Q: What is the history of the fund and how has it evolved?
American Century believes in a team-based approach that leads to repeatable process and performance. We’re a team of five, with two portfolio managers, two senior analysts, and we recently hired another analyst. We meet as a team on every single stock pitch and discuss any major weight changes as a team.
I joined the team in 2004 as an analyst. When I became a co-portfolio manager with Brendan Healy in 2010, the two of us sat down and said, “What are we trying to accomplish?”
After a top-to-bottom discussion, we created processes based on three core tenets. Although we still use a valuation model that the fund implemented in 1999, the process we evolved is less rigid in following the model. We increased our emphasis on bottom-up fundamental research.
Q: Can you tell us about your three core investment tenets?
We are a value investor at our core but we primarily focus on companies with stable or improving fundamentals and avoid most deep value investments. This leads us to be relative value investors. Delivering superior performance against our benchmark, the Russell 1000 Value, is a very difficult task. We utilize three steps to help us consistently focus on this objective.
We narrow down the universe of investible companies to ones we think have a higher chance of beating the index. We do this by asking three key questions: Is the valuation attractive? Does the company have stable or improving fundamentals? Is the risk-reward ratio favorable?
When we consider individual names for the fund, the first step of the process is to determine whether the security is attractively valued. Even though others may say a security is priced attractively, we don’t fish there. We don’t simplistically believe in reversion to the mean. We buy securities that fit all three tenets of our process.
The second step of our process is to have a clear understanding of whether a company has stable and improving fundamentals. If a company has fundamental problems that are getting worse, we avoid the stock for now, though we might keep it on our radar screen.
Finally, in our risk-reward analysis, we determine its upside target price, and equally important, if we’re wrong, what could that stock trade down to? That gives us a risk-reward ratio.
Everybody in this business likes to think they’re geniuses and never wrong. We know that’s not realistic. By understanding where we could be wrong, and what the potential damage might be, we minimize downside.
Q: Would you describe an example that highlights your three-part process?
Electronic Arts Inc., the video game software company, is a good example. We followed the company from afar for about 10 years.
Historically, Electronic Arts had been a very low-quality company. They weren’t focused on core competencies. They had made many poor decisions with capital and with mergers and acquisitions. They had too many software titles. They had a lot of game quality issues. Their marketing strategy was poor. Their earnings and returns compared poorly to their competitors’.
We had owned one of those competitors, Activision Blizzard, Inc., in the past so we understood the accounting nuances of the industry. We also understood the video game console cycle well, and knew two new major consoles were about to be released that would provide a big tailwind for all video game software offerings.
When Electronic Arts brought in new management it caught our attention. The CFO was fantastic. Even though he knew nothing about running a tech company, his entire career had centered on improving profitability. He brought a cost focus, an execution focus, a strategy focus, and he could articulate a plan to get margins up dramatically.
With its attractive valuation and its fundamentals expected to improve, Electronic Arts met our first two tenets. With expectations that sales and margins would improve, we analyzed the risk-reward of the stock. We tend to focus on where we think stocks are going more than where they have been in the past.
When the stock went from $20 into the $30s, some value managers might have trimmed it. This is one of the things that makes our fund different from its peers. Instead of trimming, we updated our risk-reward and added to the position. And we’d done that many times already on the way from $20 to $30.
What really drove the improvement for Electronic Arts was the operating line. They had a lot of games that weren’t profitable and weren’t core franchises to the company. By streamlining titles, they reduced spending on R&D, game development, and advertising. They also cut head count a bit and let that flow through to the bottom line.
That data gave us even more conviction. The risk-reward had become more favorable at $30 than it had been in the low $20s, so we increased the weight in that stock. It is now in the low $60s.
One thing that is missed by the street is how big an impact the Star Wars franchise could have on a company like Electronic Arts. There are going to be six movies, up to five variants of games, and many versions of each of those variants. That leads us to have a more favorable outlook on earnings, and still have an attractive risk-reward.
Q: What is another example of your process?
We bought HCA Holdings Inc, the hospital company, this year. It’s a good example of how we’re unique. One of the analysts on our team worked on it. Instead of focusing on where the stock was a year or two ago, we asked, “Is the valuation attractive now?” We believed it was. “Are the fundamentals stable or improving?” We believed they were.
The analyst found that because of the faster growing states HCA is in and the Affordable Care Act, it was going to have very strong topline growth. And the economy would drive the topline as well.
HCA was also trading at much lower valuation levels when we looked at its historical EBITDA or operating earnings multiples. So, we asked the question, “Why has the stock gotten cheaper if the fundamentals are actually improving?”
We think there’s an undue concern about the Supreme Court ruling for the Affordable Care Act. For HCA, that’s only about four to five percent of their EBITDA, so even if there is an adverse ruling it won’t affect the earnings of the company very much. The valuation has become quite a bit more attractive than the risk from an adverse court ruling.
We also believe running into an election year that neither political party would like to have all the people recently granted access to health care to suddenly lose that access. That would cause a lot of confusion and a lot of pain.
Further, we like that HCA is buying back a lot of their stock. They have bought back about 25 percent of the company over the last four years, and they have the ability to repeat that because they have high level of free cash flow.
We think HCA’s a very stable business even if a downturn in the economy were to come, so when we looked at the risk-reward, it’s pretty favorable.
Q: What is your buy-and-sell discipline?
We set target prices, but we don’t always sell when we hit the targets. Between a purchase and reaching the target price, we assess the fundamentals and risk-rewards. When we get to the target price, we will evaluate the stock. If its fundamentals are continuing to justify its price, like Electronic Arts did, we’ll keep it or perhaps increase our position.
We also do the opposite. Given that we are not betting on reversion to the mean, and we are not deep value investors, if we have gotten the fundamentals wrong or they have changed dramatically, we will severely cut or exit the name.
Q: Where do you see attractive opportunities?
Given that the market is two percent below an all-time high, valuations are not quite as attractive as in the recent past. However, we are still constructive on the U.S. economy and the U.S. stock market. Our bottom-up process allows us to move from more relatively expensive sectors into more attractive ones.
We have large underweights in utilities, REITs, and staples. Our largest overweight right now would be consumer discretionary. That’s about 500 basis points. Our maximum allowed sector weights would be plus or minus 1,000, so we’re running at about half that level.
We find a lot of consumer discretionary stocks attractive. We also like the tailwind from wage and jobs growth. I do not think people realize the job situation has improved so much.
The number of jobs that are open now is at an all-time high. Over the next 12–24 months we’ll probably continue to improve at a strong pace. Both from a bottom-up and a top-down perspective, we think the consumer discretionary sector is attractively positioned.
Q: Do you hold any macro-economic views?
We do. We have an opinion on interest rates, on China, on oil prices, on the euro. However, our bottom-up approach leads us to place more emphasis on individual securities. We do analyze how different macro events and trends will impact our companies.
Some top-down influences come into practice later in our process and help us determine weights, rather than security selection. And I think macro comes into play when we’re trying to determine where a stock will be 12–24 months out.
Q: How do you manage risk?
By focusing on companies with stable and improving fundamentals and having a team approach, we try to avoid the downside risk on a single-stock basis.
Looking at risk-reward is another way we manage risk. Of course we try to invest in companies that have quite favorable ratios, and we have bigger weightings in those securities.
We risk-adjust those ratios, too. Risk-reward analyses on companies like Procter & Gamble Co, AT&T Inc., or Pfizer Inc., are very different from those on a heavy cyclical, like an oil and gas company or mining company. A two-to-one ratio in some of those sectors is very different than a two-to-one in a more stable sector.
A lot of times we will do a fresh risk-reward analysis on a stock if it’s moved a lot. We perform fresh risk-rewards at least quarterly with changes to earnings. And if there is any kind of M&A, any change in our thoughts on fundamentals, or anything that would be a material change, we update the risk-rewards on a real-time or daily basis.
Q: What did you learn from the recent financial markets crisis and has your investment process changed since then?
I was covering financials in 2007. We knew something was coming, but not what or how bad.
One key lesson I learned was to pay attention to even the smallest details. I had a meeting with a, and took a copy of their 10-K so I could question a three-sentence paragraph in it. When I asked about VIEs and QSPEs, the head of legal told me he wasn’t going to talk about it.
This is an example of trying to find places where a company is not providing the right answers or other investors haven’t asked the right questions. So pay attention to the details: they always matter.
One of the things we saw in the financial crisis were stocks that became cheap, continued to become and cheaper and cheaper. Our valuation model identified some of them as quite attractive, so without the appropriate amount of focus on fundamentals, that could have caused pain for us. So we learned to look for companies with stable and improving fundamentals to find a more winnable universe.
Another key takeaway we learned from the financial crisis is having sustainable and repeatable processes is much better for investors than investing in a star portfolio manager. A star portfolio manager might retire or move on, but a process won’t.
Having a team that can implement a process, and having a process that takes an appropriate amount of risk to generate superior performance above your fees is critically important. We think we make better buy-sell and stock-weighting decisions using this approach. It’s really helped our performance a lot the last five years.
I had always believed in risk-reward analysis: what am I buying and why? But the financial crisis drove that home. Buying something just because it is cheap and you think fundamentals are great—without doing a risk-reward, you do not really have any idea whether it has a chance to outperform a benchmark.
