At the time of publication, this fund was named JOHCM International Select Fund,

Objective and strategy

The fund seeks long-term capital appreciation by investing in a compact portfolio of developed and developing markets stocks. The strategy combines fundamental analysis of individual equities with a top-down overlay which shapes country and sector weights. At the level of individual securities, the managers use a growth-at-a-reasonable-price; they characterize it as “a core investment style with a modest growth tilt.” They target firms with three characteristics:

• positive earnings surprises
• sustainably high or increasing return on equity, and
• attractive valuations.

At the country and sector level, they look for “green lights” in four areas:

• fundamentals
• valuations,
• beta, and
• price trend.

Those inquiries include questions about currency trends. They do not hedge their currency exposure. The portfolio holds around 30 equally-weighted positions. They are not hesitant “to weed out the losers.”

Adviser

J O Hambro Capital Management (JOHCM) is an investment boutique headquartered in London, but with offices in Singapore, New York and Boston. They were founded in 2001 and entered the U.S. market in 2009. As of March 2015, they managed $27.3 billion of assets for clients worldwide. Their US operations had $6.4 billion in AUM, with $3.1 billion in seven mutual funds.

Manager

Christopher Lees and Nudgem Richyal. Mr. Lees joined JOHCM in 2008 after 20 years with Barings Asset Management where he was, among other things, Lead Global High Alpha Manager. Mr. Richyal also joined JOHCM in 2008 from Barings where he ran large global resources and Latin American equity portfolios. Lees and Richyal have been working together for more than 12 years.  They manage about $15 billion in assets together, including the much younger, smaller and less accessible Global Equity Fund (JOGEX/JOGIX).

Strategy capacity and closure

$8 billion. As of May, 2015, the fund had about $2.8 billion in assets but the strategy, which is also manifested in separate accounts, was about twice that. In response, the advisor slated a “soft close” for July 2015. They would prefer to avoid a “hard close” but haven’t foreclosed that option. They anticipate reopening only if “we experienced significant redemptions, or if market conditions changed dramatically.”

Active share

94.2. “Active share” measures the degree to which a fund’s portfolio differs from the holdings of its benchmark portfolio. High active share indicates management which is providing a portfolio that is substantially different from, and independent of, the index. An active share of zero indicates perfect overlap with the index, 100 indicates perfect independence. An active share of 94.2 is extremely high for a fund with a large cap portfolio.

Management’s stake in the fund

None, which is understandable since the managers are British and the fund’s only open to U.S. investors. The managers do invest in the strategy through a separate vehicle but we do not know the extent of that investment.

Opening date

July 29, 2009 for the institutional class, March 31, 2010 for the retail class.

Minimum investment

$2,000 for Class II retail shares, $25,000 for Class I institutional shares.

Expense ratio

1.21% for investor shares and 0.98% for institutional shares on assets of $5.9 billion, as of July 2023.

Comments

It’s hard to find fault with JOHCM Select International. As of 31 March 2015, the five-year-old fund has the best performance of any international large growth portfolio:

Remarkably, those returns have not come at the expense of heightened volatility. Here’s the Observer’s risk-return profile for JOHAX’s performance against its international large-growth peers since inception.

Here’s the interpretation:

• JOHAX has made rather more than twice as much as its peers; 98% total since inception, which comes to 14.4% per year.
• Raw volatility is in-line with its peers; the maximum drawdown, peak-back-to-peak recovery time, the Ulcer Index (which measures a combination of the depth and length of a drawdown) and downside deviation are not noticeably higher than its peers.
• Measures of the risk-return trade-off (the Sharpe, Sortino and Martin ratios) are all uniformly positive.

What about that “bear decile”? On face, it’s bad: the fund has been among the worst 20% of performers during “bear market months.” In reality, it’s somewhere between inconsequential and positive. “Bear markets months” are measured by the movement of the S&P 500, which isn’t the benchmark here, and there have been only eight such months in the fund’s 60 months of existence. So, arguably inconsequential. And it’s potentially positive: JOHAX has such a high degree of independence that it sometimes falls when its benchmark is rising (three months) and rises when its benchmark is falling (3X) and it sometimes falls substantially more (3X) or substantially less (7X) than its benchmark.

JOHAX has thereby earned the highest possible ratings from Morningstar (Five Stars, but no analyst rating because they’re off Morningstar’s radar), Lipper (Lipper Leader, not that anyone really notices, for Total Return and Consistent Returns) and the Observer (it’s a Great Owl, which means it has top-tier risk-adjusted returns than its peers in every trailing measurement period).

How do they do it?

Good question. The portfolio is very distinctive. It currently holds about 30 names, which makes it the most compact international large-growth portfolio on the market and one of the 10 most compact international large cap portfolios overall. The shares are all equally-weighted, which is both rare and useful.

They claim to be benchmark agnostic, and that’s reflected in their sector and country weights. The fund’s most recent portfolio report shows huge divergences from its benchmark in most industry sectors.

Similarly, their regional allocations are distinctive. The average international large cap fund has twice as much in Europe as in Asia; JOHCM weights them equally, at about 42% each. That Asian overweight is likely to become much more pronounced in the near term. When they close out existing positions, they sometimes just add the proceeds to their existing names. As of mid-2015, however, they’re reallocating toward Japan and emerging Asia, where all of their top-down indicators are turning positive.

They describe Japan as “one of the cheapest developed markets in the world, [which] has finally embarked upon significant Western-style corporate restructuring, which is driving some of the fastest-growing earnings revisions and returns on equity in the world.” One spur for the change was the creation of a Nikkei 400 ROE index, which tracks companies “with high appeal for investors, which meet requirements of global investment standards, such as efficient use of capital and investor-focused management perspectives.” They point to tool-maker Amada as emblematic of the dramatic changes, and substantial price appreciation, possible once Japanese corporate leaders decide to reorient their capital policies in ways (the issuance of dividends and stock buybacks) that are shareholder-friendly. Amada failed to be included in the initial index, which led management to rethink and reorient.

They are unwilling to stick with stocks which are deteriorating; they repeated invoke the phrase “weeding out the losers,” which they describe as “selling stocks that were broken fundamentally and technically.” Their process seems to find a fair number of losers, with turnover running between 50-80%. That’s about in-line with comparable funds.

The managers believe they have “an idiosyncratic approach to stock picking that means [they] tend to look in parts of the market largely ignored by more traditional growth investors.” All of the available statistical evidence seems to validate that claim.

Bottom Line

Before you rush to join the party, consider three caveats:

• Independence comes with a price: when you’re structurally out-of-step with the herd, there are going to be periods when your performance diverges sharply from theirs. There will be periods when the managers look like idiots and when you’ll feel (poorly-timed) pressure to cut and run.
• Trees don’t grow to the sky: as both Morningstar’s research and ours has demonstrated, it’s exceedingly rare for managers to decisively outperform their peers for extended periods and impossible for them to do so for much more than three consecutive years. Even Buffett’s longest win streak is just three years, which matches his longest losing streak and perpetually fuels the “has Buffett lost it?” debate.
• Closing is not a panacea: the advisor has determined that it’s in the best interests of current shareholders for the fund to restrict inflows. They’ve made that decision relatively early; they’re closing at about two-thirds of strategy capacity, which is good. Nonetheless, academic and professional research both show that performance at closed funds tends to sag. It’s not universal, but it’s a common pattern.

There are no evident red flags in the fund’s construction, management or performance. There’s an indisputably fine record at hand. Folks interested in an idiosyncratic portfolio of high growth international names should review their options quickly. Investors who are hesitant to act quickly here but can afford a high minimum might consider the team’s other U.S. fund, JOHCM Global Equity (JOGEX). It’s small, comparable to their European global fund and off to a fine start; the downside is that the minimum investment is $25,000.

Fund website

JOHCM International Select. Be patient, the navigation takes a while to get used to. If you click on the “+” in the lower right of each box, new content appears for you. There’s parallel, but slightly different, content on the webpage for the fund’s European version, JOHCM Global Select, which has a bunch US stocks since, for their perspective we are a “foreign” investment.

Objective and strategy

The fund pursues long-term capital appreciation. They look to invest in a compact portfolio of 30-50 undervalued stocks. The fund is nominally all-cap but the managers have traditionally had the greatest success in identifying and investing in small cap stocks. The fund looks for “well-seasoned companies with strong market positions, identifiable catalysts for earnings improvement and [exceptional] management.” They have strong sector biases based on valuations but will not invest in tobacco, liquor, or gaming companies based on principle. For a small cap value fund, with predominantly domestic based holdings, it has unusually high exposure to international markets. They systematically track macro conditions and have the ability to move largely to cash as a defensive measure but have not done so.

Adviser

Towle & Co. Towle was founded in 1981 and is headquartered in St. Louis. They provide investment advice to institutional and private investors through the fund, partnerships and separately managed accounts. The firm had approximately $560 million in assets under management as of December 31, 2014.

Manager

The Fund’s portfolio is managed by an investment team comprised of J. Ellwood Towle, CEO, Christopher Towle, Peter Lewis, James Shields and Wesley Tibbetts. Together, they share responsibility for all day-to-day management, analytical and research duties. Other than Mr. Shields, the team has been in place since the fund’s inception. The team also manages two partnerships and about 75 separate accounts, all of which use the same strategy.

Strategy capacity and closure

The strategy’s capacity, in all vehicles, is viewed to be approximately $1 billion, but highly dependent on market conditions and opportunities. They have previously closed when they did not feel comfortable taking on new money.

Active share

98.6 “Active share” measures the degree to which a fund’s portfolio differs from the holdings of its benchmark portfolio. High active share indicates management which is providing a portfolio that is substantially different from, and independent of, the index. An active share of zero indicates perfect overlap with the index, 100 indicates perfect independence. An active share of 98.6 reflects a very high level of independence from its benchmark, the Russell 2000 Value index.

Management’s stake in the fund

The elder Mr. Towle has over $1 million in the fund and owns 6.5% of its shares, as of January 2015. The Towle family is the largest investor in the fund and in the strategy. The family has over 90% of their wealth invested in the strategy. All of the managers have invested in the fund. The younger Mr. Towle has between $50,000 and $100,000. Mr. Lewis has between $100,000 and $500,000.  Messr. Tibbetts and the newest manager, Messr. Shield, have modest investments. None of the trustees have invested in the fund, but then they oversee 76 funds and have virtually no investment in any of them.

Opening date

October 31, 2011. The underlying strategy has been in operation since January 1, 1982.

Minimum investment

$5,000, which is reduced to $2,500 for various tax-advantaged accounts.

Expense ratio

1.10% on assets of $108 million, as of July 2023. There’s also a 2% redemption fee on shares held fewer than 90 days.

Comments

There are two persistent investing anomalies worth noting. The first is “the value premium.” Value has persistently outperformed growth over the long-term in every size of stock. One 2013 essay claims that every Russell value index, everywhere in the world, in every sector, has outperformed its growth counterpart since inception. It’s true for the Russell 1000, 2000, 2500, Global 3000 ex-US, EMEA, Global ex-US ex-Japan, Global ex-US Large Cap, Greater China, Microcap, the whole shebang. In many instances, the long-term return from value investing is two or three times greater than in growth investing. Value investing is, in short, a free lunch in a business that swears that there are no free lunches.

The second anomaly is the almost no actively-managed value fund captures the value premium. That is, investors who bill themselves as dyed in the wool value guys have far wimpier performance than the theory says they should. Value funds tend to prevail over long periods but by less than you’d expect. That reflects the fact that very few of these guys invest in the sorts of deeply undervalued stocks that create the value premium. Instead, they’re sort of value-lite investors who liberally hedge their exposure to really cheap stocks with a lot of cheap relative to the rest of the market stocks. The reason’s simple: these stocks are cheap for a reason, they’re often fragile companies in out-of-favor industries and they have the potential to make investors in them look incredibly stupid for a painfully long stretch.

Few investors are willing to risk that sort of pain in pursuit of the full potential of deeply undervalued stocks. Towle & Co. is one of those few. They’ve managed to stick with their convictions because they haven’t had to worry a lot about skittish investors fleeing. In part that’s because they work really hard, mostly with separate account clients, to partner with investors who buy into the strategy. And, in part, it’s because they are their own biggest client: The Towle family has over 90% of their wealth invested in the strategy.  Happily, their convictions have reaped enormous gains for long-term investors.

While Towle assesses a wide variety of valuation metrics, a primary measure is price-to-sales. They focus on sales rather than earnings for two reasons. Topline measures like sales directly measure a firm’s vitality (are they able to sell more stuff at better prices each year?) which is important for a discipline that relies on buying robust growth at value prices. And topline measures like sales are harder to fudge than bottom line measures like earnings; a lot of financial engineering goes into “managing” earnings which makes them a less reliable measure.

Towle’s portfolio sports a price-to-sale ratio of 0.26 while its benchmark is four times pricier: 1.03. The Total Stock Market Index sells at 1.61, a 600% higher price. By that measure, only one other stock fund (out of 2300 domestic equity funds) has such a deeply undervalued portfolio. By measures such as price-to-book, Towle’s stocks sell at a 30% discount (0.91 versus 1.45) to its benchmark and a 65% discount (0.91 versus 2.52) to the broader stock market.

In the long term, this strategy has performed well. There are about two dozen small cap value funds with 20 year track records. Precisely one of those, the long-closed Bridgeway Ultra-Small Company Fund (BRUSX), has managed to outperform the Towle strategy. In the very long term, Towle has performed astonishingly well. Here are the stats for performance since the strategy’s inception in 1982:

That said, a free lunch is still not a free ride. Over shorter periods, and sometimes over quite lengthy periods, deep value stocks can remain stubbornly undervalued and unrewarding. While the strategy has a three decade track record, the mutual fund has been in operation for about four years and has married substantially above average returns with even more substantially above average volatility.

The fund’s sector concentration – lots of consumer cyclicals, energy and industrials but very little tech, pharma or utilities – contributes to the potential for short-term volatility. In addition, the managers occasionally make mistakes. Joe Bradley, one of the folks at Towle, says of the strategy’s 2011 performance, “we made some bad choices and we stunk it up.” Indeed the strategy posted three disastrous years this century in which they trailed their benchmark by double digits: 2000 (-1 versus +22.8), 2008 (-49.9 versus -28.9) and 2011 (-17.4 versus -5.5). Two of those three lagging years was then followed by phenomenal outperformance: 2001 (42.8% vs 14.0) and 2009 (101% vs 20.5). The portfolio, Mr. Bradley reports, became like a too-tightly compressed spring; when the rebound occurred, it was incredibly powerful.

Bottom Line

Towle Deep Value positions itself a “an absolute value fund with a strong preference for staying fully invested.” While most absolute value funds often pile up cash, Towle chooses to turn over more rocks – in under covered small caps and international markets alike – in order to find enough deeply undervalued stocks to populate the portfolio. The fund has the potential to play a valuable role in a long-term investor’s portfolio. Its focus is on a volatile and sometimes-despised corner of the market means that it’s not appropriate as a core holding but its distinctive strategy, sensible structure, steady discipline and outstanding long-term record makes it a serious contender for diversifying a portfolio heavily weighted in large cap stocks.

Fund website

Towle Deep Value Fund. It’s a pretty Spartan site. Folks seriously interested in understanding the strategy and its performance over the past 34 years would be better served by checking out the Towle & Co. website.

Fact Sheet

This fund profile was previously updated on March 1, 2013. You can find an archive of that profile here.

Download a .pdf of this profile here.

Objective and Strategy

Seafarer seeks to provide long-term capital appreciation along with some current income; it also seeks to mitigate volatility. The portfolio has two distinctive features. First, the fund invests a significant amount – 20-50% of its portfolio – in the securities of companies which are domiciled in developed countries but whose earnings are driven by emerging markets. The remainder is invested directly in developing and frontier markets. Second, the fund generally invests in dividend-paying common stocks but the portfolio might contain preferred stocks, convertible bonds, closed-end funds, ADRs and fixed-income securities. The fund typically has much more exposure to small- and mid-cap stocks than does its peers. On average, 80% of the portfolio is invested in common stock but that has ranged from 71% – 86%.

Adviser

Seafarer Capital Partners of San Francisco. Seafarer is a small, employee-owned firm that advises the Seafarer fund in the US and a €45 million French SICAV, Essor Asie Opportunités. The firm has about $190 million in assets under management, as of March 2015.

Managers

Andrew Foster is the manager, as well as Seafarer’s cofounder, CEO and CIO. Mr. Foster formerly was manager or co-manager of Matthews Asia Growth & Income (MACSX), Matthews’ research director and acting chief investment officer. He began his career in emerging markets in 1996, when he worked as a management consultant with A.T. Kearney, based in Singapore, then joined Matthews in 1998. Andrew was named Director of Research in 2003 and served as the firm’s Acting Chief Investment Officer during the height of the global financial crisis, from 2008 through 2009. Andrew is assisted by Kate Jacquet, Paul Espinosa and Sameer Agrawal. Ms. Jacquet has been with Seafarer since 2011; Messrs. Espinosa and Agrawal joined in 2014.

Management’s Stake in the Fund

Mr. Foster has over $1 million in the fund. None of the fund’s trustees have an investment in any of the 32 funds they oversee.

Opening date

February 15, 2012

Minimum investment

$100,000 for institutional share class accounts, $2,500 for regular retail accounts and $1000 for retirement accounts. The minimum subsequent investment is $500. In a spectacularly thoughtful gesture, individuals who invest directly with the fund and who establish an automatic investment plan on their accounts are eligible for a waiver of the institutional share class’s minimum investment requirement. The folks at Seafarer argue that they would like as many shareholders as possible to benefit from lower expenses, so they’re trying to manage an arrangement by which their institutional share class might actually be considered the “universal” share class.

Expense ratio

0.97% for retail shares and 0.87% for institutional shares, on assets of $2.4 Billion (as of July 2023).

Comments

Our contention has always been that Seafarer represents one of the best possible options for investors interested in approaching the emerging markets. It’s not a question of whether we’re right but, rather, of why we are.

Seafarer has three attributes that set it apart:

1. Its approach is distinctive. Mr. Foster’s hope is to outperform his benchmark (the MSCI EM index) “slowly but steadily over time.” He describes the approach as a “relative return strategy” which pursues growth that’s more sustainable than what’s typical in developing markets while remaining value conscious. It’s grounded in the structural realities of the emerging markets.

   A defining characteristic of emerging markets is that their capital markets (including banks, brokerages and bond and stock exchanges) cannot be counted on to operate. In consequence, you’re best off with firms who won’t need to turn to those markets for capital needs. Seafarer targets (1) firms that can grow their top line steadily in the 7-15% per annum range and (2) those that can finance their growth internally. The focus on the top line means looking for firms that can increase revenues by 7-15% without obsessing about similar growth in the bottom line. It’s almost inevitable that EM firms will have “stumbles” that might diminish earnings for one to three years; while you can’t ignore them, you also can’t let them drive your investing decisions. “If the top line grows,” Mr. Foster argues, “the bottom line will follow.” The focus on internal financing means that the firms will be capable of funding their operations and plans without needing recourse to the unreliable external sources of capital.

   Seafarer tries to marry that focus on sustainable moderate growth “with some current income, which is a key tool to understanding quality and valuation of growth.” His preference is to buy dividend-paying stocks, but he often has 20% or more of the portfolio invested in other sorts of securities. The dividends are not themselves magical, but serve as “crude but useful” tools for identifying firms most likely to preserve value and navigate rough markets.

2. Its performance is first rate. That judgment was substantiated in early March 2015 when Seafarer received its inaugural five-star rating from Morningstar. They’re also a Great Owl fund (as of May, 2015), a designation which recognizes funds whose risk-adjusted returns have finished in the top 20% of their peers for all trailing periods. Our greater sensitivity to risk, based on the evidence that investors are far less risk-tolerant than they imagine, leads to some divergence between our results and Morningstar’s: five of their five-star EM funds are not Great Owls, for instance, while some one-star funds are.

   Of 219 diversified EM funds currently tracked by Morningstar, 18 have a five-star rating (as of mid-March, 2015). 13 are Great Owls. Seafarer is one of only 10 EM funds (representing less than 5% of the peer group) that are both five-star and Great Owls.

3. Its commitment to its shareholders is unmatched. Mr. Foster has produced consistently first-rate shareholder communications that are equally clear and honest about the fund’s successes and occasional lapses. And he’s been near-evangelical about reducing the fund’s expenses, often posting voluntary mid-year fee reductions as assets permit. Seafarer is one of the least expensive actively-managed EM funds available to retail investors.

In the three years through April 30, 2015, the fund’s annualized return was 10.8% which placed it in the top 2% of all EM equity funds. Rather than trumpet the fund’s success, Mr. Foster warned, both in letters to his shareholders and on the Observer’s conference call that investors should not expect such dominant returns in the future. “Our strategy ideally matches the anemic growth conditions that emerging markets have experienced lately,” he says. As growth returns, other strategies will have their day in the sun. Seafarer, meanwhile, will continue pursuing firms with sustainable rather than maximum growth.

Bottom Line

Mr. Foster is remarkably bright, thoughtful, experienced and concerned about the welfare of his shareholders. He thinks more broadly than most and has more experience than the vast majority of his peers. The fund offers him great flexibility and he’s using it well. There are few more-attractive emerging markets options available.

Fund website

Seafarer Overseas Growth and Income. The website is remarkably rich, both with analyses of the fund’s portfolio and performance, and with commentary on broader issues. One emblem of Mr. Foster’s commitment to having you understand what the fund is up to is a remarkably complete spreadsheet that provides month-by-month and year-by-year data on the portfolio, dating all the way back to the fund’s launch. Whether you’d like to know what percentage of the portfolio was invested in convertible shares in April 2014 or how the fund’s regional exposure affected its performance relative to its benchmark in 2013, the data’s there for you.

Disclosure

The Observer has no financial ties with Seafarer Funds. I do own shares of Seafarer and Matthews Asian Growth & Income (purchased during Andrew’s managership there) in my personal account.

At the time of publication, this fund was named Queens Road Small Cap Value.

Objective and strategy

The fund pursues long-term capital growth by investing, primarily, in a diversified portfolio of US small cap stocks. The advisor defines small cap in relation to the Russell 2000 Value Index; currently that means stocks with capitalizations under $3.3 billion. The portfolio is assembled by looking at stocks with low P/E and P/CF ratios, whose underlying firms have strong balance sheets and good management. The fund, which holds 39 common stocks and shares in one closed-end fund, is nominally non-diversified. The fund’s cash position is a residue of market opportunities. In times when the market is rich with opportunities, they deploy cash decisively. In 2009, for instance, they moved to under 3% cash. As markets have increasingly become richly-priced, the cash stake has grown. Over the past five years it has averaged 24% which is also where it stands in early 2015.

Adviser

Bragg Financial Advisors, headquartered in Charlotte, NC, just across from the Dowd YMCA. They used to be located on Queens Road. Bragg is a family firm with four Braggs (founder Frank as well as sons Benton, John and Phillips) and one son-in-law (manager Steven Scruggs) leading the firm. It has been around since the early 1970s, and manages approximately $850 million in assets. A lot of that is for 300 families in the Charlotte region.

Manager

Steven Scruggs, CFA. Mr. Scruggs has worked for BFA since 2000 and manages this fund and Queens Road Value (QRVLX). That’s about it. No separate accounts, hedge funds or other distractions. He does not have research analysts but the firm’s investment committee oversees the progress of the portfolio as a whole.

Strategy capacity and closure

Based on the liquidity of their holdings, that is their ability to get into and out of positions without disrupting the market, they anticipate about $800 million in capacity. They’d likely soft close the fund at $800 million and hard close it “not far north of that.”

Active share

“Active share” measures the degree to which a fund’s portfolio differs from the holdings of its benchmark portfolio. High active share indicates management which is providing a portfolio that is substantially different from, and independent of, the index. The advisor does not calculate active share for their funds. Mr. Scruggs argues that, “By the nature of our process, we’re not going to look like the index. Whether that’s a good thing or a bad thing, I can’t say.” Indeed, measured by sector weightings, the fund is demonstrably independent: the fund’s portfolio weights differ dramatically from its peer group in 10 of 11 industry sectors that Morningstar tracks.

Management’s stake in the fund

Mr. Scruggs has invested between $100,000 and $500,000 in the fund. Though modest in absolute terms, he explains that he has “the overwhelming bulk – 90-95% – of my liquid investments” in the two funds he manages. In addition, all of the fund’s independent trustees have invested in it; three of the four have investments in excess of $100,000. Especially given their modest compensation, that level of commitment is admirable, rare and helpful.

Opening date

June 13, 2002

Minimum investment

$2500 for regular accounts, $1000 for tax-sheltered accounts.

Expense ratio

1.24% on assets of $77 million.

Comments

Sometimes our greatest, and least understood, advantages, come from all of the things we don’t have. Like distractions. Second-guessers. Friends who talk us into trying hot new fashions. Or the fear of being canned if we make a mistake.

It’s sometimes dubbed “addition by subtraction.” Thomas Gray famously celebrated the virtue of being far from the temptation of the “in” crowd in his poem “Elegy Written in a Country Churchyard” (1751):

Far from the madding crowd’s ignoble strife
Their sober wishes never learn’d to stray;
Along the cool sequester’d vale of life
They kept the noiseless tenor of their way

How madding might the investment crowd be? Mr. Scruggs commends for your consideration a classic essay by Jeremy Grantham,  My Sister’s Pension Assets and Agency Problems. Mr. Grantham has been managing the pension investments for one of his sisters since 1968. She’s, in many ways, the ideal client: she’s not even vaguely interested in what the market has or has not been doing, she doesn’t meddle and isn’t going to fire him. That’s a far cry from the fate of most professional investors.

The central truth of the investment business is that investment behavior is driven by career risk. In the professional investment business we are all agents, managing other peoples’ money. The prime directive, as Keynes knew so well, is first and last to keep your job. To do this, he explained that you must never, ever be wrong on your own. To prevent this calamity, professional investors pay ruthless attention to what other investors in general are doing. The great majority “go with the flow,” either completely or partially. This creates herding, or momentum, which drives prices far above or far below fair price.

There are many other inefficiencies in market pricing, but this is by far the largest. It explains the discrepancy between a remarkably volatile stock market and a remarkably stable GDP growth, together with an equally stable growth in “fair value” for the stock market. This difference is massive – two-thirds of the time annual GDP growth and annual change in the fair value of the market is within plus or minus a tiny 1% of its long-term trend. The market’s actual price – brought to us by the workings of wild and wooly individuals – is within plus or minus 19% two-thirds of the time. Thus, the market moves 19 times more than is justified by the underlying engines!

Investors’ fears and fads feed off each other, they do what’s “hot” rather than what’s right, they chase the same assets and prices rise briskly. Until they don’t.

The success of the two small funds managed by Mr. Scruggs for Queens Road is remarkable. He has no fancy strategies or sophisticated portfolio tools. He measures a firm’s earnings and cash flow against normal, rather than abnormal, earnings. He tries to determine whether the management is likely able to continue growing earnings. If he sees a good margin of safety in the price, he buys. His preference is to be broadly diversified across sectors and industries to reduce the impact of sector-specific risks (such as oil price or interest rate changes). He won’t buy overpriced stocks just for the sake of obtaining sector exposure (he has no investments at all in five of Morningstar’s 11 sectors while his average peer has 24% of their portfolio in those sectors) but, on whole, he thinks broader exposure is more prudent than not. In the past year, his portfolio turnover has been zero. In short, he’s not trying to outsmart the market, he’s just trying to do his job: prudently compound his investors’ capital over time.

Mr. Scruggs believes that his fund will be competitive in healthy rising markets and superior in declining ones but will likely trail noticeably in frothy markets, those driven by investor frenzy rather than fundamentals. He anticipates that, across the entirety of a five-to-seven year market cycle, he’ll offer his investors somewhat better than average returns with much less heartburn.

So far he’s been true to his word. QRSVX has returned a solid 10.25% per year run inception through the end of 2014 while its benchmark made just 9% which greater volatility. A $10,000 investment at inception would have grown to $34,400 by April 2015 – about $4,000 more than his peers would have earned.

The question is: how does Queens Road stand up to the best funds, not just to the average ones. The short answer is: really quite well. The table below compares the performance of Queens Road to the three SCV funds that Morningstar designates as “the best of the best” and the low-cost default, Vanguard’s index. This data all reflects performance over the current market cycle, from the last peak in November 2007 to March 2015. For the sake of clarity, we’ve highlighted in blue the best performer in each category.

What do we see?

• All of the funds have been above-average performers, besting their SCV peer group by 0.2 – 1.7% per year.
• Queens Road has strong absolute returns but the lowest absolute returns of the group.
• Once risk is taken into account, however, Queens Road posts the best performance in every category. Its loss during the 2007-09 crash was smaller (Max Draw), its tendency to lose in falling markets (Downside Deviation) was smaller, and its risk-adjusted returns (Sharpe, Sortino, Martin and Return group) were all the best in class.

The advisor illustrates the same point by looking the fund’s performance during all of the quarters in which the Russell 2000 Value index fell:

For those counting, the fund outperformed its benchmark in nine of 10 down quarters.

When they don’t find stocks that are unreasonably cheap given their companies’ prospects, they let cash accumulate. As of the last portfolio disclosure, cash about 24% of the portfolio. That doesn’t reflect a market call, it simply reflects a shortage of stocks that offer a sufficient margin of safety:

[H]istory says we’re due for a pullback and we think it makes sense to be prepared. How do we prepare? As we’ve often said, by not making a drastic move in the portfolio. As esteemed money manager, Peter Lynch once said, “Far more money has been lost by investors trying to anticipate corrections than has ever been lost in corrections themselves.”

So why hasn’t he fallen into the trap that Mr. Grantham describes? That is, does he actually have a sustainable advantage as an investor? The fund’s 2014 Annual Report suggests three:

This is where we think we have an advantage …. First, we live in Charlotte, North Carolina, far away from the investment swirl and noise of New York, Boston or Chicago. Second, we are not a huge fund shop with a massive sales force/marketing division. Fall behind your peers for a few quarters, or heaven forbid, you lag for a couple of years at a big fund shop, and you’ve got the marketing guys in your office asking you, “What are you doing wrong? You gotta change something.” Third, we believe in our process. Collectively, our fund manager, investment committee, Board of Directors, and family have over $3 million of our own money invested in our Queens Road Funds … We understand the investment process. We are comfortable under-performing during certain periods. And we have the patience to stay the course.

Bottom Line

Most of us are best served by funds whose managers speak clearly, buy cautiously, sell rarely, and keep out of the limelight. It’s clear that thrilling funds are a disastrous move for most of us. The funds that dot the top of last year’s performance list have a real risk of landing on next year’s fund liquidation list. Investors who understand the significance of “for the long-term” in the phrase “stocks for the long-term” come to have patience with their portfolios; that patience willingness to let an investment play out over six years rather than six months distinguishes successful investors from the herd. Based on his record over the past 13 years, Mr. Scruggs has earned the designations patient, disciplined, successful. If you aspire to the same, the two Queens Road funds should surely be on your due-diligence list.

Fund website

Queens Road Small Cap Value fund

Objective

Pinnacle Value seeks long-term capital appreciation by investing in small- and micro-cap stocks that it believes trade at a discount to underlying earnings power or asset values. It might also invest in companies undergoing unpleasant corporate events (companies beginning a turnaround, spin-offs, reorganizations, broken IPOs) as well as illiquid investments. It also buys convertible bonds and preferred stocks which provide current income plus upside potential embedded in their convertibility. The manager writes that “while our structure is a mutual fund, our attitude is partnership and we built in maximum flexibility to manage the portfolios in good markets and bad.”

Adviser

Bertolet Capital of New York. Bertolet has $83 million in assets under management, including this fund and one separate account.

Manager

John Deysher, Bertolet’s founder and president. From 1990 to 2002 Mr. Deysher was a research analyst and portfolio manager for Royce & Associates. Before that he managed equity and income portfolios at Kidder Peabody for individuals and small institutions. The fund added an equities analyst, Mike Walters, in January 2011 who is also serving as a sort of business development officer.

Strategy capacity and closure

The strategy’s maximum capacity has not been formally determined. It’s largely dependent on market conditions and the availability of reasonably priced merchandise. Mr. Deysher reports “if we ever reach the point where Fund inflows threaten to dilute the quality of investment ideas, we’ll close the Fund.” Given his steadfast and enduring commitment to his investment discipline, I have no doubt that he will.

Active share

99%. “Active share” measures the degree to which a fund’s portfolio differs from the holdings of its benchmark portfolio. High active share indicates management which is providing a portfolio that is substantially different from, and independent of, the index. An active share of zero indicates perfect overlap with the index, 100 indicates perfect independence. Pinnacle’s active share is typically between 98.5-99%, indicating an exceedingly high level of independence.

Management’s stake in the fund

Mr. Deysher has in excess of $1,000,000 in the fund, making him the fund’s largest shareholder. He also owns the fund’s advisor. Two of the fund’s three independent directors have invested over $100,000 in the fund while one has only a nominal investment, as of the May 2014 Statement of Additional Information.

Opening date

April Fool’s Day, 2003.

Minimum investment

$2500 for regular accounts and $1500 for IRAs. The fund is available through TD Ameritrade, Fidelity, Schwab, Vanguard and other platforms.

Expense ratio

1.32%, after waivers, on assets of $31.4 million, as of July 2023. There is a 1% redemption fee for shares held less than a year.

Comments

By any rational measure, for long-term investors Pinnacle Value is the best small cap value fund in existence.

There are two assumptions behind that statement:

1. Returns matter.
2. Risk matters more.

The first is self-evident; the second requires just a word of explanation. Part of the explanation is simple math: an investment that falls by 50% must subsequently rise by 100% just to break even. Another part of the explanation comes from behavioral psychology. Investors are psychologically ill-equipped to deal with risk: we hate huge losses and we react irrationally in the face of them but we refuse to believe that they’re going to happen to us, so we rarely act appropriately to mitigate them. In good times we delude ourselves into thinking that we’re not taking on unmanageable risks, then they blow up and we sit for years in cash. The more volatile the asset class, the greater the magnitude of our misbehavior.

If you’re thinking “uh-uh, not me,” you need to go buy Dan Kahneman’s Thinking, Fast and Slow (2013) or James Montier’s The Little Book of Behavioral Investing (2010). Kahneman won the Nobel Prize for his work on the topic, Montier is an asset allocation strategist with GMO and used to be head of Global Strategy at Société Générale.

John Deysher does a better job of managing risks in pursuit of reasonable returns than any other small cap manager. Since inception, Pinnacle Value has returned about 9.9% annually. 

Using the Observer’s premium MultiSearch tool, we were able to assess the ten-year risk adjusted performance of every small cap value fund. Here’s what we found:

Those rankings are essentially unchanged even if we look only at results for the powerful Upmarket cycle that began in March 2009: Pinnacle returned an average of 11.4% annually during the cycle, with the group’s best performance in six of the seven measures above. It’s fourth of 94 on the Martin ratio.

We reach the same conclusion when we compare Pinnacle just against Morningstar’s “Gold” rated small cap value funds and Vanguard’s SCV index. Again, these are the 10-year numbers:

So what does he actually do?

The short version: he buys very good, very small companies when their stocks are selling at historic lows. Pinnacle looks for firms with strong balance sheets since small firms have fewer buffers in a downturn than large ones do, management teams that do an outstanding job of allocating capital including their own, and understandable businesses which tends to keep him out of tech, bio-tech and other high obsolescence industries.

For each of the firms they track, they know what qualifies as the “fire sale” price of the stock, typically the lowest p/e or lowest price/book ratios at which the stock has sold. When impatient investors offer quality companies at fire sale prices, Mr. Deysher buys. When they demand higher prices, he waits.

There’s an old saying, Wall Street is the place where the patient take from the impatient. Impatient investors tend to make mistakes. We are there to exploit those mistakes. We are very patient. When we find a compelling value, we step up quickly. That reflects the fact that we’re very risk adverse, not action adverse. John Deysher

His aspiration is to be competitive in rising markets and to substantially outperform in falling ones. That’s pretty much was his ten-year performance chart shows. Pinnacle is the blue line levitating over the 2008 crash; his peer group is in orange.

Pinnacle’s portfolio is compact, at 37 names.  Since fire sales are relatively rare, the fund generally sits between 40-60% in cash though he’s been willing to invest substantial amounts of that cash in a relatively short period. Many of his holdings are incredibly small; of 202 small cap value funds, only five have smaller average market caps. And many of the holdings are unusual, even by the standard of microcap value funds. Some trade over-the-counter and for some he’s virtually the only mutual fund holding them. He also owns seven closed-end funds as arbitrage plays: he bought them at vast discounts to their NAVs, those discounts will eventually revert to normal and provide Pinnacle with a source of market-neutral gain.

Bottom line

The small cap Russell 2000 index closed February 2015 at an all-time high. An investment made six years ago – March 2009 – in Vanguard’s small cap index has almost quadrupled in value. GMO calculates that U.S. small caps are the most overvalued equity class they track. If investors are incredibly lucky, prices might drift up or stage a slow, orderly decline. If they’re less lucky, small cap prices might reset themselves 40% below their current level. No one knows what path they’ll take. So Dirty Harry brings us to the nub of the matter:

You’ve gotta ask yourself one question: “Do you feel lucky?” Well, do ya, punk?

Mr. Deysher would prefer to give his investors the opportunity to earn prudent returns, sleep well at night and, eventually, profit richly from the irrational behavior of the mass of investors. Over the past decade, he’s pulled that off better than any of his peers.

Fund website

Pinnacle Value Fund. Yuh … really, John’s not much into marketing, so the amount of information available on the site is pretty limited. Jeez, we’ve profiled the fund twice before and never even made it to his “In the News” list. And while I’m pretty sure that the factsheet was done on a typewriter…. After two or three hours’ worth of conversations over the years, it’s clear that he’s a very smart and approachable guy. He provides his direct phone number on the factsheet. If I were an advisor worried about how long the good times will last and how to get ahead of events, I’d likely call him.

Fact Sheet

At the time of publication, this fund was named Osterweis Strategic Investment.

Objective and strategy

The fund pursues the reassuring objective of long-term total returns and capital preservation. The plan is to shift allocation between equity and debt based on management’s judgment of the asset class which offers the best risk-return balance. Equity can range from 25 – 75% of the portfolio, likewise debt. Both equity and debt are largely unconstrained, that is, the managers can buy pretty much anything, anywhere. That means that the fixed-income portfolio might at one point contain a large exposure to high-yield securities and, at another, to Treasuries. The two notable restrictions are minor: no more than 50% of the total portfolio can be invested outside the U.S. and no more than 15% may be invested in Master Limited Partnerships, which are generally energy and natural resources investments.

Adviser

Osterweis Capital Management. Osterweis Capital Management was founded in 1983 by John Osterweis to manage money for high net worth individuals, foundations and endowments. They’ve got $10 billion in assets under management (as of December 31, 2015), and run both individually managed portfolios and four mutual funds. Osterweis once managed hedge funds but concluded that such vehicles served their investors poorly and so wound them down in 2012. (Their argument is recapped in the “Better Mousetrap” article, linked below.) The firm is privately-held, mostly by its employees. Mr. Osterweis is in his early 70s and, as part of the firm’s transition plan, has been transferring his ownership stake to a cadre of key employees. At least six of the eight co-managers listed below own 5% of more of the adviser.

Managers

John Osterweis, Matt Berler and Carl Kaufman lead a team that includes the folks (John Osterweis, Matthew Berler, Alexander “Sasha” Kovriga, Gregory Hermanski, and Nael Fakhry) who manage Osterweis Fund (OSTFX) and those at the Osterweis Strategic Income Fund (Carl Kaufman, Simon Lee and Bradley Kane). The equity team manages over 300 separate accounts; the fixed-income team handles “a small number” of them. The team members have all held senior positions with distinguished firms (Robertson Stephens, Morgan Stanley, and Merrill Lynch).

Strategy capacity and closure

Mr. Kaufman was reluctant to estimate capacity since it’s more determined by market conditions (“in 2008 we could have put $50 billion to work with no problem”) than by limits on the asset classes or team. Conservatively estimated, the fixed-income team could handle at least an additional $4 billion given current conditions.

Active share

“Active share” measures the degree to which a fund’s portfolio differs from the holdings of its benchmark portfolio. High active share indicates management which is providing a portfolio that is substantially different from, and independent of, the index. An active share of zero indicates perfect overlap with the index, 100 indicates perfect independence. Typically active share is calculated only for equity funds, so we do not have a calculation for OSTVX. The equity sleeve of this fund is the same as the flagship Osterweis Fund (OSTFX), whose active share is 94 which reflects a very high level of independence from its benchmark.

Management’s stake in the fund

Four of the eight team members had investments in excess of $1 million in the fund, a substantial increase since our last profile of the fund. The four younger members of the team generally have substantial holdings. As of December 31, 2013, none of the fund’s independent trustees (who are very modestly compensated for their work) had an investment in the fund. Two of the five had no investment in any of the Osterweis funds they oversee.

Opening date

August 31, 2010

Minimum investment

$5000 for regular accounts, $1500 for IRAs and other tax-advantaged accounts.

Expense ratio

0.97% on assets of $166.6 million (as of July 18, 2023).

Comments

Explanations exist; they have existed for all time; there is always a well-known solution to every human problem — neat, plausible, and wrong. H.L. Mencken, “The Divine Afflatus,” New York Evening Mail, 16 Nov 1917.

If you had to invest in a portfolio that held a lot of fixed-income securities which of the following would you prefer, a fund that’s “more conservative than the portfolio’s credit profile suggests,” which “shines when volatility is considered” and its “lowest 10-year Morningstar Risk score” or one that suffers from “a lack of balance,” is “one-sided,” “doubles down on related risks” and “is vulnerable to contractions”?

Good news! You don’t have to choose since those excerpts, all from Morningstar analyst Kevin McDevitt’s latest analyses, describe the exact same portfolio: Osterweis Strategic Income (OSTIX), which serves as the fixed-income portion of the Osterweis Strategic Investment Fund’s portfolio.

How does the same collection of fixed-income securities end up being praised for their excellent low risk score and being pilloried for their riskiness? Start with the dogmatic belief that “investment grade” is always safe and good and that “high yield” is always dangerous and bad. Add in the assumption that the role of fixed-income in a stock/bond hybrid “is to provide ballast” and you’ve got a recipe for dismissing funds that don’t conform to the cookie-cutter.

Neither assumption is universally true which is to say, neither should be used as an assumption when you’re judging your investments.

Is high-yield always riskier than investment grade?

No.

There are two sources of risk to consider: interest-rate risk and credit risk. Investment grade bond investors thrive when interest rates are falling; they suffer loss of principal when interest rates rise. The risk is systemic: all sorts of intermediate-term bonds are going to suffer about equally when the Feds raise rates. Fed funds rate futures are currently forecasting a 50% prospect of a 0.25% rate hike in April and an equal chance of a 0.50% hike by October. Credit risk, the prospect that a bond issuer won’t be able to repay his debt, is idiosyncratic. That is, it’s particular to individual issuers and it’s within the power of fund managers to dodge it. In a strengthening economy, interest rate risks rise and credit risk falls. Because ratings agencies under-react to changing conditions, companies and entire sectors of the economy might have substantially lower credit risk than their “non-investment grade” ratings imply. Mr. Kaufman, one of the managers, reports on the case of “one firm in the portfolio which cut its outstanding debt in half, has lots of free cash flow and was still belatedly downgraded.” Likewise, the debt of energy companies was rated as investment grade while the sector was imploding; now that it has likely bottomed, it’s being reclassified as junk.

The Osterweis team argues that it’s possible to find lots of opportunities in shorter term high yield debt, in particular of companies that are fundamentally stronger than outdated ratings reports recognize. Such firms, Mr. Kaufman argues, offer the best risk-return tradeoff of any fixed income option today:

We invest in fixed-income for absolute return. We’re playing chicken right now, betting that interest rates won’t rise just yet. When the music stops, people are going to get hurt. I don’t like to make bets. I want to control what I can control. Investment grade investors win only if interest rates go lower. Look at what’s going to happen if nothing happens. The yield on the 10-year Treasury is 1.673%. That’s what you would get for returns if nothing happens.

Is fixed-income always the portfolio’s ballast?

No.

There are, broadly speaking, two sorts of funds which mix both stocks and bonds in their portfolios. One sort, often simply called a “balanced” fund, sticks with a mix that changes very little over time: 60% stocks (mostly domestic large caps) plus 40% bonds (mostly investment grade), and we’re done. They tend to be inexpensive, predictable and reassuringly dull. An excellent anchor for a portfolio, at least if interest rates don’t rise.

The second sort, sometimes called an “allocation” fund, allows its manager to shift assets between and within categories, sometimes dramatically. These funds are designed to allow the management team to back away from a badly overvalued asset class and redeploy into an undervalued one. Such funds tend to be far more troubled than simple balanced funds for two reasons. First, the manager has to be right twice rather than once. A balanced manager has to be right in his or her security selection. An allocation manager has to be right both on the weighting to give an asset class (and when to give it) and on the selection of stocks or bonds within that portion of the portfolio. Second, these funds can carry large visible and invisible expenses. The visible expenses are reflected in the sector’s high expense ratios, generally 1.5 – 2%. The funds’ trading, within and between sectors, invisibly adds another couple percent in drag though trading expenses are not included in the expense ratio and are frequently not disclosed.

Why consider these funds at all?

If you believe that the market, like the global climate, seems to be increasingly unstable and inhospitable, it might make sense to pay for an insurance policy against an implosion in one asset class or one sector. One is to seek a fund designed to dodge and weave through the hard times. If the manager is good (see, for example, Rob Arnott’s PIMCO All Asset PASDX, Steve Romick’s FPA Crescent FPACX or Leuthold Core LCORX) you’ll receive your money’s worth and more. Another option would be to use the services of a good fee-only financial planner who specializes in asset allocation. In either case, you’re going to pay for access to the additional “dynamic allocation” expertise.

Why consider Osterweis Strategic Investment?

There are two reasons. First, Osterweis makes sense in an uncertain world. Osterweis Strategic Investment is essentially the marriage of the flagship Osterweis Fund (OSTFX) and Osterweis Strategic Income (OSTIX). OSTFX is primarily a stock fund, but the managers have the freedom to move decisively into bonds and cash if need be. In the last 10 years, the fund’s lowest stock allocation was 60% and highest was 96%, but it tends to have a neutral position in the upper-80s. Management has used that flexibility to deliver solid long-term returns (7.3% over the past 15 years, as of 1/21/2015) with a third less volatility than the stock market’s. Osterweis Strategic Income (OSTIX) plays the same game within the bond universe, moving between bonds, convertibles and loans, investment grade and junk, domestic and foreign. This plays hob with its long-term rankings at Morningstar, which has placed it in three very different categories (convertibles, multi-sector income and high-yield bonds) over the past 10 years but now benchmarks all of its trailing returns as if it had been a high-yield bond fund all along.

For now, the fund is dialing back on its stock exposure. Mr. Kaufman reports:

We can invest 75%/25% in either direction. Our decision to lighten up on stocks now – we’ve dropped near 60% – determined by opportunity set. We’re adding fixed income now because we’re finding lots of great value in the short-term side of the market. Equities might return 6% this year and we think we can get equity-like returns, without equity-like risk, in fixed-income portfolio.

In his recent communication with shareholders, he writes:

We prefer to add risk only when we see a “fat pitch,” of which there are precious few at this time … at current yields there is no investment grade “fat pitch.” Our focus remains on keeping duration short and layering-in higher yielding paper, especially on sharp corrections in the market like we have seen recently. We believe that the appropriate time to take a swing at investment grade bonds will be when yields are much higher and the economy is teetering towards recession.

Second, Osterweis’s expenses, direct and indirect, are more reasonable than most. The 1.15% ratio (as of the most recent prospectus) has been dropping steadily and is at the lower end for an active allocation fund, strikingly so for a tiny one. And the other two Osterweis funds each started around 1.5% and then steadily lowered their expense ratios, year after year, as assets grew. In addition, both funds tend to have lower-than-normal portfolio turnover, which decreases the drag created by trading costs.

Bottom Line

It is easy to dismiss OSTVX because it refuses to play by other people’s rules; it rejects the formulaic 60/40 split, it refuses to maintain a blind commitment to investment grade bonds, its stock sector-, size- and country-weightings are all uncommon. Because rating systems value herd-like behavior and stolid consistency, these funds may often look bad. The question is, are such complaints “neat, plausible and wrong”? The fund’s fixed income portfolio have managed a negative down-market capture over the past 12 years; that is, it rises when the bond market falls, then rises some more when the bond market rises. Osterweis closed down their hedge fund business, concluding that many investors would derive much more benefit, more economically, from using a balanced fund as a significant part of their portfolio. Given reasonable expenses, outstanding management and a long, solid track record, Osterweis Strategic Investment warrants a place on any investor’s due-diligence short list.

Fund website

Osterweis Growth & Income Fund. There’s a link to a really nicely-reasoned, well-written piece on why, to be blunt, hedge funds are stupid investments. Osterweis used to run one and concluded that they could actually serve their investors better (better risk/return balance, less complexity, lower expenses) by moving them to a balanced fund. 

Objective and strategy

The managers pursue long-term growth of capital and income by investing in a fairly compact portfolio of international small cap stocks. Their goal is to find the most undervalued streams of sustainable cash flow that they can. The managers start with quantitative screens to establish country and industry rankings, then a second set of valuation screens to identify a pool of potential buys. There are around 17,000 unique companies between $50 million – $3 billion in market cap. Around 400 companies have been passing the screens consistently for the past many months. Portfolio companies are selected after intensive fundamental review. The portfolio typically holds between 75-100 stocks representing at least 10 countries.

Adviser

Pear Tree Advisors is an affiliate of U.S. Boston. U.S. Boston was founded in 1969 to provide wealth management services to high net worth individuals. In 1985, they began to offer retail funds, originally under the Quantitative Funds name, each of which is sub-advised by a respected institutional manager. There are six funds in the family, two domestic (U.S. large cap quality and U.S. small cap) and four international (international multi cap value, international small cap value, and two emerging markets funds). The sub-adviser for this fund is Polaris Capital Management, LLC. Founded in 1995, Polaris describes itself as a “global value equity manager.” The firm is owned by its employees and, as of December 2014, managed $5.6 billion for institutions, retirement plans, insurance companies, foundations, endowments, high-net-worth individuals, investment companies, corporations, pension and profit sharing plans, pooled investment vehicles, charitable organizations, state or municipal governments, and limited partnerships.

Manager

Bernard Horn, Sumanta Biswas and Bin Xiao. Mr. Horn is Polaris’s founder, president, chief investment officer and lead manager on Polaris Global Value Fund. He is, on whole, well-known and well-respected in the industry. Day to day management of the fund, including security selection and position sizing, is handled by Messrs. Biswas and Xiao. Mr. Biswas joined the firm as an intern (2001), was promoted to research analyst (2002), then assistant portfolio manager (2004), vice president (2005) and Partner (2007). Mr. Xiao joined the firm as an analyst in 2006 and was promoted to assistant portfolio manager in 2012. Both are described as investment generalists. The team manages about $5.6 billion together, including the Polaris Global Value Fund (PGVFX) and subadvisory of PearTree Polaris Foreign Value (QFVOX) the value portion of PNC International Equity (PMIEX), and other multi-manager funds.

Strategy capacity and closure

Between $1 – 1.5 billion, an amount that might rise or fall as market conditions change. The number of international small cap stocks is growing, up by nearly 100% in the past decade and the number of international IPOs is growing at ten times the U.S. rate. 

Size constraint is ‘time’ dependent.  The Fund objective is to beat the benchmark with lower than benchmark risk (risk is the ITD annualized beta of the portfolio). The managers’ past experience suggests that a portfolio of around 75-100 stocks provides an acceptable risk/return trade-off. Overlaying a liquidity parameter allowed the Fund to reach the $1- $1.5 billion in potential assets under management. 

However the universe of companies is expanding and liquidity conditions keep changing. Fund managers suggested that they are open to increasing the number of companies in the portfolio as long as the new additions do not compromise their risk/return objective. So, the main constraining factor guiding fund size is how many investable companies the market is offering at any given point in time.  

Active share

“Active share” measures the degree to which a fund’s portfolio differs from the holdings of its benchmark portfolio. High active share indicates management which is providing a portfolio that is substantially different from, and independent of, the index. An active share of zero indicates perfect overlap with the index, 100 indicates perfect independence. The advisor has not calculated the active share for its funds but the managers note that the high tracking error and low correlation with its benchmark implies a high active share.

Management’s stake in the fund

Mr. Horn has over $1 million in the fund and owns about 5% of the fund’s institutional shares. Messrs. Xiao and Biswas each have been $50,000-100,000 invested here; “we have,” they report, “all of our personal investments in our funds.” Three of the four independent trustees have no investment in the fund; one of them has over $100,000.

Opening date

May 1, 2008.

Minimum investment

$2,500, reduced to $1,000 for tax-advantaged accounts. The institutional minimum is $1 million. Roger Vanderlaan, one of the Observer’s readers, reports that the institutional shares of this fund, as well as the two others sub-advised by Polaris for Pear Tree, are all available from Vanguard for a $10,000 initial purchase though they do carry a transaction fee.

Expense ratio

1.04% on assets of $995.3 million for the institutional class shares, 1.41% for investor class shares, as of July 2023. 

Comments

There are three, and only three, great international small cap funds: Wasatch International Opportunities (WAIOX), Grandeur Peak International Opportunities (GPIOX) and Pear Tree Polaris Foreign Value Small Cap.

What do we mean by “small cap”? We looked for funds that invested in (brace yourselves) small and micro-cap stocks. One signal of that is the fund’s average market cap; we targeted funds at $2 billion or less since about 80% of all stocks are below that threshold. Of the 90 funds in the Morningstar’s international small- to mid-cap categories, only 17 actually had portfolios dominated by small cap stocks.

What do we mean by “great”? We started by looking at the returns of those 17 funds over the past one-, three- and five-year periods. Two things were clear: the same names dominated the top four spots over and over and only three funds managed to make money over the past year (through the end of January, 2015). And the fourth fund, Brandes International Small Cap Equity “A”(BISAX) looked strong except (1) it sagged over the past year and (2) the great bulk of its track record, from inception in August 1996 through January 2012, occurred when it was organized as “a private investment commingled fund.” The SEC allowed BISAX to assume the performance record of the prior fund, but questions always arise when an investment vehicle moves from one structure to another.

(all returns are through January 30, 2015)

That’s leads to two questions: should you consider adding any international small cap exposure to your portfolio? And should you especially consider adding Pear Tree Polaris to it? For many investors, the answer to both is “yes.”

Why international small cap?

There are four reasons to consider adding international small cap exposure.

1. They are a large opportunity set. About 80% of the world’s stocks have market caps below $2 billion. Grandeur Peak estimates that there are 29,000 investible small cap stocks worldwide, 25,000 being outside of the U.S.
2. The opportunity set is growing. Since 2000, over 90% of IPOs have been filed outside of the US. Meanwhile, the number of US listed stocks declined from 9,000 to under 5,000 in the first 12 years of the 21stcentury. As markets deepen and the middle class grows in many emerging nations, the number of small caps will continue to climb.
3. You’re ignoring them, and so is almost everyone else. As we noted above, there are fewer than 20 true international small cap funds. Most of the funds that bear the designation actually invest most of their money into mid-caps and often a lot into large caps as well. According to Morningstar, the average small- to mid-cap international growth fund has 24% of its money in small caps and 19% in large caps. International small value and blend funds invest, on average, 35-38% in small caps. Broad international indexes have only 3-4% of their weightings in small caps, so those won’t help you either. Given that the average individual US investor has an 80% allocation to US stocks, it’s likely that you have under 1% of your portfolio in international small caps.
4. They are a valuable opportunity set. There are three factors that make them valuable. They are independent: they are weakly correlated with the US market, international large caps or each other, they are rather state-owned and they are driven more by local conditions than by government fiat or global macro trends. They are mispriced. Because of liquidity constraints, they’re ignored by large institutions and index-makers. The average international microcap is covered by one analyst, the average small cap by four, and 20% of international small caps have no analyst coverage. Across standard trailing time periods, they outperform international large caps with higher Sharpe and Sortino ratios. Finally, they are the last, best haven of active management. The average international small cap manager outperforms his or her benchmark by 200-300 bps. Really good ones can add a multiple of that.

Why Pear Tree Polaris?

While this fund is relatively new, the underlying discipline has been in place for 30 years and has been on public display in Polaris Global Value Fund (PGVFX) for 17 years.  The core strategy is disciplined, simple and repeatable. They’re looking to buy the most undervalued companies in the world, based on their calculation of a firm’s sustainable free cash flow discounted by conditions in the firm’s home country. They look, in particular, at free cash flow from operations minus the capital expenditures needed to maintain those operations. By using conservative assumptions about growth and a high discount rate, the system builds a wide margin of safety into its modeling.

The managers overlay those factors with an additional set of risk control in recognition of the fact that individual international small cap stocks are going to be volatile, no matter how compelling the underlying firm’s business model and practices.

Mr. Biswas remembers Mr. Horn’s warning, long ago, that emerging markets stocks are intrinsically volatile. Thinking that he’d found a way around the volatility trap, Biswas targeted a portfolio of defensive essentials, such as rice, fish and textbooks, and then discovered that even “essentials” might plummet 80% one year then rocket 90% the next.

Among the risk management tools they use are position sizing and an attempt to understand what really matters to the firm’s prospects. The normal position size is 1.6% of assets, but they might invest just half of that in a stock with limited liquidity. 

They are typically overweight companies in five sectors: utilities, telecom, healthcare, energy and materials.  The defensive sectors of utilities, telecom and healthcare are only 15% of the 17,000 companies in the small-cap universe. Energy is less than 5% of the same universe.   Materials is adequately represented in the 17,000 company set.  However, finding value opportunities (businesses with stable cash flows with limited down side risk at high discount rates) in these sectors is often challenging. In view of the above, they typically overweight companies in these 5 sectors to ensure greater diversification and lower portfolio volatility.

Because small companies are often monoline, that is they do or make just one thing, their prospects are easier to understand than are those of larger firms, at least once you understand what to pay attention to. Mr. Biswas says that, for many of these firms, you need to understand just three or four key drivers. The other factors, he says, have “low marginal utility.” If you can simplify the firm’s business model, identify the drivers and then learn how to talk with management about them, you can quickly verify a stock’s fundamental attractiveness.

Because those factors change slowly and the portfolio is compact with low turnover (about 10% per year so far, though that might rise over time to the 20-30% range), it’s entirely possible for a small team to track their investible universe.

Bottom Line

This is about the most consistent and most consistently risk-conscious international small cap fund around. It has, since inception, maintained its place among the best funds in its universe and has handily outperformed both the only Gold-rated international small value fund (DFA International Small Value DSIVX) and its average peer by a lot. It has done that while compiling the group’s most attractive risk-return profile. Any fund that invests in such risky assets comes with the potential for substantial losses. That includes this fund. The managers have done an uncommonly good job of anticipating those risks and executing a system that is structurally risk-averse. While they will not always lead the pack, they will – on average and over time – serve their investors well. They deserve a place near the top of the due diligence list for investors interested in risk assets that have not yet run their course.

Fund website

Pear Tree Polaris Foreign Value Small Cap. For those looking for a short introduction to the characteristics of international or global small caps as an asset class, you might consider Chris Tessin’s article “International Small Cap A Missed Opportunity” from Pensions & Investments (2013)

Fact Sheet

(2023)

Objective and strategy

The fund pursues long-term capital appreciation by investing in large cap growth stocks, which it defines generously as those with capitalizations over $5 billion. The manager describes his style as having a “value orientation toward growth.” Their discipline combines a macro-level sensitivity to the effects of powerful and enduring secular changes and on industries which are being disrupted, with intense fundamental research and considerable patience. The fund holds a fair fraction of its portfolio, about 20% at the end of 2014, in mid-cap stocks and has a small lower market cap, lower turnover and more compact portfolio than its peers. Most portfolio positions are weighted at about 2-3% of assets.

Adviser

RiverPark Advisors, LLC. RiverPark was formed in 2009 by former executives of Baron Asset Management. The firm is privately owned, with 84% of the company being owned by its employees. They advise, directly or through the selection of sub-advisers, the seven RiverPark funds. Overall assets under management at the RiverPark funds were over $3.5 billion as of September, 2014.

Manager

Mitch Rubin, a Managing Partner at RiverPark and their CIO. Mr. Rubin came to investing after graduating from Harvard Law and working in the mergers and acquisitions department of a law firm and then the research department of an investment bank. The global perspective taken by the M&A people led to a fascination with investing and, eventually, the opportunity to manage several strategies at Baron Capital. He’s assisted by RiverPark’s CEO, Morty Schaja, and Conrad van Tienhoven, a long-time associate of his. Mitch and his wife are cofounders of The IDEAL School of Manhattan, a small school where gifted kids and those with special needs study and play side-by-side.

Strategy capacity and closure

While Morty Schaja describes capacity and closure plans as “somewhat a comical issue” for a tiny fund, he estimates capacity “to be around $20 billion, subject to refinement if and when we get in the vicinity.” We’ll keep a good thought.

Active share

79.6, as of November 2014. “Active share” measures the degree to which a fund’s portfolio differs from the holdings of its benchmark portfolio. High active share indicates management which is providing a portfolio that is substantially different from, and independent of, the index. An active share of zero indicates perfect overlap with the index, 100 indicates perfect independence. As a rule of thumb, large cap funds with an active share over 70 have legitimately “active” managers while the median for Morningstar’s large cap Gold funds is 76. The active share for RiverPark Large Growth is 79.6, which reflects a high level of independence from its benchmark, the S&P 500 index.

Management’s stake in the fund

Mr. Rubin and Mr. Schaja each have over $1 million invested in the fund. Between them, they own 70% of the fund’s institutional shares. One of the fund’s three trustees has invested between $10,000 and $50,000 in the fund while the other two have not invested in it. As of December 31, 2013, the Trustees and officers of the Trust, as a group, owned 16.27% of the outstanding shares of the fund.

We’d also like to compliment RiverPark for exemplary disclosure: the SEC allows funds to use “over $100,000” as the highest report for trustee ownership. RiverPark instead reports three higher bands: $100,000-500,000, $500,000-1 million, over $1 million. That’s really much more informative than the norm.

Opening date

September 30, 2010.

Minimum investment

The minimum initial investment in the retail class is $1,000 and in the institutional class is $50,000.

Expense ratio

Retail class at 1.23% and institutional class at 0.95% on total assets of $38.3 million, as of July 2023.

Comments

If we had written this profile in January 2014 instead of January 2015, our text could have been short and uncontroversial.  It would read something like:

Mitch Rubin is one of the country’s most experienced growth managers. He’s famously able to follow companies for decades, placing them first in one of the small cap funds he’s run, later in a large cap fund before selling them when they plateau and shorting them as they enter their latter years. With considerable discipline and no emotional investment in any of his holdings, he has achieved outstanding results here and in his earlier charges. From inception through the end of 2013, Large Growth has dramatically outperformed both its large cap growth peer group and the S&P500, and had easily matched or beaten the performance of the top tier of growth funds.  That includes Sequoia (SEQUX), RiverPark Wedgewood (RWGFX), Vanguard PRIMECAP (VPMCX) and the other Primecap funds.

Accurate, true and sort of dull.

Fortunately, 2014 gave us a chance to better understand the fund and Mr. Rubin’s discipline. How so? Put bluntly, the fund’s short-term performance sort of reeked and it managed to reduce a five-star rating down to a three-star one. While it finished 2014 with a modest profit, the fund trailed more than 90% of its large-growth peers. That one year slide then pulled its three-year record from “top 10%” to “just above average.”

The question is: does 2014 represent “early” (as in, the fund moved toward great companies whose discount to fair value kept growing during the year) or “wrong” (that is, making an uninformed, undisciplined or impulsive shift that blew up)? If it’s the former, then 2014’s lag offers reasons to buy the fund while its portfolio is underpriced. If it’s the latter, then it’s time for investors to move on.

Here’s the case that Mitch, Conrad and Morty make for the former.

• They’re attempting to invest in companies which will grow by at least 20% a year in the future, in hopes of investing in stocks which will return 20% a year for the period we hold them. Since no company can achieve that rate of growth, the key is finding growth that is substantially underpriced.
• There’s a sort of time arbitrage at work, a claim that’s largely substantiated by a lot of behavioral finance research. Investors generally do not give companies credit for high rates of growth until that growth has been going on for years, at which point they pile in. RiverPark’s goal is to anticipate where next year’s growth is going to be, rather than buying where last year’s growth – or even this year’s growth – was.
• The proper questions then are (1) is the company’s performance outpacing its stock performance? And, if so, (2) can that performance be sustained? If you answer “yes” to both, then it’s probably time to buy. The mantra was “buy, hold, and, if necessary, double down.”
• If they’re right, in 2014 they bought a bunch of severely underpriced growth. The firms in the portfolio are growing earnings by about 20% a year and they’re paying a 16x p/e for those stocks. Investors in the large cap universe in general are also paying a 16x p/e, but they’re doing it for stocks that are growing by no more than 7% annually.

Those lower quality firms have risen rapidly, bolstered by low interest rates which have made it cheap for them to buy their way to visibility through financial engineering; debt refinance, for example, might give a one-time boost to shaky earnings while cheap borrowing encourages them to “buy growth” by acquiring smaller firms. Such financial engineering, though, doesn’t provide a basis for long-term growth. For the Large Growth portfolio, they target firms with “fortress-like balance sheets.”

So, they buy great growth companies for cheap. How does that explain the sudden sag in 2014? They point to three factors:

• Persistently low interest rates: in the short term, they prop up the fortunes of shaking companies, whose stock prices continue to rise as late-arriving investors pile in. In the interim, those rates punish cash-rich financial services firms like Schwab (SCH) and Blackstone Group (BX)
• Energy repricing: about 13% of the portfolio is focused on energy firms, about twice the category average. Three of their four energy stocks have lost money this year, but are cash-rich with a strong presence in the Marcellus shale region. Globally natural gas sells for 3-4 times more than it does in the US; our prices are suppressed by a lack of transport capacity. As that becomes available, our prices are likely to move toward the global average – and the global average is likely to rise as growth resumes.
• Anti-corruption contagion: the fund has a lot of exposure to gaming stocks and gaming companies have a lot of exposure to Asian gambling and retail hubs such as Macau. Those are apt to be incredibly profitable long-term investments. The Chinese government has committed to $500 billion in new infrastructure investments to help middle class Chinese reach Macau, and Chinese culture puts great stock in one’s willingness to challenge luck. As a result, Chinese gamblers place far higher wagers than do Western ones, casinos catering to Chinese gamblers have far higher margins (around 50%) than do others and the high-end retailers placed around those casinos rake in about $7,000 per square foot, well more than twice what high-end stores here make. In the short term, though, Prime Minister Xi’s anti-corruption campaign has terrified Chinese high-rollers who are buying and gambling a lot less in hopes of avoiding the attention of crusaders at home. While the long-term profits are driven by the mass market, in the short-term their fate is tied to the cowed high-wealth cohort.

Sooner rather than later, the managers argue, energy prices will rise and firms like Cabot Oil & Gas (COG) will see their stocks soar. Sooner rather than later, the gates of Macau will be opened to hundreds of millions of Chinese vacationers, anxious to challenge luck and buy some bling and stocks like Wynn Resorts (WYNN) will rise dramatically.

This is not a high turnover, momentum strategy designed to capture every market move. Almost all of the apparent portfolio turnover is simply rebalancing within the existing names in order to capture a better risk/return profile. It’s a fairly patient strategy that has, for decades, been willing to tolerate short-term underperformance as the price of long-term outperformance.

Bottom Line

The argument for RiverPark is “that spring is getting compressed tighter and tighter.” That is, a manager with a good track record for identifying great underpriced growth companies and then waiting patiently currently believes he has a bunch of very high quality, very undervalued names in the portfolio. They point to the fact that, for 26 of the 39 firms in the portfolio, the firm’s underlying fundamentals exceeded the market while the stock price in 2014 trailed it. It is clear that the manager is patient enough to endure a flat year or two as the price for long-term success; the fund has, after all, returned an average of 20% a year. The question is, are you?

Fund website

RiverPark Large Growth. Folks interested in hearing directly from Messrs. Rubin and Schaja might listen to our December 2014 conference call with them, which is housed on the Featured Fund page for RiverPark Large Growth.

Fact Sheet

Objective and strategy

Polaris Global Value attempts to provide above average return by investing in companies with potentially strong sustainable free cash flow or undervalued assets. Their goal is “to invest in the most undervalued companies in the world.” They combine quantitative screens with Graham and Dodd-like fundamental research. The fund is diversified across country, industry and market capitalization. They typically hold 50 to 100 stocks.

Adviser

Polaris Capital Management, LLC. Founded in 1995, Polaris describes itself as a “global value equity manager.” The firm is owned by its employees and, as of September 2014, managed $5 billion for institutions, retirement plans, insurance companies, foundations, endowments, high-net-worth individuals, investment companies, corporations, pension and profit sharing plans, pooled investment vehicles, charitable organizations, state or municipal governments, and limited partnerships. They subadvise four funds include the value portion of the PNC International Equity, a portion of the Russell Global Equity Fund and two Pear Tree Polaris funds.

Manager

Bernard Horn. Mr. Horn is Polaris’s founder, president and senior portfolio manager. Mr. Horn founded Polaris in April 1995 to expand his existing client base dating to the early 1980s. Mr. Horn has been managing Polaris’ global and international portfolios since the firm’s inception and global equity portfolios since 1980. He’s both widely published and widely quoted. He earned a BS from Northeastern University and a MS in Management from MIT. In 2007, MarketWatch named him their Fund Manager of the Year. Mr. Horn is assisted by six investment professionals. They report producing 90% of their research in-house.

Strategy capacity and closure

Substantial. Mr. Horn estimates that they could manage $10 billion firm wide; current assets are at $5 billion across all portfolios and funds.. That decision has already cost him one large client who wanted Mr. Horn to increase capacity by managing larger cap portfolios.

About half of the global value fund’s current portfolio is in small- to mid-cap stocks and, he reports, “it’s a pretty small- to mid-cap world. Something like 80% of the world’s 39,000 publicly traded companies have market caps under $2 billion.” If this strategy reaches its full capacity, they’ll close it though they might subsequently launch a complementary strategy.

Active share

Polaris hasn’t calculated it. It’s apt to be high since, they report “only 51% of the stocks in PGVFX overlap with the benchmark” and the fund’s portfolio is equal-weighted while the index is cap-weighted.

Management’s stake in the fund

Mr. Horn has over $1 million in the fund and owns over 75% of the advisor. Mr. Horn reports that “All my money is invested in the funds that we run. I have no interest in losing my competitive advantage in alpha generation.” In addition, all of the employees of Polaris Capital are invested in the fund.

Opening date

July 31, 1989.

Minimum investment

$2,500, reduced to $2,000 for IRAs. That’s rather modest in comparison to the $75 million minimum for their separate accounts.

Expense ratio

0.99% on $399 million in assets, as of July 2023. The expense ratio was reduced at the end of 2013, in part to accommodate the needs of institutional investors. With the change, PGVFX has an expense ratio in the bottom third of its peer group.

Comments

There’s a lot to like about Polaris Global Value. I’ll list four particulars:

1. Polaris has had a great century. $10,000 invested in the fund on January 1, 2000 would have grown to $36,600 by the end of November 2014. Its average global stock peer was pathetic by comparison, growing $10,000 to just $16,700. Focus for a minute on the amount added to that initial investment: Polaris added $26,600 to your wealth while the average fund would have added $6,700. That’s a 4:1 difference.
2. It’s doggedly independent. Its median market cap – $8 billion – is about one-fifth of its peers’. The stocks in its portfolio are all about equally weighted while its peers are much closer to being cap weighted. It has substantially less in Asia and the US (50%) than its peers (70%), offset by a far higher weighting in Europe. Likewise its sector weightings are comparable to its peers in only two of 11 sectors. All of that translates to returns unrelated to its peers: in 1998 it lost 9% while its peers made 24% but it made money in both 2001 and 2002 while its peers lost a third of their money.
3. It’s driven by alpha, not assets. The marketing for Polaris is modest, the fund is small, and the managers have been content having most of their assets reside in their various sub-advised funds.
4. It’s tax efficient. Through careful management, the fund hasn’t had a capital gains payout in years; nothing since 2008 at least and Mr. Horn reports a continuing tax loss carry forward to offset still more gains.

The one fly in the ointment was the fund’s performance in the 2007-09 market meltdown. To be blunt, it was horrendous. Between October 2007 and March 2009, Polaris transformed a $10,000 account into a $3,600 account which explains the fund’s excellent tax efficiency in recent years. The drop was so severe that it wiped out all of the gains made in the preceding seven years.

Here’s the visual representation of the fund’s progress since inception.

Okay, if that one six quarter period didn’t exist, Polaris would be about the world’s finest fund and Mr. Horn wouldn’t have any explaining to do.

Sadly, that tumble off a cliff does exist and we called Mr. Horn to talk about what happened then and what he’s done about it. Here’s the short version:

“2008 was a bit of an unusual year. The strangest thing is that we had the same kinds of companies we had in the dot.com bubble and were similarly overweight in industrials, materials and banks. The Lehman bankruptcy scared everyone out of the market, you’ll recall that even money market funds froze up, and the panic hit worst in financials and industrials with their high capital demands.”

Like Dodge & Cox, Polaris was buying when prices were at their low point in a generation, only to watch them fall to a three generation low. Their research screens “exploded with values – over a couple thousand stocks passed our initial screens.” Their faith was rewarded with 62% gains over the following two years.

The experience led Mr. Horn and his team to increase the rigor of their screening. They had, for example, been modeling what would happen to a stock if a firm’s growth flat lined. “Our screens are pretty pessimistic; they’re designed to offer very, very conservative financial models of these companies” but 2008 sort of blindsided them. Now they’re modeling ten and twenty percent declines as a sort of stress test. They found about five portfolio companies that failed those tests and which they “kinda got rid of, though they bounced back quite nicely afterward.” In addition they’ve taken the unconventional step of hiring private investigators (“a bunch of former FBI guys”) to help with their due diligence on corporate management, especially when it comes to non-U.S. firms.

He believes that the “soul-searching after 2008” and a bunch of changes in their qualitative approach, in particular greater vigilance for the sorts of low visibility risks occasioned by highly-interconnected markets, has allowed them to fundamentally strengthen their risk management.

As he looks ahead, two factors are shaping his thinking about the portfolio: deflation and China.

On deflation: “We think the developed world is truly in a period of deflation. One thing we learned in investing in Japan for the past 5 plus years, we were able to find companies that were able to raise their operating revenue and free cash flows during what most central bankers would consider the scourge of the economic Earth.” He expects very few industries to be able to raise prices in real terms, so the team is focusing on identifying deflation beating companies. The shared characteristic of those firms is that they’re able to – or they help make it possible for other firms – to lower operating costs by more than the amount revenues will fall. “If you can offer a company product that saves them money – only salvation is lowering cost more dramatically than top line is sinking – you will sell lots.”

On China: “There’s a potential problem in China; we saw lots of half completed buildings with no activity at all, no supplies being delivered, no workers – and we had to ask, why? There are many very, very smart people who are aware of the situation but claim that we’re more worried than we need to be. On whole, Chinese firms seem more sanguine. But no one offers good answers to our concerns.” Mr. Horn thinks that China, along with the U.S. and Japan, are the world’s most attractive markets right now. Still he sees them as a potential source of a black swan event, perhaps arising from the unintended consequences of corruption crackdowns, the government ownership of the entire banking sector or their record gold purchases as they move to make their currency fully convertible on the world market. He’s actively looking for ways to guard against potential surprises from that direction.

Bottom Line

There’s a Latin phrase often misascribed to the 87-year-old titan, Michelangelo: Ancora imparo. It’s reputedly the humble admission by one of history’s greatest intellects that “I am still learning.” After an hour-long conversation with Mr. Horn, that very phrase came to mind. He has a remarkably probing, restless, wide-ranging intellect. He’s thinking about important challenges and articulating awfully sensible responses. The mess in 2008 left him neither dismissive nor defensive. He described and diagnosed the problem in clear, sharp terms and took responsibility (“shame on us”) for not getting ahead of it. He seems to have vigorously pursued strategies that make his portfolio better positioned. It was a conversation that inspired our confidence and it’s a fund that warrants your attention.

Fund website

Polaris Global Value

Fact Sheet

FPA Paramount Fund was reorganized as Phaeacian Global Value Fund.

Objective and Strategy

The FPA Global Value Strategy will seek to provide above-average capital appreciation over the long term while attempting to minimize the risk of capital losses by investing in well-run, financially robust, high-quality businesses around the world, in both developed and emerging markets. The portfolio holds between 25-50 stocks, 33 at present. As of October 2014, the fund’s cash stake was 16.7%.

Adviser

FPA, formerly First Pacific Advisors, which is located in Los Angeles. The firm is entirely owned by its management which, in a singularly cool move, bought FPA from its parent company in 2006 and became independent for the first time in its 50 year history. The firm has 28 investment professionals and 72 employees in total. Currently, FPA manages about $33 billion across five equity strategies and one fixed income strategy. Each strategy is manifested in a mutual fund and in separately managed accounts; for example, the Contrarian Value strategy is manifested in FPA Crescent (FPACX), in nine separate accounts and a half dozen hedge funds. On April 1, 2013, all FPA funds became no-loads.

Managers

Pierre O. Py and Greg Herr. Mr. Py joined FPA in September 2011. Prior to that, he was an International Research Analyst for Harris Associates, adviser to the Oakmark funds, from 2004 to 2010. Mr. Py has managed FPA International Value (FPIVX) since launch. Mr. Herr joined the firm in 2007, after stints at Vontobel Asset Management, Sanford Bernstein and Bankers Trust. He received a BA in Art History at Colgate University. Mr. Herr co-manages FPA Perennial (FPPFX) and the closed-end Source Capital (SOR) funds with the team that used to co-manage FPA Paramount. Py and Herr will be supported by the two research analysts, Jason Dempsey and Victor Liu, who also contribute to FPIVX.

Strategy capacity and closure

Undetermined.

Active share

99.6. “Active share” measures the degree to which a fund’s portfolio differs from the holdings of its benchmark portfolio. High active share indicates management which is providing a portfolio that is substantially different from, and independent of, the index. An active share of zero indicates perfect overlap with the index, 100 indicates perfect independence. The active share for Paramount is 99.6 measured against an MSCI all-world index, which reflects extreme independence.

Management’s Stake in the Fund

At December 31, 2013, by Mr. Herr was between $100,001 and $250,000, and by Mr. Py was still $0 after two years as manager. Mr. Py did have a very large investment in his other charge, FPA International Value. Three of the five independent trustees had between $10,000 and $50,000 invested in the fund, a fourth trustee had over $100,000 and the final trustee was relatively new to the organization and had no investment in the fund.

Opening date

September 8, 1958.

Minimum investment

$1,500, reduced to $100 for IRAs or accounts with automatic investing plans.

Expense ratio

1.26% on $304 million in assets, as of October, 2014. That is 32 basis points higher than it was a year earlier. Mr. Herr explained that the fund’s board of trustees and shareholders approved a higher management fee; global funds typically charge more than domestic ones in recognition of the fact that such portfolios are costlier to assemble and maintain. The fund remains less expensive than its peers.

Comments

Until September 2013, FPA Paramount and FPA Perennial (FPPFX) were essentially clones of one another. High quality clones, but clones nonetheless. FPA has decided to change that. Beginning in 2011, they began to transition-in a new management team by adding Messrs Herr and Py to the long-tenured team of Stephen Geist and Eric Ende. In September 2013, Messrs Geist and Ende focused all of their efforts on Perennial while Herr and Py have sole charge of Paramount.

That same month, the fund shifted its principal investment strategies to more closely mirror the approach taken in FPA International Value (FPIVX). Ende and Geist stayed fully invested in high-quality domestic small and mid-cap stocks. Herr and Py pursued a global, absolute value strategy. That shift shows up in three ways:

1. The market cap has climbed. Paramount’s market cap is about four times higher than it was a year ago.
2. The global exposure has climbed. They’ve shifted from about 10% non-US to about 50%.
3. The cash stash has climbed. Ende and Geist generally held frictional cash, 3-4% or so. Herr and Py have nearly 17%. At base, an absolute value discipline holds that you should not put money into risky assets unless you’re being more than compensated for those risks. If valuations are high, future returns are iffy and the party’s roaring on, absolute value investors hold cash and wait.

Sadly, the performance has not climbed. Between the date of the strategy transition and October 30, 2014, a $10,000 investment in Paramount would have grown to $10,035. The average global stock fund would have provided $11,670. The fund had been modestly trailing its peers until the 3^rd quarter of 2014, when it dropped 9% compared to a modest 3.3% loss for its peers.

Manager Greg Herr and I talked about the fund’s performance in late October, 2014. He attributed the fund’s modest lag through the beginning of July to three factors:

1. A small drag from unhedged foreign currency exposure, primarily the euro and pound.
2. A more substantial drag from the fund’s largest cash stake.
3. The inevitable lag of a value-oriented portfolio in a growth-oriented period.

The more substantial lag from July to the present seems largely driven by the fund’s hidden emerging markets exposure, and particularly exposure to the EM consumer. The fund added five new positions in the second quarter of 2014 (Adidas, ALS Limited, Hypermarcas SA, Prada TNT Express) which have significant EM exposure. Adidas, for example, is the world’s largest provider of golf equipment and supplies; it has consciously expanded into the emerging markets, including adding 850 outlets in Russia. Oops. Prada is the brand of choice for Chinese consumers looking to express their appreciation to local elected officials, a category that’s been dampened by an anti-corruption initiative. Hypermarcas is a Brazilian retailer selling global brands (Johnson & Johnson products, for example) into a market destabilized by economic and political uncertainty ahead of recent presidential elections.

The largest hit came from their stake in Fugro, a Dutch oil services company that does a lot of the geoscience stuff for exploration and production companies. The stock dropped 40% in July on profit warnings, driven by a combination of a deterioration in the oil & gas exploration business and in some “company-specific issues.” David Herro, who managers Oakmark International and who also owns a lot of Fugro, remains “a firm shareholder” because he thinks Fugro has great potential.

Herr and Py agree. They continue to monitor their holdings, but believe that the portfolio is now deeply undervalued which means it’s also positioned to produce abnormally high returns. They’ve continued adding to some of these positions as the value deepened. In addition, the market instability in the third quarter is beginning to drive the price of some strong businesses – perhaps five or six are “near the door” – low enough to provide potential near-term uses for the fund’s large cash reserve.

Bottom Line

It’s hard being independent and this is a very independent fund. When a member of the investment herd is out-of-step with the rest of the herd, it’s likely to be only marginally and almost invisible so. It remains safely masked by mediocrity. When a highly independent fund is out-of-step, it’s really visible and can cause considerable shareholder anxiety. That said, the question is whether you’re better served by understanding and reacting to the distinctive tactics of an absolute value portfolio or by reacting to a single striking quarter. The latter is certainly the common response, which almost surely means it’s the wrong one. That said, FPA’s recent and substantial fee increase has raised the bar for Paramount’s managers and have disadvantaged its shareholders. The fund is intriguing but the business decision is regrettable.

Fund website

FPA Paramount Fund

At the time of publication, this fund was named Matthews Asia Strategic Income.

We’ve published several profiles of MAINX.  for background, our February 2013 profile is here.

*Matthews Asia liquidated their two fixed-income funds in March, 2023. In consequence, the information for Marathon Value should be read for archival purposes only.*

Objective and Strategy

MAINX seeks total return over the long term with an emphasis on income. The fund invests in income-producing securities including, but not limited to, debt and debt-related instruments issued by government, quasi-governmental and corporate bonds, dividend-paying stocks and convertible securities (a sort of stock/bond hybrid). The fund may hedge its currency exposure, but does not intend to do so routinely. In general, at least half of the portfolio will be in investment-grade bonds. Equities, both common stocks and convertibles, will not exceed 20% of the portfolio.

Adviser

Matthews International Capital Management. Matthews was founded in 1991 and advises the 15 Matthews Asia funds. As of July 31, 2014, Matthews had $27.3 billion in assets under management. On whole, the Matthews Asia funds offer below average expenses. They also publish an interesting and well-written newsletter on Asian investing, Asia Insight.

Manager(s)

Teresa Kong is the lead manager. Before joining Matthews in 2010, she was Head of Emerging Market Investments at Barclays Global Investors (now BlackRock) and responsible for managing the firm’s investment strategies in Emerging Asia, Eastern Europe, Africa and Latin America. In addition to founding the Fixed Income Emerging Markets Group at BlackRock, she was also Senior Portfolio Manager and Credit Strategist on the Fixed Income credit team. She’s also served as an analyst for Oppenheimer Funds and JP Morgan Securities, where she worked in the Structured Products Group and Latin America Capital Markets Group. Kong has two co-managers, Gerald Hwang and Satya Patel. Mr. Hwang for three years managed foreign exchange and fixed income assets for some of Vanguard’s exchange-traded funds and mutual funds before joining Matthews in 2011. Mr. Patel worked more in the hedge fund and private investments universe.

Strategy capacity and closure

“We are,” Ms. Kong notes, “a long way from needing to worry about that.” She notes that Matthews has a long record of moving to close their funds when asset flows and market conditions begin to concern the manager. Both the $8 billion Pacific Tiger (MAPTX) and $5.4 billion Asia Dividend (MAPIX) funds are currently closed.

Management’s Stake in the Fund

As of the April 2014 Statement of Additional Information, Ms. Kong had between $100,000 and 500,000 invested in the fund, as well as substantial investments in seven other Matthews funds.  There’s no investment listed for her co-managers. In addition, two of the fund’s five trustees have invested in it: Geoffrey Bobroff has between $10,000 – 50,000 and Mr. Matthews has over $100,000.

Opening date

November 30, 2011.

Minimum investment

$2500 for regular accounts, $500 for IRAs for the retail shares. The fund’s available, NTF, through most major supermarkets.

Expense ratio

1.10%, after waivers, on $66 million in assets (as of August, 2014). There’s also a 2% redemption fee for shares held fewer than 90 days. The Institutional share class (MINCX) charges 0.90% and has a $3 million minimum.

Comments

If I spoke French, I’d probably shrug eloquently, gesture broadly with an impish Beaujolais and declare “plus ça change, plus c’est la même chose.” (Credit Jean-Baptiste Alphonse Karr, 1849.)

After four conversations with Teresa Kong, spread out over three years, it’s clear that three fundamental things remain unchanged:

1. Asia remains a powerful and underutilized source of income for many investors. The fundamentals of their fixed-income market are stronger than those in Europe or the U.S. and most investors are systematically underexposed to the Asian market. That underexposure is driven by a quirk of the indexes and of all of the advisors who benchmark against them. Fixed income indexes are generally debt-weighted, that is, they give the greatest weight to the most heavily indebted issuers. Since few of those issuers are domiciled in Asia, most investors have very light exposure to a very dynamic region.
2. Matthews remains the firm best positioned to help manage your exposure there. The firm has the broadest array of funds, longest history and deepest analyst core dedicated to Asia of any firm in the industry.
3. MAINX remains a splendid tool for gaining that exposure. MAINX has the ability to invest across a wide array of income-producing securities, including corporate (61% of the portfolio, as of August 2014) and government (22%) bonds, convertibles (9%), equities (5%) and other assets. It has the freedom to hedge its currency exposure and to change duration in response to interest rate shifts. The fund’s risk and return profile maximum drawdown continues to track the firm’s expectations which is good given the number of developments which they couldn’t have plausibly predicted before launch. Ms. Kong reports that “the maximum drawdown over one- and three- months was -4.41% and -5.84%, which occurred in June and May-July 2013, respectively. This occurred during the taper tantrum and is fully in-line with our back-tests. From inception to July 2014, the strategy has produced an annualized return of 6.63% and a Sharpe ratio of 1.12 since inception, fully consistent with our long-term return and volatility expectations.”

The fund lacks a really meaningful Morningstar peer group and has few competitors. That said, it has substantially outperformed its World Bond peer group (the orange line), Aberdeen Asian Bond (AEEAX, yellow) and Wisdom Tree Asia Local Debt ETF (ALD, green).

In our August 2014 conversation, Ms. Kong made three other points which are relevant for folks considering their options.

1. the US is being irreversibly marginalized in global financial markets which is what you should be paying attention to. She’s neither bemoaning nor celebrating this observation, she’s just making it. At base, a number of conditions led to the US dollar becoming the world’s hegemonic currency which was reinforced by the Saudi’s decision in the early 1970s to price oil only in US dollars and to US investment flows driving global liquidity. Those conditions are changing but the changes don’t seem to warrant the attention of editors and headline writers because they are so slow and constant. Among the changes is the rise of the renminbi, now the world’s #2 currency ahead of the euro, as a transaction currency, the creation of alternative structures to the IMF which are not dollar-linked or US driven and a frustration with the US regulatory system (highlighted by the $9B fine against BNP Paribas) that’s leading international investors to create bilateral agreements that allow them to entirely skirt us. The end result is that the dollar is likely to be a major currency and perhaps even the dominant currency, but investors will increasingly have the option of working outside of the US-dominated system.
2. the rising number of “non-rated” bonds is not a reflection on credit quality: the simple fact is that Asian corporations don’t need American money to have their bond offerings fully covered and they certainly don’t need to expense and hassle of US registration, regulation and paying for (compromised) US bond rating firms to rate them. In lieu of US bond ratings, there are Asia bond-rating firms (whose work is not reflecting in Morningstar credit reports) and Matthews does extensive internal research. The depth of the equity-side analyst corps is such that they’re able “to tear apart corporate financials” in a way that few US investors can match.
3. India is fundamentally more attractive than China, at least for a fixed-income investor. Most investors enthused about India focus on its new prime minister’s reform agenda. Ms. Kong argues that, by far, the more significant player is the head of India’s central bank, who has been in office for about a year. The governor is intent on reducing inflation and is much more willing to deploy the central bank’s assets to help stabilize markets. Right now corporate bonds in India yield about 10% – not “high yield” bond but bonds from blue chip firms – which reflects a huge risk premium. If inflation expectations change downward and inflation falls rather than rises, there’s a substantial interest rate gain to be harvested there. The Chinese currency, meanwhile, is apt to undergo a period of heightened volatility as it moves toward a free float; that is, an exchange rate set by markets rather than by Communist Party dictate. She believes that that volatility is not yet priced in to renminbi-denominated transactions. Her faith is such that the fund has its second greatest currency exposure to the rupee, behind only the dollar.

Bottom Line

MAINX offers rare and sensible access to an important, under-followed asset class. The long track record of Matthews Asia funds suggests that this is going to be a solid, risk-conscious and rewarding vehicle for gaining access to that class. The fund remains small though that will change. It will post a three-year record in November 2014 and earn a Morningstar rating by year’s end; the chart above hints at the possibility of a four- or five-star rating. Ms. Kong also believes that it’s going to take time for advisors get “more comfortable with Asia Fixed Income as an asset class. It took a decade or so for emerging markets to become more widely adopted and we expect that Asia fixed income will become more ubiquitous as investors gain comfort with Asia as a distinct asset class.” You might want to consider arriving ahead of the crowd. 

Disclosure: while the Observer has no financial or other ties to Matthews Asia or its funds, I do own shares of MAINX in my personal account and have recently added to them.

Fund website

Matthews Asia Strategic Income homepage and Factsheet. There’s a link to a very clear discussion of the fund’s genesis and strategy in a linked document, entitled Matthews Q&A.  It’s worth your time.

Objective

The fund seeks long-term capital appreciation by investing, mostly, in US stocks of various sizes and in “other equity-like instruments.”  The manager looks for companies with good management teams (those with “a history of treating public shareholders like partners”), little reliance on debt markets and above-average returns on equity. Once they find such companies, they wait until the stock sells at a discount to “a conservative estimate of the company’s intrinsic value.” The Fund is non-diversified, with both a compact portfolio (30 or so names) and a willingness to put a lot of money (often three or four times more than a “neutral weighting” would suggest) in a few sectors.

Adviser

Akre Capital Management, LLC, an independent Registered Investment Advisor located in Middleburg, VA. Mr. Akre, the founder of the firm, has been managing portfolios since 1986. As of June 30, 2014, ACM had approximately $3.8 billion in client assets under management, split between Akre Capital Management, which handles the firm’s separately managed accounts ($1 million minimum), a couple hedge funds, and Akre Focus Fund.  

Managers

John Neff and Chris Cerrone. 

Mr. Neff is a Partner at Akre Capital Management and has served as portfolio manager of the fund since August 2014, initially with founder Chuck Akre. Before joining Akre, he served for 10 years as an equity analyst at William Blair & Company. Mr. Cerrone is a Partner at Akre Capital Management and has served as portfolio manager of the fund since January 2020. Before that he served as an equity analyst for Goldman Sachs for two years.

Strategy capacity and closure

Mr. Akre allows that there “might be” a strategy limit. The problem, he reports, is that “Every time I answer that question, I’ve been proven to be incorrect.  In 1986, I was running my private partnership and, if you’d asked me then, I would have said ‘a couple hundred million, tops.’”  As is, he and his team are “consumed with producing outcomes that are above average.  If no opportunities to do that, we will close the fund.”

Active share

96. “Active share” measures the degree to which a fund’s portfolio differs from the holdings of its benchmark portfolio. High active share indicates management which is providing a portfolio that is substantially different from, and independent of, the index. An active share of zero indicates perfect overlap with the index, 100 indicates perfect independence. The active share for the Akre Focus Fund is 96, which reflects a very high level of independence from its benchmark S&P 500.

Management’s Stake in the Fund

Mr. Neff and Mr. Cerrone have each invested over $1 million of their own money in Akre Focus.

Opening date

August 31, 2009 though the FBR Focus fund, which Mr. Akre managed in the same style, launched on December 31, 1996.

Minimum investment

$2,000 for regular accounts, $1000 for IRAs and accounts set up with automatic investing plans. The fund also has an institutional share (AKRIX) class with a $250,000 minimum.

Expense ratio

1.3% on assets of about $4.2 billion, as of June 2023. There’s also a 1.00% redemption fee on shares held less than 30 days. The institutional share class on assets of about $7.2 billion has an expense ratio of 1.04% with the difference being the absence of a 12(b)1 fee. 

Comments

In 1997, Mr. Akre became of founding manager of FBR Small Cap Growth – Value fund, which became FBR Small Cap Value, then FBR Small Cap, and finally FBR Focus (FBRVX). Across the years and despite many names, he applied the same investment strategy that now drives Akre Focus. Here’s his description of the process:

1. We look for companies with a history of above average return on owner’s capital and, in our assessment, the ability to continue delivering above average returns going forward.

   Investors who want returns that are better than average need to invest in businesses that are better than average. This is the pond we seek to fish in.

2. We insist on investing only with firms whose management has demonstrated an acute focus on acting in the best interest of all shareholders.

   Managers must demonstrate expertise in managing the business through various economic conditions, and we evaluate what they do, say and write for demonstrations of integrity and acting in the interest of shareholders.

3. We strive to find businesses that, through the nature of the business or skill of the manager, present clear opportunities for reinvestment in the business that will deliver above average returns on those investments.

   Whether looking at competitors, suppliers, industry specialists or management, we assess the future prospects for business growth and seek out firms that have clear paths to continued success.

The final stage of our investment selection process is to apply a valuation overlay…

Mr. Akre’s discipline leads to four distinguishing characteristics of his fund’s portfolio:

1. It tends to have a lot of exposure to smaller cap stocks. His explanation of that bias is straightforward: “that’s where the growth is.”
2. It tends to make concentrated bets. He’s had as much as a third of the portfolio in just two industries (gaming and entertainment) and his sector weightings are dramatically different from those of his peers or the S&P500. 
3. It tends to stick with its investments. Having chosen carefully, Mr. Akre tends to wait patiently for an investment to pay off. In the past 15 years his turnover rate never exceeded 25% and is sometimes in the single digits.
4. It tends to have huge cash reserves when the market is making Mr. Akre queasy. From 2001 – 04, FBRVX’s portfolio averaged 33.5% cash – and crushed the competition. It was in the top 2% of its peer group in three of those four years and well above average in the fourth year. At the end of 2009, AKREX was 65% in cash. By the end of 2010, it was still over 20% in cash. 

It’s been a very long time since anyone seriously wondered whether investing with Mr. Akre was a good idea. As a quick snapshot, here’s his record (blue) versus the S&P500 (green) from 1996 – 2009:

And again from 2009 – 2014:

Same pattern: while the fund lags the market from time to time – for as long as 18-24 months on these charts – it beats the market by wide margins in the long term and does so with muted volatility. Over the past three to five years AKREX has, by Morningstar’s calculation, captured only about half of the market’s downside and 80-90% of its upside.

There are two questions going forward: does the firm have a plausible succession plan and can the strategy accommodate its steadily growing asset base? The answers appear to be: yes and so far.

Messrs. Saberhagen and Neff have been promoted from “analyst” to “manager,” which Mr. Akre says just recognizes the responsibilities they’d already been entrusted with. While they were hired as analysts, one from a deep value shop and one from a growth shop, “their role has evolved over the five years. We operate as a group. Each member of the group is valued for their contributions to idea generation, position sizing and so on.” There are, on whole, “very modest distinctions” between the roles played by the three team members. Saberhagen and Neff can, on their own initiative, change the weights of stocks in the portfolio, though adding a new name or closing out a position remains Mr. Akre’s call. He describes himself as “first among equals” and spends a fair amount of his time trying to “minimize the distractions for the others” so they can focus on portfolio management. 

The continued success of his former fund, now called Hennessy Focus (HFCSX) and still managed by guys he trained, adds to the confidence one might have in the ultimate success of a post-Akre fund.

The stickier issue might be the fund’s considerable girth. Mr. Akre started as a small cap manager and much of his historic success was driven by his ability to ferret out excellent small cap growth names. A $3.3 billion portfolio concentrated in 30 names simply can’t afford to look at small cap names. He agrees that “at our size, small businesses can’t have a big impact.” Currently only about 3% of the portfolio is invested in four small cap stocks that he bought two to three years ago. 

Mr. Akre was, in our conversation, both slightly nostalgic and utterly pragmatic. He recalled cases where he made killings on an undervalued subprime lender or American Tower when it was selling for under $1 a share. It’s now trading near $100. But, “those can’t move the needle and so we’re finding mid and mid-to-large cap names that meet our criteria.” The portfolio is almost evenly split between mid-cap and large cap stocks and sits just at the border between a mid-cap and large cap designation in Morningstar’s system. So far, that’s working.

Bottom Line

This has been a remarkable fund, providing investors with a very reliable “win by not losing” machine that’s been compounding returns for decades. Mr. Akre remains in control and excited and is backed by a strong next generation of leadership. In an increasingly pricey market, it certainly warrants a sensible equity investor’s close attention.

Fund website

Akre Focus Fund

Objective and strategy

The fund seeks long term capital growth through investing in what they deem to be 30 of the world’s most innovative companies. They take an eclectic approach to identifying global innovators. They read widely (for example Fast Company and MIT’s Technology Review, as well as reports from the Boston Consulting Group and Thomson Reuters) and maintain ongoing conversations with folks in a variety of industries. At base, though, the list of truly innovative firms seems finite and relatively stable. Having identified a potential addition to the portfolio, they also have to convince themselves that it has more upside than anyone currently in the portfolio (since there’s a one-in-one-out discipline) and that it’s selling at a substantial discount to fair value (typically about one standard deviation below its 10 year average). They rebalance about quarterly to maintain roughly equally weighted positions in all thirty, but the rebalance is not purely mechanical. They try to keep the weights “reasonably in line” but are aware of the importance of minimizing trading costs and tax burdens. The fund stays fully invested.

Adviser

Guinness Atkinson Asset Management. The firm started in 1993 as the US arm of Guinness Flight Global Asset Management and their first American funds were Guinness Flight China and Hong Kong (1994) and Asia Focus(1996). Guinness Flight was acquired by Investec, then Tim Guinness and Jim Atkinson acquired Investec’s US funds business to form Guinness Atkinson. Their London-based sister company is Guinness Asset Management which runs European funds that parallel the U.S. ones. The U.S. operation has about $460 million in assets under management and advises the eight GA funds.

Manager

Matthew Page and Ian Mortimer. Mr. Page joined GA in 2005 after working for Goldman Sachs. He earned an M.A. from Oxford in 2004. Dr. Mortimer joined GA in 2006 and also co-manages the Global Innovators (IWIRX) fund. Prior to joining GA, he completed a doctorate in experimental physics at the University of Oxford. The guys also co-manage the Inflation-Managed Dividend Fund (GAINX) and its Dublin-based doppelganger Guinness Global Equity Income Fund.

Strategy capacity and closure

Approximately $1-2 billion. After years of running a $50 million portfolio, the managers admit that they haven’t had much occasion to consider how much money is too much or when they’ll start turning away investors. The current estimate of strategy capacity was generated by a simple calculation: 30 times the amount they might legally and prudently own of the smallest stock in their universe.

Active share

96. “Active share” measures the degree to which a fund’s portfolio differs from the holdings of its benchmark portfolio. High active share indicates management which is providing a portfolio that is substantially different from, and independent of, the index. An active share of zero indicates perfect overlap with the index, 100 indicates perfect independence. The active share for Global Innovators is 96, which reflects a very high level of independence from its benchmark MSCI World Index.

Management’s stake in the fund

The managers are not invested in the fund because it’s only open to U.S. residents.

Opening date

Good question! The fund launched as the Wired 40 Index on December 15, 1998. It performed splendidly. It became the actively managed Global Innovators Fund on April 1, 2003 under the direction of Edmund Harriss and Tim Guinness. It performed splendidly. The current team came onboard in May 2010 (Page) and May 2011 (Mortimer) and tweaked the process, after which it again performed splendidly.

Minimum investment

$5,000, reduced to $1,000 for IRAs and just $250 for accounts established with an automatic investment plan.

Expense ratio

1.45% on assets of about $100 million, as of August 1, 2014. The fund has been drawing about $500,000/day in new investments this year.  

Comments

Let’s start with the obvious and work backward from there.

The obvious: Global Innovators has outstanding (consistently outstanding, enduringly outstanding) returns. The hallmark is Lipper’s recognition of the fund’s rank within its Global Large Cap Growth group:

Morningstar, using a different peer group, places it in the top 1 – 6% of US Large Blend funds for the past 1, 3, 5 and 10 year periods (as of 07/31/14). Over the past decade, a $10,000 initial investment would have tripled in value here while merely doubling in value in its average peer.

But why?

Good academic research, stretching back more than a decade, shows that firms with a strong commitment to ongoing innovation outperform the market. Firms with a minimal commitment to innovation trail the market, at least over longer periods. 

The challenge is finding such firms and resisting the temptation to overpay for them. The fund initially (1998-2003) tracked an index of 40 stocks chosen by the editors of Wired magazine “to mirror the arc of the new economy as it emerges from the heart of the late industrial age.” In 2003, Guinness concluded that a more focused portfolio and more active selection process would do better, and they were right. In 2010, the new team inherited the fund. They maintained its historic philosophy and construction but broadened its investable universe. Ten years ago there were only about 80 stocks that qualified for consideration; today it’s closer to 350 than their “slightly more robust identification process” has them track. 

This is not a collection of “story stocks.” The managers note that whenever they travel to meet potential US investors, the first thing they hear is “Oh, you’re going to buy Facebook and Twitter.” (That would be “no” to both.) They look for firms that are continually reinventing themselves and looking for better ways to address the opportunities and challenges in their industry. While that might describe eBay, it might also describe a major petroleum firm (BP) or a firm that supplies backup power to data centers (Schneider Electric). The key is to find firms which will produce disproportionately high returns on invested capital in the decade ahead, not stocks that everyone is talking about.

Then they need to avoid overpaying for them. The managers note that many of their potential acquisitions sell at “extortionate valuations.” Their strategy is to wait the required 12 – 36 months until they finally disappoint the crowd’s manic expectations. There’s a stampede for the door, the stocks overshoot – sometimes dramatically – on the downside and the guys move in.

Their purchases are conditioned by two criteria. First, they look for valuations at least one standard deviation below a firm’s ten year average (which is to say, they wait for a margin of safety). Second, they maintain a one-in-one-out discipline. For any firm to enter the portfolio, they have to be willing to entirely eliminate their position in another stock. They turn the portfolio over about once every three years. They continue tracking the stocks they sell since they remain potential re-entrants to the portfolio. They note that “The switches to the portfolio over the past 3.5 – 4 years have, on average, done well. The additions have outperformed the dropped stocks, on a sales basis, by about 25% per stock.”

Bottom Line

While we need to mechanically and truthfully repeat the “past performance is not indicative of future results” mantra, Global Innovator’s premise and record might give us some pause. Its strategy is grounded in a serious and sustained line of academic research. Its discipline is pursued by few others. Its results have been consistent across 15 years and three sets of managers. For investors willing to tolerate the slightly-elevated volatility of a fully invested, modestly pricey equity portfolio, Global Innovators really does command careful attention.

Fund website

GA Global Innovators Fund. While you’re there, please do read the Innovation Matters (2014) whitepaper. It’s short, clear and does a nice job of walking you through both the academic research and the managers’ approach.

Objective and strategy

The fund tries to provide total return, rather than just income. The strategy is to divide the portfolio between two distinctive strategies. Oaktree Capital Management pursues a “barbell-shaped” strategy consisting of senior bank loans and high-yield debt. RiverNorth Capital Management pursues an opportunistic closed-end fund (CEF) strategy in which they buy income-producing CEFs when those funds are (1) in an attractive sector and (2) are selling at what the manager’s research estimates to be an unsustainable discount to NAV. In theory, the entire portfolio might be allocated to any one of the three strategies; in practice, RiverNorth anticipates a “neutral position” in which 25 – 33% of the portfolio is invested in CEFs.

Adviser

RiverNorth Capital Management. RiverNorth is a Chicago-based firm, founded in 2000 with a distinctive focus on closed-end fund arbitrage. They have since expanded their competence into other “under-followed, niche markets where the potential to exploit inefficiencies is greatest.” RiverNorth advises the five RiverNorth funds: Core (RNCOX, closed), Managed Volatility (RNBWX), Equity Opportunity (RNEOX), RiverNorth/DoubleLine Strategic Income (RNDLX) and this one. They manage about $1.9 billion through limited partnerships, mutual funds and employee benefit plans.

Manager

Patrick Galley and Stephen O’Neill of RiverNorth plus Desmund Shirazi, Sheldon M. Stone and Shannon Ward of Oaktree. Mr. Galley is RiverNorth’s founder, president and chief investment officer; Mr. O’Neill is the chief trader, a remarkably important position in a firm that makes arbitrage gains from trading on CEF discounts. Mr. Shirazi is one of Oaktree’s senior loan portfolio managers, former head of high-yield research and long-ago manager of TCW High Yield Bond. Ms. Ward, who joined this management team just a year ago, was a vice president for high-yield investments at AIG back when they were still identified with The Force. The RiverNorth portion of the team manages about $2 billion in assets. The Oaktree folks between them manage about $200 million in mutual fund assets and $25 billion in private accounts and funds.

Strategy capacity and closure

In the range of $1 billion, a number that the principals agree is pretty squishy. The major capacity limiter is the fund’s CEF strategy. When investors are complacent, CEF discounts shrink which leaves RiverNorth with few opportunities to add arbitrage gains. The managers believe, though, that two factors will help keep the strategy limit high. First, “fear is here to stay,” so investor irrationality will help create lots of mispricing. Second, on March 18 2014, RiverNorth received 12(d)1 exemptive relief from the SEC. That exemption allows the firm to own more than 3% of a CEF’s outstanding shares, which then expands the amount they might profitably invest.

Management’s stake in the fund

The RiverNorth Statement of Additional Information is slightly screwed-up on this point. It lists Mr. Galley as having either $0 (page 33) or “more than $100,000” (page 38). The former is incorrect and the latter doesn’t comply with the standard reporting requirement where the management stake is expressed in bands ($100,000-500,000, $500,000 – $1 million, over $1 million). Mr. O’Neill has between $10,000 and $50,000 in the fund. The Oaktree managers and, if the SAI is correct, the fund’s directors have no investment in the fund.

Opening date

December 28, 2012

Minimum investment

$5,000, reduced to $1,000 for IRAs.

Expense ratio

1.44% for “I” class shares and 1.69% for “R” class shares on assets of $54.9 million, as of July 2023. 

Comments

In good times, markets are reasonably rational. In bad times, they’re bat-poop crazy. The folks are RiverNorth and Oaktree understand you need income regardless of the market’s mood, and so they’ve attempted to create a portfolio which operates well in each. We’ll talk about the strategies and then the managers.

What are these people up to?

The managers will invest in a variable mix of senior loans, high yield bonds and closed-end funds.

High yield bonds are a reasonably well understood asset class. Firms with shaky credit have to pay up to get access to capital. Structurally they’re like other bonds (that is, they suffer in rising rate environments) but much of their attraction arises from the relatively high returns an investor can earn on them. As investors become more optimistic about the economy, the premium they demand from lower-credit firms rises; as their view darkens, the amount of premium they demand rises. Over the past decade, high yield bonds have earned 8.4% annually versus 7.4% for large cap stocks and 6.5% for investment–grade corporate bonds. Sadly, investors crazed for yield have flooded into high-yield bonds, driving up their prices and driving their yield down to 5.4% in late May.

Senior loans represent a $500 billion asset class, which is about the size of the high-yield bond market. They represent loans made to the same sorts of companies which issue high-yield bonds. While the individual loans are private, collections of loans can be bundled together and sold to investors (a process called “securitizing the loans”). These loans have two particularly attractive structural features: they have built-in protection against loss of principal because they’re “senior” in the firm’s capital structure, which means that there’s collateral behind them and their owners would receive preferential treatment in the case of a bankruptcy. Second, they have built-in protection against loss of interest because they’re floating rate loans; as interest rates rise, so does the amount paid to the loan’s owner. These loans have posted positive returns in 15 of the past 16 years (2008 excepted).

In general, these loans yield a lot more than conventional investment grade bonds and operate with a near-zero correlation to the broad bond market.

Higher income. Protection against loss of capital. Protection against rising rates. High diversification value. Got it?

Closed-end funds share characteristics of traditional mutual funds and of other exchange-traded securities, like stocks and ETFs. Like mutual funds, they represent pools of professionally managed securities. The amount that one share of a mutual fund is worth is determined solely by the value of the securities in its portfolio. Like stocks and ETFs, CEFs trade on exchanges throughout the day. The amount one share of a CEF is worth is not the value of the securities in its portfolio; it’s whatever someone is willing to pay you for the share at any particular moment in time. Your CEF share might be backed by $100 in stocks but if you need to sell it today and the most anyone will offer is $70, then that share is worth $70. The first value ($100) is called the CEF’s net asset value (NAV) price, the second ($70) is called its market price. Individual CEFs have trading histories that show consistent patterns of discounts (or premiums). A particular fund might always have a market price that’s 3% below its NAV price. If that fund is sudden available at a 30% discount, an investor might buy a share that’s backed by $100 in securities for $70 and sell it for $97 when panic abates. Even if the market declined 10% in the interim, the investor could still sell a share purchased as $70 for $87 (a 10% NAV decline and a 3% discount) when rationality returns. As a result, you might pocket gains both from picking a good investment and from arbitrage as the irrational discount narrows; that arbitrage gain is independent of the general direction of the market.

RiverNorth/Oaktree High Income combines these three high-income strategies: an interest-rate insensitive loan strategy and a rate-sensitive high-yield one plus an opportunistic market-independent CEF arbitrage strategy.

Who are these guys, and why should we trust them?

Oaktree Capital Management was founded in April 1995 by former TCW professionals. They specialize in specialized credit investing: high yield bonds, convertible securities, distressed debt, real estate and control investments (that is, buying entire firms). They manage about $80 billion for clients on five continents. Among their clients are 100 of the 300 largest global pension plans, 75 of the 100 largest U.S. pension plans, 300 endowments and foundations, 11 sovereign wealth funds and 38 state retirement plans in the United States. Oaktree is widely recognized as an extraordinarily high-quality firm with a high-quality investment discipline.

To be clear: these are not the sorts of clients who tolerate carelessness, unwarranted risk taking or inconsistent performance.

RiverNorth Capital Management pursues strategies in what they consider to be niche markets where inefficiencies abound. They’re the country’s pre-eminent practitioner of closed-end fund arbitrage. That’s most visible in the (closed) RiverNorth Core Opportunity Fund (RNCOX), which has $700 million in assets and five-year returns in the top 13% of all moderate allocation funds. A $10,000 investment made in RNCOX at inception would be worth $19,000 by May 2014 while its average competitor would have returned $14,200.

Their plan is to grow your money steadily and carefully.

Patrick Galley describes this as “a risk-managed, high-yield portfolio” that’s been “constructed to maximize risk-adjusted returns over time, rather than shooting for pure short-term returns.” He argues that this is, in his mind, the central characteristic of a good institutional portfolio: it relies on time and discipline to steadily compound returns, rather than luck and boldness which might cause eye-catching short term returns. As a result, their intention is “wealth preservation: hit plenty of singles and doubles, rely on steady compounding, don’t screw up and get comfortable with the fact that you’re not going to look like a hero in any one year.”

Part of “not screwing up” requires recognizing and responding to the fact that the fund is investing in risky sectors. The managers have the tactical freedom to change the allocation between the three sleeves, depending on evolving market conditions. In the fourth quarter of 2013, for example, the managers observed wide discounts in CEFs and had healthy new capital flows, so they quickly increased CEF allocation to over 40% from a 25-33% neutral position. They’re now harvesting gains, and the CEF allocation is back under 30%.

So far, they’ve quietly done exactly what they planned. The fund is yielding 4.6% over the past twelve months. It has outperformed its multi-sector bond benchmark every quarter so far. Below you can see the comparison of RNOTX (in blue) and its average peer (in orange) from inception through late May 2014.

Bottom Line

RNOTX is trying to be the most sensible take possible on investing in promising, risky assets. It combines two sets of extremely distinguished investors who understand the demands of conservative shareholders with an ongoing commitment to use opportunism in the service of careful compounding. While this is not a low-risk fund, it is both risk-managed and well worth the attention of folks who might otherwise lock themselves into a single set of high-yield assets.

Fund website

RiverNorth/Oaktree High Income. Interested in becoming a better investor while you’re browsing the web? You really owe it to yourself to read some of Howard Marks’ memos to Oaktree’s investors. They’re about as good as Buffett and Munger, but far less known by folks in the mutual fund world.

Fact Sheet

At the time of publication, this fund was named Huber Equity Income.
This fund was formerly named Huber Capital Equity Income.

Objective and strategy

The Fund is pursuing both current income and capital appreciation. They typically invest in 40 of the 1000 largest domestic large cap stocks. It normally invests in stocks with high cash dividends or payout yields relative to the market but can buy non-payers if they have growth potential unrecognized by the market or have undergone changes in business or management that indicate growth potential.

Adviser

Huber Capital Management, LLC, of Los Angeles. Huber has provided investment advisory services to individual and institutional accounts since 2007. The firm has about $4 billion in assets under management, including $450 million in its three mutual funds.

Manager

Joseph Huber. Mr. Huber was a portfolio manager in charge of security selection and Director of Research for Hotchkis and Wiley Capital Management from October 2001 through March 2007, where he helped oversee over $35 billion in U.S. value asset portfolios. He managed, or assisted with, a variety of successful funds across a range of market caps. He is assisted by seven other investment professionals.

Strategy capacity and closure

Approximately $10 billion. That’s based on their desire to allow each position to occupy about 2% of the fund’s portfolio while not owning a controlling position in any of their stocks. Currently they manage about $1.5 billion in their Select Large Value strategy.

Active share

Not calculated. “Active share” measures the degree to which a fund’s portfolio differs from the holdings of its benchmark portfolio. High active share indicates management which is providing a portfolio that is substantially different from, and independent of, the index. An active share of zero indicates perfect overlap with the index, 100 indicates perfect independence. Mr. Huber, independently enough, dismisses it as “This year’s new risk-control nomenclature. Next year it’ll be something else.” 

Management’s stake in the fund

Mr. Huber has over $1 million invested in each of his three funds. His analysts are all on track to become partners and equity owners of the advisor.

Opening date

June 29, 2007

Minimum investment

$5,000 for regular accounts and $2,500 for retirement accounts.

Expense ratio

1.39% on $85 million in assets, as of July 2023. 

Comments

There’s no question that it works.

None at all.

Morningstar thinks it works:

Lipper lavishly thinks so:

And the Observer mostly concurs, recognizing both of the established Huber funds as Great Owls based on their consistently excellent risk-adjusted performance:

In addition to generating top-tier absolute and risk-adjusted returns, the Huber funds also generate very light tax burdens. By consciously managing when to sells securities (preferably when they qualify for lower long-term rates) and tax-loss harvesting, his investors have lost almost nothing to taxes over the past five years.

It works.

There’s only one question: does it work for you?

Mr. Huber pursues a rigorous, research-driven, value-oriented style. He’s been refining it for 20 years but the core has remained unchanged since his Hotchkis & Wiley days. He has done a lot of reading in behavioral finance and has identified a series of utterly predictable mistakes that investors – his team as much as other folks – are prone to make over and over. His strategy is two-fold:

Exploit other investors’ mistakes. Value investors tend to buy too early and sell too early; growth investors do the opposite. Both sides tend to extrapolate too much from the present, assuming that companies with miserable financials (for example, extremely low return on capital) will continue to flounder. His research demonstrates the inevitability of mean reversion, the currently poorest companies will tend to rise over time and the currently-strongest will fall. By targeting low ROC firms, which most investors dismiss as terminal losers, he harvests over time a sort of arbitrage gain as ROC rises toward the mean on top of market gains.

Guard against his own tendency to make mistakes. He’s created a red flags list, a sort of encyclopedia of all the errors that he or other investors have made, and then subjects each holding to a red flag review. They also have a “negative first to negative second derivative” tool that keeps them from doubling down on a firm whose rate of decline is accelerating and a positive version that might slow down their impulse to sell early.

Beyond that, they do rigorous and distinctive research. While many investors believe that large caps occupy the most efficient part of the market, Mr. Huber strongly disagrees. His argument is that large caps have an enormous number of moving parts, divisions within the firm that have their own management, culture, internal dynamics and financials. Pfizer, a top holding, has divisions specializing in Primary Care; Specialty Care and Oncology; Established Products and Emerging Markets; Animal Health; and Consumer Healthcare. Pfizer need not report the divisions’ financials separately, so many investors are stuck with investing backs on aggregate free cash flow firm-wide and a generic metric about what that flow should be. The Huber folks approach it differently: they start by looking at smaller monoline firms (for example, a firm that just specializes in animal care) which allows them to see that area’s internal dynamics. They then adjust the smaller firm’s financials to reflect what they know of Pfizer’s operations (Pfizer might, for example, have lower cost of capital than the smaller firm). By modeling each unit or division that way and then assembling the parts, they end up with a surrogate for Pfizer as a whole. 

Huber’s success is illustrated when we compare HULIX to three similarly-vintaged large-value funds:

Artisan Value (ARTLX), mostly because Artisan represents consistent excellence and this four-star fund from the U.S. Value team is no exception.

LSV Conservative Core (LSVPX) because LSV’s namesake founders published some 200 papers on behavioral finance and incorporated their research into LSV’s genes.

Hotchkis and Wiley Diversified Value (HWCAX) because Mr. Huber was the guy who built, designed and implemented H&W’s state of the art research program.

Higher returns, competitive downside, and higher risk-adjusted returns (those are all the ratios on the right where higher is better).

The problem is those returns are accompanied by levels of volatility that many investors are unprepared to accept. It’s a problem that haunted two other Morningstar Manager of the Decade award winners. Here are the markers to keep in mind:

• • Morningstar risk: over the past five years is high.
  • Beta: over the past five years is 1.18, or 18% greater than average.
  • Standard deviation: over the past five years is 18% compared to 14.9 for its peers.
  • Investor returns: by Morningstar’s calculation, the average investor in the fund over the past five years has earned 23.9% while the fund returned 32.1%. That pattern usually reflects bad investor behavior: buying in greed, selling in fear. This pattern is generally associated with funds that are more volatile investors can bear. (There’s an irony in the prospect that investors in the fund might be undone by the very sorts of behavioral flaws that the manager so profitably exploits.)

He also remains fully invested at all times, since he assumes that his clients have made their own asset allocation decisions. His job is to buy the best stocks possible for them, not to decide whether they should be getting conservative or aggressive.

Mr. Huber’s position on the matter is two-fold. First, short-term volatility should have no place in an investor’s decision-making. For the 45 year old with a 40 year investment horizon, nothing that happens over the next 40 months is actually consequential. Second, he and his team try to inform, guide, educate and calm their investors through both written materials and conference calls.

Bottom Line

Huber Equity Income has all the hallmarks of a classic fund: it has a disciplined, distinctive and repeatable process. There’s a great degree of intention and thought in its design.  Its performance, like that of its small cap sibling, is outstanding. It is a discipline well-suited to Huber’s institutional and pension-plan accounts, which contribute 90% of the firm’s assets. Those institutions have long time horizons and, one hopes, the sort of professional detachment that allows them to understand what “investing for the long-term” really entails. The challenge is deciding whether, as a small investor or advisor, you will be able to maintain that same cool, unflustered demeanor. If so, this might be a very, very good move for you.

Fund website

Huber Capital Equity Income Fund

Objective and strategy

The Fund seeks to deliver superior, risk-adjusted returns over full market cycles by investing primarily in a compact portfolio of domestic mid- to large-cap stocks. They invest in between 25-35 stocks. They’re fundamental investors who assess the quality of the underlying business and then its valuation. Factors they consider in that assessment include expected future profits, sustainable revenue or asset growth, and capital requirements of the business which allows them to estimate normalized free cash flow and generate valuation estimates. Typical characteristics of the portfolio:

• 85% of the portfolio to be invested in investment grade companies
• 85% of the portfolio to be invested in dividend paying companies
• 85% of the portfolio to be invested in the 1,000 largest companies in the U.S.

Adviser

Poplar Forest Capital. Poplar Forest was founded in 2007. They launched a small hedge fund, Poplar Forest Fund LP, in October 2007 and their mutual fund in 2009. The firm has just over $1 billion in assets under management, as of March 2014, most of which is in separate accounts for high net worth individuals.

Manager

J. Dale Harvey. Mr. Harvey founded Poplar Forest and serves as their CEO, CIO and Investment Committee Chair. Before that, he spent 16 years at the Capital Group, the advisor to the American Funds. He was portfolio counselor for five different American Funds, accounting for over $20 billion of client funds. He started his career in the Mergers & Acquisitions department of Morgan Stanley. He’s a graduate of the University of Virginia and the business school at Harvard University. He’s been actively engaged in his community, with a special focus on issues surrounding children and families.

Management’s stake in the fund

Over $1 million. “Substantially all” of his personal investment portfolio and the assets of his family’s charitable foundation, along with part of his mom’s portfolio, are invested in the fund. One of the four independent members of his board of directors has an investment (between $50,000 – 100,000) in the fund. In addition, Mr. Harvey owns 82% of the advisor, his analysts own 14% and everyone at the firm is invested in the fund. While individuals can invest their own money elsewhere, “there’s damned little of it” since the firm’s credo is “If you’ve got a great idea, we should own it for our clients.”

Strategy capacity and closure

$6 billion, which is reasonable given his focus on larger stocks. He has approximately $1 billion invested in the strategy (as of March 2014). Given his decision to leave Capital Group out of frustration with their funds’ burgeoning size, it’s reasonable to believe he’ll be cautious about asset growth.

Active share

90.2. “Active share” measures the degree to which a fund’s portfolio differs from the holdings of its benchmark portfolio.  High active share indicates management which is providing a portfolio that is substantially different from, and independent of, the index. An active share of zero indicates perfect overlap with the index, 100 indicates perfect independence. The active share for Poplar Forest is 90.2, which reflects a very high level of independence from its benchmark, the S&P 500 index.

Opening date

12/31/2009

Minimum investment

$25,000, reduced to $5,000 for tax-advantaged accounts. Morningstar incorrectly reports a waiver of the minimum for accounts with automatic investment provisions.

Expense ratio

1.20% on about $319 million in assets. The “A” shares carry a 5% sales load but it is available without a load through Schwab, Vanguard and a few others. The institutional share class (IPFPX) has a 0.95% expense ratio and $1 million minimum.

(as of July 2023)

Comments

Dale Harvey is looking for a few good investors. Sensible people. Not the hot money crowd. Folks who take the time to understand what they’ve invested in, and why. He’s willing to work to find them and to keep them.

That explains a lot.

It explains why he left American Funds, where he had a secure and well-paid position managing funds that were swelling to unmanageable, or perhaps poorly manageable, size. “I wanted to hold 30 names but had to hold 80. We don’t want to be big. We’re not looking for hot money. I still remember the thank-you notes from investors we got when I was young man. Those meant a lot.”

It explains why he chose to have a sales load and a high minimum. He really believes that good advisors add immense value and he wants to support and encourage them. Part of that encouragement is through the availability of a load, part through carefully-crafted quarterly letters that try to be as transparent as possible.  His hope is that he’ll develop “investor-partners” who will stay around long enough for Poplar Forest to make a real difference in their lives.

So far he’s been very pleased with the folks drawn to his fund. He notes that the shareholder turnover rate, industry-wide, is something like 25% a year while Poplar Forest’s rate is in the high teens. That implies a six or seven year holding period. Even during an early rough patch (“we were a year too early buying the banks and our results deviated from the benchmark negatively but we still didn’t see big redemptions”), folks have hung on. 

And, in truth, Mr. Harvey has given them reason to. The fund’s 17.1% annualized return places it in the top 1% of its peer group over the past three years, through March 2014. It has substantially outperformed its peers in three of its first four years; because of his purchase of financial stocks he was, he says, “out of sync in one of four years. Investing is inherently cyclical. It’s worked well for 17 years but that doesn’t mean it works well every year.”

So, what’s he do?  He tries to figure out whether a firm is something he’d be willing to buy 100% of and hold for the next 30 years. If he wouldn’t want to own all of it, he’s unlikely to want to own part of it. There are three parts to the process:

Idea generation: they run screens, read, talk to people, ponder. In particular, “we look for distressed areas. There are places people have lost confidence, so we go in to look for the prospect of babies being tossed with the bathwater.” Energy and materials illustrate the process. A couple years ago he owned none of them, today they’re 20% of the portfolio. Why? “They tend to be highly capital intensive but as the bloom started coming off the rose in China and the emerging markets, we started looking at companies there. A lot are crappy, commodity businesses, but along the way we found interesting possibilities including U.S. natural gas and Alcoa after it got bounced from the Dow.” 

Modeling:  their “big focus is normalized earnings power for the business and its units.” They focus on sustainable earnings growth, a low degree of capital intensity – that is, businesses which don’t demand huge, repeated capital investments to stay competitive – and healthy margins.  They build the portfolio security by security. Because “bond surrogates” were so badly bid up, they own no utilities, no telecom, and only one consumer staple (Avon, which they bought after it cut its dividend).

Reality checks: Mr. Harvey believes that “thesis drift is one of the biggest problems people have.”  An investor buys a stock for a particular reason, the reasoning doesn’t pan out and then they invent a new reason to keep from needing to sell the stock. To prevent that, Poplar Forest conducts a “clean piece of paper review every six months” for every holding. The review starts with their original purchase thesis, the date and price they bought it, and price of the S&P.”  The strategy is designed to force them to admit to their errors and eliminate them.   

Bottom Line

So why might he continue to win?  Two factors stand out. The first is experience: “Pattern recognition is helpful, you know if you’ve seen this story before. It’s like the movies: you recognize a lot of plotlines if you watch a lot of movies.”  The second is independence. Mr. Harvey is one of several independent managers we’ve spoken with who believe that being away from the money centers and their insular culture is a powerful advantage. “There’s a great advantage in being outside the flow that people swim in, in the northeast. They all go to the same meetings, hear the same stuff. If you want to be better than average, you’ve got to see things they don’t.” Beyond that, he doesn’t need to worry about getting fired. 

One of the biggest travesties in the industry today is that everyone is so afraid of being fired that they never differentiate from their benchmarks …  Our business is profitable, guys are getting paid, doing it because I get to do it and not because I’ve got to do it. It’s about great investment results, not some payday.

Fund website

Poplar Forest Partners Fund. While the fund’s website is Spartan, it contains links to some really thoughtful analysis in Mr. Harvey’s quarterly commentaries.  The advisor’s main website is more visually appealing but contains less accessible information.  

Fact Sheet

Objective

The Fund pursues long-term capital appreciation by investing primarily in common stocks of small and mid-cap companies, those with market caps under $5 billion. The Fund typically invests in 40 to 50 companies. The manager reserves the right to go to cash as a temporary move but is generally 94-97% invested.

Adviser

Walthausen & Co., LLC, which is an employee-owned investment adviser located in Clifton Park, NY. Mr. Walthausen founded the firm in 2007. In September 2007, he was joined by the entire investment team that had worked previously with him at Paradigm Capital Management, including an assistant portfolio manager, two analysts and head trader. Subsequently this group was joined by Mark Hodge, as Chief Compliance Officer, bringing the total number of partners to six. It specializes in small- and mid-cap value investing through separate and institutional accounts, and its two mutual funds. They have about $1.4 billion in assets under management.

Manager

John B. Walthausen. Mr. Walthausen is the president of the Advisor and has managed the fund since its inception. Mr. Walthausen joined Paradigm Capital Management on its founding in 1994 and was the lead manager of the Paradigm Value Fund (PVFAX) from January 2003 until July 2007. He oversaw approximately $1.3 billion in assets. He’s got about 35 years of experience and is supported by four analysts. He’s a graduate of Kenyon College (a very fine liberal arts college in Ohio), the City College of New York (where he earned an architecture degree) and New York University (M.B.A. in finance).

Strategy capacity and closure

In the neighborhood of $2 billion. That number is generated by three constraints: he wants to own 40 stocks, he does not want to own more than 5% of the stock issued by any company, and he wants to invest in companies with market caps in the $500 million – $5 billion range. In the hypothetical instance that  market conditions led him to invest mostly in $1 billion stocks, the calculation is $50 million invested in each of 40 stocks = $2 billion. Right now the strategy holds about $200 million.

Active share

Not calculated. “Active share” measures the degree to which a fund’s portfolio differs from the holdings of its benchmark portfolio. High active share indicates management which is providing a portfolio that is substantially different from, and independent of, the index. An active share of zero indicates perfect overlap with the index, 100 indicates perfect independence. They’ve done the calculation for an investor in their separate accounts but haven’t seen demand for it with the mutual funds.

Management’s stake in the fund

Mr. Walthausen has between $500,000 and $1,000,000 in this fund, over $1 million invested in his flagship fund, and he also owns a majority stake in the fund’s adviser.

Opening date

December 27 2010.

Minimum investment

$2,500 for all accounts. There’s also an institutional share class with a $100,000 minimum and 1.22% expense ratio.

Expense ratio

1.47% on an asset base of about $40 million (as of 03/31/2014).

Comments

It’s hard to know whether to be surprised by Walthausen Select Value’s excellent performance. On the one hand, the fund has some fairly pedestrian elements. It invests primarily in small- to mid-cap domestic stocks. Together they represent more than 90% of the portfolio, which is about average for a small-blend fund. Likewise for the average market cap. The portfolio is compact – about 40 names – but not dramatically so. Their strategy is to pursue two sorts of investments:

Special situations (firms emerging from bankruptcy or recently spun-off from larger corporations), which average about 20% of the portfolio though there’s no set allocation to such stocks.

Good dull plodders – about 80% of the portfolio. These are solid businesses with good management teams that know how to add value. This second category seems widely pursued by other funds under a variety of monikers, mid-cap blue chips and steady compounders among them.

His top holdings are shared with 350-700 other funds.

And yet, the portfolio has produced top-tier results. Over the past three years, the fund’s 17.8% annualized returns places it in the top 3% of all small-blend funds. It has finished in the top half of its peer group each year. It has never trailed its peer group for more than two consecutive months.

Should we be surprised? Not really. He’s doing here what he’s been doing for decades. The case for Walthausen Select Value is Paradigm Value (PVFAX), Paradigm Select (PFSLX) and Walthausen Small Cap Value (WSCVX). Those three funds had two things in common: each holds a mix of small and mid-cap stocks and each has substantially outperformed its peers.

Paradigm Select turned $10,000 invested at inception into $16,000 at his departure. His average mid-blend peer would have returned $13,800.

Paradigm Value turned $10,000 invested at inception to $32,000 at his departure. His average small-blend peer would have returned $21,400. From inception until his departure, PVFAX earned 28.8% annually while its benchmark index (Russell 2000 Value) returned 18.9%.

Walthausen Small Cap Value turned $10,000 invested at inception to $26,500 (as of 03/28/2014). His average small-value peer would have returned $17,200. Since inception, WSCVX has out-performed every Morningstar Gold-rated fund in the small-value and small-blend groups. Every one. Want the list? Sure:

• Artisan Small Cap Value
• DFA US Microcap
• DFA US Small Cap
• DFA US Small Cap Value
• DFA US Targeted Value
• Diamond Hill Small Cap
• Fidelity Small Cap Discovery
• Royce Special Equity
• Vanguard Small Cap Index, and
• Vanguard Tax-Managed Small Cap

The most intriguing part? Since inception (through March 2014), Select Value has outperformed the stellar Small Cap Value.

There are, of course, reasons for caution. First, like Mr. Walthausen’s other funds, this has been a bit volatile. Beta (1.02) and standard deviation (17.2) are just a bit above the group norm. Investors here need to be looking for alpha (that is, high risk-adjusted returns), not downside protection. Because it will remain fully-invested, there’s no prospect of sidestepping a serious market correction. Second, this fund is more concentrated than any of his other charges. It currently holds 40 stocks, against 80 in Small Cap Value and 65 in his last year at Paradigm Select. Of necessity, a mistake with any one stock will have a greater effect on the fund’s returns. At the same time, Mr. Walthausen believes that 80% of the stocks will represent “good, unexciting companies” and that it will hold fewer “special situation” or “deeply troubled” firms than does the small cap fund. And these stocks are more liquid than are small or micro-caps. All that should help moderate the risk. Third, Mr. Walthausen, born in 1945, is likely in the later stages of his investing career. 

Bottom line

There’s reason to give Walthausen Select careful consideration. There’s a quintessentially Mairs & Power feel about the Walthausen funds. In conversation, Mr. Walthausen is quiet, comfortable, thoughtful and understated. In execution, the fund seems likewise. It offers no gimmicks – no leverage, no shorting, no convertibles, no emerging markets – and excels, Mr. Walthausen suggests, because of “a dogged insistence on doing our own work and reaching our own conclusions.” He’s one of a surprising number of independent managers who attribute part of their success to being “far from the madding crowd” (Malta, New York, in his case). Folks willing to deal with a bit of volatility in order to access Mr. Walthausen’s considerable skill at adding alpha should carefully consider this splendid little fund.

Website

Walthausen Funds homepage, which remains a pretty durn Spartan spot but there’s a fair amount of information if you click on the tiny text links across the top.

Objective and strategy

The fund is pursuing both high current income and capital appreciation. The fund primarily invests in shorter-term high-yield corporate bonds, bank debt, convertibles and U.S. government securities. They have the option of buying a wider array of income-producing securities, including investment-grade debt, dividend-paying common or preferred stock. It shifts between security types based on what the manager’s believe offers the best risk-adjusted prospective returns and is also willing to hold cash. The portfolio is generally very concentrated. 

Adviser

Intrepid Capital Management of Jacksonville Beach, Florida. Intrepid, founded in 1994, primarily serves high net worth individuals.  As of December 30, 2013, it had $1.4 billion in assets under management. Intrepid advises the four Intrepid funds (Capital, Small Cap, Disciplined Value and Income).

Manager

Jason Lazarus, with the help of Ben Franklin, and Mark Travis. Messrs. Franklin and Lazarus joined Intrepid in 2008 after having completed master’s degrees at the University of North Florida and Florida, respectively. Mr. Travis is a founding partner and has been at Intrepid Capital since 1994. Before that, he was Vice President of the Consulting Group of Smith Barney and its predecessor firms for ten years.

Strategy capacity and closure

The managers estimate they might be able to handle up to $1 billion in this strategy. Currently the strategy manifests itself here, in balanced separate accounts and in the fixed-income portion of Intrepid Capital Fund (ICMBX/ICMVX).  In total, they’re currently managing about $300 million.   

Management’s stake in the fund

All of the managers have investments in the fund. Mr. Lazarus has invested between $50,000 – 100,000; Mr. Franklin has invested between $10,000 – 50,000 and Mr. Travis has between $100,000 – 500,000. That strikes me as entirely reasonable for relatively young investors committing to a relatively conservative fund.

Opening date

You get your pick! The High-Yield Fixed Income strategy, originally open only to private clients, was launched on April 30, 1999.  The fund’s Investor class was launched on July 2, 2007 and the original Institutional class on August 16, 2010.

Minimum investment

$2,500.  On January 30, 2014, the Investor and Institutional share classes of the fund were merged. Technically the surviving fund is institutional, but it now carries the low minimum formerly associated with the Investor class.

Expense ratio

0.90% on assets of $106 million. With the January 2014 merger, retail investors saw a 25 bps reduction in their fees, which we celebrate.

Comments

There are some very honorable ways to end up with a one-star rating from Morningstar.  Being stubbornly out-of-step with the herd is one path, being assigned to an inappropriate peer group is another. 

There are a number of very good conservative managers running short-term high yield bond funds who’ve ended up with one star because their risk-return profiles are so dissimilar from their high-yield bond peer group.  Few approach the distinction with as much panache as Intrepid Income:

Why the apparent lack of concern for a stinging and costly badge? Two reasons, really. First, Intrepid was founded on the value of independence from the investment herd. Mr. Lazarus reports that “the firm is set up to avoid career risk which frequently leads to closet-indexing.  Mark and his dad [Forrest] started it, Mark believes in the long-term so managers are evaluated on process rather than on short-term outcomes. If the process is right but the returns don’t match the herd in the short term, he doesn’t care.”  Their goal, and expectation, is to outperform in the long-term. And so, doing the right thing seems to be a more important value than getting recognized.

In support of that observation, we’ll note that Intrepid once employed the famously independent Eric Cinnamond, now of Aston/River Road Independent Value (ARIVX), as a manager – including on this fund.

Second, they recognize that their Morningstar rating does not reflect the success of their strategy. Their intention was to provide reasonable return without taking unnecessary risks. In an environment where investment-grade bonds look to return next-to-nothing (by GMO’s most recent calculations, the aggregate US bond market is priced to provide a real – after inflation – yield of 0.4% annually for the remainder of the decade), generating a positive real return requires looking at non-investment-grade bonds (or, in some instances, dividend-paying equities). 

They control risk – which they define as “losing money” or “permanent loss of capital,” as opposed to short-term volatility – in a couple ways.

First, they need to adopt an absolute value discipline – that is, a willingness both to look hard for mispriced securities and to hold cash when there are no compelling options in the securities market – in order to avoid the risk of permanent impairment of capital. That generally leads them to issuers in healthy industries, with predictable free cash flow and tangible assets. It also leads to higher-quality bonds which yield a bit less but are much more reliable.

Second, they tend to invest in shorter-term bonds in order to minimize interest rate risk. 

If you put those pieces together well, you end up with a low volatility fund that might earn 3.5 to 4.5% in pricey markets and a multiple of that in attractively valued ones. Because they’ve never had a bond default and they rarely sell their bonds before they’re redeemed (Mr. Lazarus recalls that “I can count on two hands the number of core bond positions we’ve sold in the past five years,” though he also allows that they’ve sold some small “opportunistic” positions in things like convertibles), they can afford to ignore the day-to-day noise in the market. 

In short, you end up with Intrepid Income, a fund which might comfortably serve as “a big part of your mother’s retirement account” and which “lots of private clients use as their core fixed-income fund.”

In both the short- and long-term, their record is excellent.  The longest-term picture comes from looking at the nearly 15 year record of the High-Yield Fixed Income strategy which is manifested both in separate accounts and, for the past seven years, in this fund.

Since inception, the strategy has earned 7.25% annually, trailing the Merrill Lynch high-yield index by just 38 basis points.  That’s about 94% of the index’s total return with about 60% of its volatility.  Over most shorter periods (in the three to ten year range), annual returns have been closer to 5-6%.

In the shorter term, we can look at the risks and returns of the fund itself.  Here’s Intrepid Income charted against its high-yield peer group.

By every measure, that’s a picture of very responsible stewardship of their shareholders’ money.  The fund’s beta is around 0.25, meaning that it is about one-fourth as volatile as its peers. Its standard deviation from inception to January 2014 is just 5.52 while its peers are around nine. Its maximum drawdown – 14.6% – occurred over a period of just three months (September – November 2008) before the fund began rebounding. 

Bottom Line

The fund’s careful, absolute value focus – shorter term, higher quality high-yield bonds and the willingness to hold cash when no compelling values present themselves – means that it will rarely keep up with its longer-term, lower quality, fully invested peer group.

And that’s good. By the Observer’s calculation, Intrepid Income qualifies as a “Great Owl” fund. That’s determined by looking at the fund’s risk-adjusted returns (measured by the fund’s Martin Ratio) for every period longer than one year and then recognizing only funds which are in the top 20% for every period. Intrepid is one of the few high-yield funds that have earned that distinction. While this is not a cash management account, it seems entirely appropriate for conservative investors who are looking for real absolute returns and have a time horizon of at least three to five years. You owe it to yourself to look beyond the star rating to the considerable virtues the fund holds.

Fund website

We think it’s entirely worth looking at both the Intrepid Income Fund homepage and the homepage for the underlying High-Yield Fixed Income strategy. Because the strategy has a longer public record and a more sophisticated client base, the information presented there is a nice complement to the fund’s documentation.

At the time of publication, this fund was named ASTON / River Road Long-Short.
This fund was previously profiled in June 2012. You can find that profile here.
This fund was formerly named AMG River Road Long-Short Fund.

On August 16, 2021 AMG River Road Long-Short Fund became 
AMG River Road International Value Equity Fund. At that point,
everything changed except the fund's ticker symbol: new strategies, 
new management team, new risks, new benchmark. As a result,
the analysis below is for archival purposes only. Do not rely
on it as a guide to the current fund's prospects or practices. 

Objective and Strategy

ARLSX seeks to provide absolute returns (“equity-like returns,” they say) while minimizing volatility over a full market cycle. The fund invests, long and short, mostly in US common stocks but can also take positions in foreign stock, preferred stock, convertible securities, REITs, ETFs, MLPs and various derivatives. The fund is not “market neutral” and will generally be “net long,” which is to say it will have more long exposure than short exposure. The managers have a strict, quantitative risk-management discipline that will force them to reduce equity exposure under certain market conditions.

Adviser

Aston Asset Management, LP, which is based in Chicago. Aston’s primary task is designing funds, then selecting and monitoring outside management teams for those funds. As of December 31, 2013, Aston is the adviser to 23 mutual funds with total net assets of approximately $15.9 billion. Affiliated Managers Group (AMG) has owned a “substantial majority” of Aston for years. In January 2014 they exercised their right to purchase the remainder of the company. AMG’s funds will be reorganized under Aston, but Aston’s funds will maintain their own identity. AMG, including Aston, has approximately $73 billion in assets across 62 mutual funds and sub-advised products.

Managers

Matt Moran and Daniel Johnson. Both work for River Road Asset Management, which is based in Louisville. They manage $10 billion for a variety of private clients (cities, unions, corporations and foundations) and sub-advise six funds for Aston, including the splendid (and closed) Aston/River Road Independent Value (ARIVX). River Road employs 19 investment professionals. Mr. Moran, the lead manager, joined River Road in 2007, has about a decade’s worth of experience and is a CFA. Before joining River Road, he was an equity analyst for Morningstar (2005-06), an associate at Citigroup (2001-05), and an analyst at Goldman Sachs (2000-2001). His MBA is from the University of Chicago. Mr. Johnson is a CPA and a CFA. Before joining River Road in 2006, he worked at PricewaterhouseCoopers.

Strategy capacity and closure

Between $1 and $1.5 billion.

Management’s Stake in the Fund

Mr. Moran and Mr. Johnson had between $100,000 and $500,000 as of the last-filed Statement of Additional Information (October 30, 2012). Those investments represent a significant portion of the managers’ liquid net worth.

Opening date

May 4, 2011.

Minimum investment

$2,500 for regular accounts and $500 for retirement accounts.

Expense ratio

1.70%, after waivers, on assets of $220 million. The fund’s operating expenses are capped at 1.70%, but expenses related to shorting add another 1.46%. Expenses of operating the fund, before waivers, are 5.08%.

Comments

When we first wrote about ARLSX eighteen months ago, it had a short public record and just $5.5 million in assets. Nonetheless, after a careful review of the managers’ strategy and a long conversation with them, we concluded:

[F]ew long-short funds are more sensibly-constructed or carefully managed than ARLSX seems to be.  It deserves attention. 

We were right. 

River Road’s long-short equity strategy is manifested both in ARLSX and in a variety of institutional accounts. Here are the key metrics of that strategy’s performance, from inception through December 30, 2013.

How do you read that chart? Easy. The first three measure how the managers perform on the upside; higher values are better. The second three reveal how they perform on the downside; lower values are better. The final two ratios reflect an assessment of the balance of risks and returns; again, higher is better.

Uhhh … more upside, less downside, far better overall.

The Sharpe and Sortino ratios bear special attention. The Sharpe ratio is the standard measure of a risk/return profile and its design helped William Sharpe win a Nobel Prize for economics. As of December 31, 2013, River Road had the highest Sharpe ratio of any long-short strategy. The Sortino ratio refines Sharpe, to put less emphasis on overall volatility and more on downside volatility. The higher the Sortino ratio, the lower the prospects for a substantial loss.

After nearly three years, ARLSX seems to be getting it right and its managers have a pretty cogent explanation for why that will continue to be the case.

In long stock selection, their mantra is “excellent companies trading at compelling prices.” Between 50% and 100% of the portfolio is invested long in 15-30 stocks. They look for fundamentally attractive companies (those with understandable businesses, good management, clean balance sheets and so on) priced at a discount to their absolute value. 

In short stock selection, they target “challenged business models with high valuations and low momentum.” In this, they differ sharply from many of their competitors. They are looking to bet against fundamentally bad companies, not against good companies whose stock is temporarily overpriced. They can be short with 10-90% of the portfolio and typically have 20-40 short positions.

Their short universe is the mirror of the long universe: lousy businesses (unattractive business models, dunderheaded management, a history of poor capital allocation, and favorites of Wall Street analysts) priced at a premium to absolute value.

Finally, they control net market exposure, that is, the extent to which they are exposed to the stock market’s gyrations. Normally the fund is 50-70% net long, though exposure could range from 10-90%. The extent of their exposure is determined by their drawdown plan, which forces them to react to reduce exposure by preset amounts based on the portfolio’s performance; for example, a 4% decline requires them to reduce exposure to no more than 50. They cannot increase their exposure again until the Russell 3000’s 50 day moving average is positive. 

This sort of portfolio strategy is expensive. A long-short fund’s expenses come in the form of those it can control (fees paid to management) and those it cannot (expenses such as repayment of dividends generated by its short positions). At 3.1%, the fund is not cheap but the controllable fee, 1.7% after waivers, is well below the charges set by its average peer. With changing market conditions, it’s possible for the cost of shorting to drop well below 1% (and perhaps even become an income generator). With the adviser absorbing another 2% in expenses as a result of waivers, it’s probably unreasonable to ask for lower.

Bottom Line

Messrs. Moran and Johnson embrace Benjamin Graham’s argument that “The essence of investment management is the management of risks, not the management of returns.” With the stock market up 280% from its March 2009 lows, there’s rarely been a better time to hedge your gains and there’s rarely been a better team to hedge them with.

Fund website

ASTON / River Road Long-Short Fund. 

Disclosure

By way of disclosure, while the Observer has no financial relationship with or interest in Aston or River Road, I do own shares of ARLSX in my own accounts.