Just because a stock is cheap doesn't mean it's a good value,-- says Ray McCaffrey, manager of the PBHG Large Cap Value Fund (PLCVX). To McCaffrey, 37, "value is being able to buy a quality company with a strong long-term outlook that's below market value." McCaffrey calls this approach "common sense," and it has served his shareholders well through the bull market of the late 1990s and the bear market of today.
The fund has posted an average annual return of 23.85% since its inception in January 1997. With a quick trading style and 1,018% portfolio turnover rate last year, McCaffrey, who has been managing the fund since June 1999, has led PBHG Large Cap Value to the best return of any large value fund over a three-year period. In the first quarter of 2001, the fund tallied a 0.1% advance, Morningstar says, placing it ahead of 93% of its peers.
While the turnover rate may be shocking to some at first, McCaffrey attributes it to being a reflection of what's going on in today's market environment. "If the market were not as volatile as it has been, we would be trading less. Six percent days on the Nasdaq have become the norm. And while you're having that 6% day there are individual stocks that are up 10% or 15%, or down 10% or 15%. That's the traditional one-year movement on the stock market, and now you're getting that one-year return in one day. We own some that are down and some that are up."
Your fund has posted great returns since its inception. What kinds of things are you doing in the midst of this market downswing to keep things rolling? The reason we've been able to have good returns over the last four years is the process or style that we employ. What we're trying to do is balance a company's valuation against both its near-term and long-term earnings outlook. What that means is that we're not chasing the high flyers, and we're also not buying the bad companies that look really cheap. A lot of value managers are buying these beaten-up companies. We're not doing that either, because a lot of times they deserve to be beaten-up types of companies. We're playing in the middle and because of that we look at different factors such as valuation and earnings dynamics. We're able to balance the two. When you're in a growth market like we had in the later 1990s, you put more focus on the earnings revisions. In that strong economy, if a company is missing expectations you have to question why you own it. As we got into 2000 with a slowdown in the economy and more of a value market, you put more emphasis on valuation and you pay more attention to the balance sheet and the company's competitive position. So now most companies are missing earnings expectations. You have to dig down a little more and do the fundamental research and find the companies that are best positioned to come out of this.
Your Web site states you not only disregard the 25% that represent the most expensive stocks, but you disregard the 25% with the poorest business fundamentals. What exactly do you mean by poor business fundamentals? Warren Buffet says if you have to choose between a good management team in a really lousy industry, or a bad management team in a really good industry, the [good] industry will win every time. That's the philosophy we've taken. While we look at all kinds of companies, we tend to stay away from the commodity types. When we say bad business fundamentals, it's companies that continually miss expectations. We don't like companies that have trouble controlling their own destiny.
How do you pick your stocks? I'm responsible for all the buy and sell decisions. There's another portfolio manager, Jerome Heppelmann, with whom I work closely. He runs our mid- and small-cap value funds. We have an analyst, Jim Bell, who does the fundamental research on all the value funds. We also interact with the tech fund managers and growth managers. We work side by side. It's not a team, but we work closely.
Morningstar classifies you as a Large Cap Blend fund in its equity style box. Why? I guess sometimes people look at our style and say we are a blend fund. We're really not. If you look at the characteristics of the portfolio, the valuation will be below the index of the S&P 500. We're usually at a 20% discount to the P/E of the S&P 500. We try to match the earnings growth rate of the S&P 500. The most recent portfolio they got hold of may have triggered some valuation considerations. The P/E of the fund is roughly the same as the P/E of the Russell 1000 Value Index.
Can you fill me in on your background? I went to Villanova University and majored in economics. I joined an investment club while I was there. That's where I became interested in stocks. I then went to Carnegie Mellon for my MBA. As I was graduating, I thought the stock market would be a good place to use my economics background. I ended up starting out at Fidelity Bank in Philadelphia as a research analyst. A rival bank acquired [Fidelity] and after a while it became clear there wasn't going to be a need for a ton of research people. Eventually I ended up at Penn Mutual Life where I did both equity and fixed income analysis. Being there really helped me to focus on balance sheets and cash flow statements. From there I went to Cypress Capital where I was part of a three-person team that looked at equities. Then before I came to Pilgrim Baxter I was at Pitcairn Trust, where I was an analyst. I joined Pilgrim Baxter in 1997. In early 1998 I started running separate accounts, and in June 1999 I took over the fund.
Your fund has been labeled as having a fast trading style. What are some of the advantages and disadvantages of that style? It only makes sense that the ones that are up a lot you should pare back and the ones that are down a lot, if you continue to like their story, you should act on those positions. For example, let's say you buy any stock and it's a 2% position in your fund. Over the course of a month, it's up 20%, so it's up to 2.4%. On every kind of valuation measure it's now more expensive than when you bought it. Now you have a larger position in your fund that is less attractive than it was when you bought it because it's up 20%. It only makes sense that that position should actually be a smaller position than what you bought. That's the kind of thing we try to do. The stocks that we like, if they're going down, we're adding to those positions, and the stocks that are going up, we're trimming them. I also pay attention to the tax consequences of trading.
Wouldn't the high turnover contribute to high taxes? You would intuitively assume that we have high taxes. What we try to do is offset that by taking some losses by selling and buying like securities. For example, Fannie Mae and Freddie Mac are two stocks that trade similarly, if you compare their charts. So if I own Fannie Mae and for some reason it's down 15%, I'll sell it, take the tax loss, and buy Freddie Mac. Then, 31 days later, if the stocks are down again, you can sell your Freddie Mac and buy back your Fannie Mae. So in the course of 30 days you've taken two tax losses and you end up with the same stock you started out with 60 days ago. It has nothing to do with investment knowledge; it's just common sense. It's just actively managing the portfolio to take advantage of ways to maximize return for your shareholders.
Has your investment philosophy changed much since the day you started managing this fund? I like to think that from the day I started managing money that I've progressed and gotten better. There's still room to improve. Almost every analyst wants to be a portfolio manager, and they think it's easy to be one, but when you actually have to pull the trigger and make decisions, at first it's as hard as they come because you're stepping up and you have to be responsible for it. I think you grow into that. You get more courage and conviction in what you're doing, and I think I've become a better portfolio manager.
What types of investors should be looking at your fund? If you look at the way we run our money, it's pretty logical. We picked the S&P 500 as the benchmark to compete against. We really pay attention to sectors. We'll underweight or overweight by up to 10% because we can be wrong. We may be right about a sector, but sometimes we may be early, and being early can be as bad as being wrong. Investing is a batting average game. We don't want one decision to overwhelm the portfolio and be responsible for its success or failure. We want to make a lot of little decisions and play the percentages. We feel we can be right two out of three times. If you can be right two out of three times and you make enough bets, you can win over time. I'm buying mostly large-cap, blue-chip types of names, so that if there is any kind of exogenous shock to the market you'd hope that these stocks hold up better than the rest of the market. And then I'm actively managing it. You are getting broad sector representation, you are getting large-cap, safer types of stocks, and you're getting it actively traded to take advantage of market volatility. I think the average investor would feel comfortable making this a core fund in their portfolio. It's not going to give the super pizzazz in the up markets, but we think it will keep pace with the up markets, and we think investors will do better in the down markets.
What are you going to be happy with this year? Anything positive? I actually think we're getting near the end of this. The Fed has lowered rates three times. Everyone's complaining that [Federal Reserve Board Chairman Alan Greenspan] is not being aggressive enough, but he's doing 50 basis points a month. I don't know how much more he can do. He'll continue to cut until he sees evidence that recovery is in place. He'll probably be cutting most of this year. At some point this year, the market is going to react positively. Last year we were pretty defensive because he was raising rates. He was determined to slow the economy down, and he wasn't going to stop until he did. He was successful, and he will be successful the other way. I don't know when, but at some point he will be. As a guess, I think the S&P will get into positive territory by the end of the year. The Nasdaq may have a little tougher time doing it, but I think it will be higher at the end of the year than it is today.
You went against the trend a bit by picking up stock in Microsoft and Lexmark. Why? We had been pretty defensive mostof last year, and in January the Fed started easing. Lower interest rates are a powerful force. Once the easing cycle begins you have to respect that. We've slowly moved towards becoming less defensive, more aggressive. We have been heavily weighted in stable types of companies and we've been moving to getting more economically sensitive companies. I liked Microsoft and Lexmark for their defensiveness in the tech industry. I don't own either one of those stocks right now. They both had decent moves and we sold them. I've been moving more into the cyclical types of technology companies like Motorola. Companies with stocks trading at very low multiples of sales to book value. Obviously earnings are not that great. They are down now but that's what happens. It's a real good value. They are taking steps to get costs out of their business and when the economy turns I think they will be there participating in it.
What have been some of your individual winners? Last year, the natural gas company Burlington Resources was a winner. We started buying that in July 2000. We were onto the energy story fairly early last year, realizing that there was a real imbalance in the supply and demand for natural gas. Also through a combination of environmental restrictions and natural gas companies not replacing what they'd taken out of the ground, there was a shortage of supply. We also realized that over the last several years demand for natural gas has grown rapidly. Before this year, the last couple of winters had been warm and the demand for the product had been lower than what was normal. Then this winter it got really cold, and the combination of rising demand and flat-to-down supply really helped the stock.
And your losers? One that we didn't have such good luck with was Verizon. During the height of the whole tech craze, it was a stock that looked pretty attractive to us, although it wasn't reflected in the valuation. Portfolio managers were paying huge prices to buy pure-play wireless companies and pure-play DSL companies, and we thought Verizon offered all those things. We felt that if you're willing to pay these huge premiums for these pure-play companies that you should be willing to pay something for Verizon as well. We owned stock, but unfortunately, people began to realize they were paying way too much for these pure plays and they took them way down and in the process took Verizon way down.