Q: Would you provide an overview of the fund?

As with all New Century Portfolios, this Portfolio was created as an alternative to single-manager mutual funds. This enables clients to achieve broader exposure to the market, without single-manager risk, via a multi-capitalization, multi-geographic opportunity. 

Unlike comparable funds, we have broader flexibility in selecting asset classes. We are strategically based in the U.S. but span beyond that, with investments in market cap sizes ranging from mega, large, mid, and small caps. We use mutual funds, exchange-traded funds (ETFs), single stocks, and even bonds.

Our investors like having a single fund as opposed to many positions in their portfolio. They like the reporting structure, and we work diligently, mindful of the tax consequences of a fund-of-funds structure. We use no-load, institutional class shares within our mutual funds, which cost investors potentially a lot less than if they owned a smaller amount of another fund’s A or C class, for example. 

We run the Portfolio thematically, primarily investing in dividend growth companies and secular growth stories, blending top-down positions through an ETF or a quantitative manager with bottom-up, secular stories to enhance return. 

Simply taking on beta, such as an index ETF poses a lot of downside risk exposure, while using managers who are true stock pickers from a bottom-up perspective assumes selection risk. Combining these two investment types provides a smoother path for our clients. 

One of our current distinctions is the amount of international stock we have in the Portfolio. We are underweight compared to some competitors. We believe the U.S. carries less volatility right now and want further clarification on a lot of macro factors abroad, including political- and central bank-wise. There are some sectors in other parts of the world, financial services being one of them, that we do not want much exposure to right now. 

Our current assets under management are just under $100 million. 

Q: What is your investment philosophy?

We are big fans of academics and focus on whether growth or value will outperform within a certain timeframe. Over long periods, value generally outperforms, but in the last decade or so, companies that can grow their top-line revenues and increase efficiencies to where it translates to the bottom line appear worthy of higher valuations versus dividend-heavy companies. We are wary of the latter’s ability to create the necessary earnings power to cover their dividend yields and justify their pricing. 

We think the market rewards companies with potential for both top-line and bottom-line growth and we are willing to pay a reasonable price, or slightly more, to be in those sectors, with companies demonstrating such leadership. 

Right now the areas we like are healthcare, technology, and areas where valuations are attractive. Healthcare, particularly in the U.S., has an aging population demographic tailwind and has only been held back in the last year by political rhetoric that will not lead to any fundamental real pricing change. Some of these companies are trading at cheap multiples and we like that area a lot, not only in the U.S. but around the world. 

Q: How would you describe your investment strategy and process?

We structure the Portfolio’s holdings in three buckets: core, strategic, and tactical or trade positions. 

Core positions are long-term, so we seek the best, most innovative managers and companies we feel will reward us if we hold them for full market cycles, approximately five to eight years. We perform a full due diligence process regarding the managers of these positions and their philosophies. Performance gets you on our radar, but your investment philosophy is what keeps us with you in hard times. We look at their positions, team, everything. This bucket comprises the core of the Portfolio. 

The strategic bucket contains positions we intend to hold from eighteen to thirty-six months. There we play much more in the demographics and the political and central banking sides of where the world is headed. For example, if we think rates will stay low, we think about what positions we would like to be overweight. In healthcare, for example, we look at the demographics of the next two to three years and the research end, like how many innovative drugs the FDA has passed lately. As we saw a big spike in the last two years, we also anticipate a big spike in the coming two years. 

The third bucket is our tactical area, spanning a few months to about a year and a half. We look for mispricings in the market, or whether we should protect our money if volatility looks low and the market might be over bought, or deploy it if volatility spikes and stocks sell off. 

Those three buckets reduce unnecessary portfolio turnover as we focus on areas that can add value without changing the Portfolio’s fundamental structure. 

Q: How do you assess a specific fund?

Capture ratios tell the story of a fund over time and should reflect a manager’s philosophy. Capture ratios demonstrate this more than virtually any other data point, more than alpha, more than Sharpe ratios. 

If a manager seeks growth at a reasonable price, their companies should be innovative without being priced too high. Their capture ratios should reflect their benchmark. If, instead, a manager espouses taking the highest-flying stocks, seeking growth above everything, their capture ratios should be higher. 

We ask each manager what their benchmark is, then rip apart their portfolio, look at the individual holdings, look at their sector bets, and compare that to using passive investments to see if the manager creates value. It goes beyond a simple alpha metric and we compare it to what the manager says their philosophy is. 

Q: What other characteristics do you look for?

We consider AUM (assets under management) more than many other managers. Too much can be unwieldy. You need enough AUM to carry out your strategy but not so much that you become an elephant, unable to move in a tactical form, a bigger concern in the industry these days. 

We also focus on expense more than most. There is a lot that has been written lately on how important low turnover and the lowest expense ratios are. We rip apart a portfolio and ask whether the fund’s expenses are fundamentally driven by the portfolio and the team necessary to create it. Cheapest exposure is not always the best. By putting together active managers with passive exposures, we create a better downside over time versus simply boasting the lowest expense ratio. 

We look for managers focused on free cash flow growth and those looking at established companies or those with moats as those are less susceptible to market downturns or recession fears, ones that can potentially become the world’s next blue-chip stocks.

Q: How do you look for opportunities in your research process?

We get full access to research networks from multiple sell-side firms, which we use to narrow down potential managers based on criteria. And we conduct quarterly calls with our active managers, either the strategist or the portfolio manager. We also visit or host managers when warranted, and this is done at least biannually. 

We track sectors and various indexes around the world monthly, quarterly, annually, and for the three-year rate, looking for trends. When we see a trend in an attractive area, and outperformance of growth versus value, or small caps versus large caps, we consider whether macro trends are sustainable to make it an investable position. 

Single securities comprise a smaller part of the Portfolio, although not a set percentage. We have recently been emphasizing mid caps as those companies are well-positioned to increase revenues and gross margins, thanks to U.S. economic growth, while relatively unaffected by international headwinds caused by volatility or differing growth in certain areas. 

Both portfolio managers are owners in this Portfolio, to ensure our investments are ones we would choose as individual holdings. 

Opportunities first appear at the macro level, but we look at both macro and micro to avoid taking unneeded risk. In terms of macro, we ask where equity markets are positioned today, where there is potential value, where earnings growth is happening, and where we think we are in the economic cycle. Right now, the U.S. appears to be in the mid-stage of the economic cycle globally, while the rest of the world is in the early stages, trying to gain traction. We focus on some growth areas that are not necessarily the highest cyclical areas. 

Q: Can you give an example where you saw one such opportunity?

In late 2014 into 2015, from a macro perspective, we believed the dollar would rise, that there would be a central bank divergence and that mid caps, and to some extent small caps, could outperform U.S. large caps, which had increased exposure to international revenues. 

While it was not realized in 2015, those positions were in our strategic bucket. We continued to hold them into 2016 and have been rewarded, and we plan to do the same in 2017. 

Q: What is your portfolio construction process?

We create a custom benchmark for the Portfolio based on indexes, usually about 25% of MSCI ACWI (All Country World) ex USA Index. The remaining 75% is top-heavy, so we view it as about 40% or so in the U.S. large cap space, 20% in the mid cap space, and 15% in the small cap space. We compare the Portfolio to this blended benchmark because we think those exposures help client returns long-term. 

The number of positions generally falls between 25 and 45, with 35 right now. We want to establish about 8 core positions, 12 strategic positions, and the rest in tactical positions. 

We are currently underweight international stocks, which are more volatile right now, and where the standard deviation does not warrant the returns of those sectors. In the U.S., the latest rally confirms that small and mid cap stocks have outperformed more expensive large caps. 

We run metrics on the Portfolio to see where the Portfolio lines up versus just U.S., just international, and our blended benchmark. We keep an eye on our capture ratios to determine whether this is what we want compared to other alternatives in the space, or other managers, benchmarks or categories. 

We try not to be market timers, and we are not huge fans of managers who carry a lot of cash unless that manager has demonstrated a propensity for managing cash, because you pay an expense ratio on that cash, which we feel is inefficient. We prefer to run almost fully allocated all the time. 

Q: How do you define and control risk?

We look at both systemic and non-systemic risks and target volatility. Volatility is a measure of degree, not direction. Volatility and risk to portfolios are highlighted when the market drops, but it is equally important to look at these when the market rises. Right now the market is rising, but we see that as a potential risk. We do not want to become too enamored with a market that has already risen considerably and put even more money into higher-risk sectors. 

Right before the Brexit vote, for example, the markets had run up all week. We felt no matter which way the vote went, the market would be volatile and probably sell off, and we got a little more defensive. That is one reason we carried a lot less international stock exposure. 

We think on a macro view. If we think risk is increasing, we look at our buckets and how our core managers are doing. If we like them then we do not want to change much there. Then we look at the strategic areas. Have they reached a valuation and return level where we believe they should no longer be in that bucket? Maybe they should be moved down toward a lower time holding bucket, or turned over. 

Then we look at the tactical or trade bucket. In that area we have established return levels. We know how much risk we want to take and the return we want. We remain diligent. We would rather leave return on the table than keep the money in an overheated investment and risk it will revert lower. 

In some cases the difference between the top and bottom companies in an industry or sector is gigantic. That is why we are hesitant to simply say, “This is a value company,” or “This is a growth company,” because there are intricacies: what your markets are, what your client base is, what you learn when you rip apart a cash flow statement to see how a company is doing, and, at the manager level, ask what active bets are being made. 

In healthcare, biotech, and pharmaceuticals, with established drug pipelines, we gauge how much extra revenue that might equate to and separate companies with healthy, approved drug pipelines from single drug manufacturers and those hoping to be acquired, for example.

We gravitate towards companies in better positions, and managers that are holding those better positions, instead of moon-shot bets unlikely to benefit the Portfolio much, and increase risk for potential investors. 

The beauty of having a fund-of-funds is that it is a single investment that can bring down expense ratios and smooth out a return profile versus just holding a large cap or international stock, while creating alpha over what we determine to be our benchmark.