got us into that particular stock is that it does have a low price to sales ratio, increasing earnings, and positive three, six, and 12-month momentum.
We also recently added Mohawk Industries. I think there is an opportunity for a company like Mohawk, where you have a whole slew of people who deferred maintenance on their house because it was a declining asset for so long. Real estate prices have largely rebounded and houses are hopefully back to even, or have equity in them, so we are seeing, for lack of a better term, a “deferral trend reversal”, where a lot of people who have not spent money on their house over the last seven or eight years and have instead been paying down debt are now in a position to do some discretionary spending. We believe one of the beneficiaries of this will be Mohawk as homeowners remodel their homes.
A lot of companies have really taken a shareholder-centric focus, which is important. What tends to rise to the top of our list is the category of companies that are redeploying capital in smart ways, whether it is through buybacks, increasing or initiating dividends, or through capital expenditures. A lot of companies are managing their business exceedingly well, and this is reflected in their top-line growth. Despite the stock market being at near all-time highs, we are still finding good companies that are trading at reasonable valuations.
Since the price-to-sales ratio of 1.5 tends to limit what type of companies we invest in, what generally happens is that when you look at pure growth companies you are paying for the expectation that something may happen in the future. What we tend to see by keeping that 1.5 threshold is a higher concentration of economically cyclical companies—companies where growth is predicated on the strength or recovery of the economy. We usually have a higher percentage of consumer discretionary and industrial names, which are the type of companies we think will do exceptionally well as the economy recovers.
The converse to that, and we have seen it in periods of down markets as well, is that 1.5 price-to-sales threshold tends to keep us out of the high flying, more volatile stocks, allowing us to weather the downturns in the market.
If you look at this year’s portfolio, we have zero exposure to energy, not because there are not some potentially attractive opportunities, but simply because energy stocks have declined precipitously in the last six months. At some point they are likely to turn around, but we are not willing to “catch a falling knife” and we buy these companies at deep discounts. We would rather wait until the growth cycle turns back around and heads higher and buy companies on the upswing.
When it comes to selection within a particular industry, we do not try to limit exposure, meaning that if there are multiple stocks within a sector that meet our criteria, we will purchase positions in all of those companies. We do have some restrictions, however. Our goal is to have a fully diversified fund and to do that we cannot have more than 25% invested in one sub-sector. If it were to come to a situation where we owned so much within one particular sub-sector, we would simply take that last stock which put us over the 25% threshold and replace it with the 31st stock on our list. Historically, we have not come close to the threshold, as we typically see the maximum sub-sector weighting has generally been in the 6% to 12% range.
Typically, most of the companies will be replaced during the rebalance, as only a few companies will generally continue to meet all of the Fund’s parameters year to year. For example, when a company’s stock price increases 100% in a year, it is very atypical to see the revenue component grow at 100% as well. While it still may be an attractive company, the price-to-sales number may shift higher than our 1.5 cutoff, and that would preclude us from continuing to own the stock.
In between rebalances any new money that comes into the Fund is allocated at the current percentages. This means that if one stock goes from 3% to 4% and another goes from 3% to 2%, when we put new money to work we are allocating at the current percentages, essentially buying more of our winners and less of our losers.
Q: What are your thoughts on portfolio concentration as it pertains to risk?
At the outset of any portfolio’s design, we first consider the right number of holdings. Would it be 10, 20, 50 or 100 stocks? Where is the sweet spot of where we believe we can get above-market returns with a lower-risk profile? In a small-cap stock portfolio you may want more than 30 companies because there is a business risk. If a small-cap company has one bad product or bad cycle, that can weigh on the company for years to come.
Mid-caps tend to be a little more secure in the sense that with a market cap above $1 billion they are probably not going to have a misstep which is going to put them out of business. There is a little less risk in a mid-cap portfolio than a small-cap. We are comfortable with a slightly more concentrated portfolio.
When we looked for the right number we felt that if we could get above 20 we would diversify away most of the economic risk domestically. It is a domestic portfolio so we are not worrying about country-specific risk.
We then want to limit the individual equity risk, and we think we do that by only taking moderate positions of a 3.3% weighting in each company. We are not trying to pick our favorites and underweight or overweight them, we just allocate equally across the board. We manage that risk by taking some money off the table when we do the rebalancing.
What we are trying to do is pick the best companies regardless of industry; we think individual companies provide the greatest opportunity as opposed to buying into a particular sector in its entirety.
Rebalancing a portfolio can mitigate certain allocation risks, so if you were comfortable with say a 10% risk profile in a particular sector at the outset, your weighting should probably be closer to the 10% number now as you rebalance, as opposed to a much larger number. For us the rebalancing is an opportunity to take some risk off the table, and allocate to other areas.
We look at the overall perspective of the portfolio to keep risk manageable and similar every year, so that investors know what to expect from the investment. We do not want to be in a position where a couple of stocks are such a large portion of the portfolio that the underlying portfolio itself rises and falls on the performance of those particular names.
Q: How do you define and manage risk?
We look at risk from an overall portfolio perspective. We think we do enough to manage the individual stocks and by following them closely, reading all the disclosures and 8-Ks, we are able to look at the overall portfolio and see whether it is functioning the way it should.
We are constantly analyzing the overall portfolio to see if there are any adjustments that can be made to mitigate risk. Ultimately, we want to be able to provide investors with a risk profile commensurate with their goals. Simply stated, we strive to offer products that allow investors to sleep at night, not having to worry about the volatility in their portfolio.
