When it comes to building a portfolio, some mutual fund managers want to see as much independent research as they can. They want to talk to the CEO and find out what makes a company tick. J.C. Waller III isn't that kind of portfolio manager and doesn't want to be. For Waller and everyone else at Icon Advisers in Greenwood Village, Colorado, what matters is looking at the numbers in a dispassionate manner and making a decision based on a quantitative, value-based system of industry rotation. While that approach may counter conventional wisdom, the company's Web site points out that it's just an evolution of the methodology originally developed by Benjamin Graham.
For the Icon Energy Fund, this approach has paid off handsomely. A $10,000 investment in December 1999 would have grown to more than $29,845 as of year-end 2004, dramatically outpacing the growth of the S&P 500 Energy Sector Index ($15,223) or the S&P 500 Composite ($8,903). Since Icon's philosophy attempts to identify industry themes lasting one or more years, there's little desire to make incremental changes to the portfolio. That approach helps keep the fund's turnover rate much lower than its peers, according to S&P, and overall expenses to a minimum.
S&P gives the Icon Energy Fund five stars, as does Morningstar. All these factors may help explain why the fund increased net assets more than fivefold during 2004.
In an interview, Waller provides some insight into the performance of the fund and explains why a disciplined, non-emotional approach can help investors capture "excess returns."
How would you describe the investment philosophy behind the Icon Energy Fund? It's non-emotional and very disciplined and systematic. It's a belief that industry themes can be determined based on valuation in a quantitative method. We're strictly by the numbers. We have nine different sector funds and some domestic core equity funds for which we use our same methodology. We overweight sectors that appear to be the best bargains and underweight those that appear to be expensive or laggards.
We believe that the market is led by certain industry themes that typically last one to two years. To capture those industry themes, we use a bottom-up valuation approach. We're attempting to identify industries that are the best bargains and are beginning to show leadership using a bottom-up valuation.
Another part of our philosophy is that we're market-cap indifferent. We'll go where value pulls us. If the small caps or mid caps or large caps appear to be better discounts, it really doesn't matter. We also don't use any traditional measures of value. There's no P/E, P/B, P/S or anything like that.
What industries have you identified as bargains in energy with leadership and where are you concentrating now? We subscribe to Standard & Poor's Global Industry Classification Standard (GICS). They break the energy sector down into five sub-industries: oil and gas drilling; oil and gas equipment & services; oil and gas exploration & production; oil and gas refining & marketing & transportation; and, finally, integrated oil and gas. [In December 2004, the GICS for the energy sector was redefined, adding a new sub-industry (coal and consumable fuels) and splitting oil and gas refining & marketing & transportation into two--oil and gas refining & marketing, and oil and gas storage & transportation--bringing the total of energy sub-industries to seven.--Ed.] We believe that certain industries lead the market for typically one to two years, so we will overweight our favorite industries and underweight our least favorite. Looking at 2004 as the most recent example, based on oil and gas refining & marketing & transportation being the best bargain, combined with it showing leadership, we took an overweight position in that sub-industry relative to the fund's benchmark and we underweighted integrated oil and gas, which is where you would find Exxon/Mobil, BP, and other large integrated companies. We were significantly underweight in that sub-industry relative to its benchmark. By using our methodology, remaining disciplined and systematic, and not being emotional, we were able to capture some excess returns.
What benchmark do you use? We use Standard & Poor's SuperComposite 1500 Index. It's a combination of the S&P 500, the Small-Cap 600, and the Mid-Cap 400.
Going into 2005, do you anticipate making changes in the fund's investments? It's possible we could see some leadership change. This leadership within the energy sector has been in place from about November 2003, so when we look at September '03 to September '04, the fund only had 13% turnover. But from November 30, 2004, through the present [The interview took place during the first week of January 2005--Ed.] there's been some turbulence within the sector, and it's difficult to determine how things will shape up in '05. So we haven't made any changes yet. I've let cash accumulate to some degree, but I'm waiting either for a continuation of this theme that's been in place for a year and a half, or for some other kind of change.
When gasoline prices started rising last spring, there was a lot of talk about increased energy exploration. Is that going to become a bigger issue in the coming months? That particular industry group, exploration & production, has been our largest industry weighting through 2004, and remains so. Rather than forecasting based on macro perspectives, we base it on bottom-up valuation.
In terms of individual holdings, I don't see any industry giants. Is that a function of valuation? It was a combination in 2004 not only of valuation, but of relative strength. We look at relative strength over a six-month time period, so when we combine those two, value and strength, the large integrated companies--Conoco, Phillips, BP, ExxonMobil, and all those guys--had value that was closer to fair value and they weren't performing as well as refining & marketing & transportation. It wasn't that they were so bad. It was just that there were better places to be within the energy sector. Using the SuperComposite 1500 Index for 2004, if you look at these five sub-industries, refining & marketing & transportation returned over 66%, while integrated oil and gas returned a little bit under 26%.
How often do you make a shift in the fund's holdings? I review several sectors here at Icon, of which energy is one. I have 130 [energy] companies in my database, distributed among these five sub-industries, and I get through every company in the database, in addition to other sectors, at least once a quarter. So I'm reviewing the inputs to the model at least once a quarter. Of course, I'm looking at the holdings daily. It really depends on how long a theme is in place. As long as a theme is in place, I don't have a reason to make changes or have a high turnover rate.
Talk about some of the fund's largest holdings and what it is that made them attractive investments. We have one called Cal Dive International in the equipment & services sub-industry. That industry group on average is still trading at about an 11% discount relative to our evaluation of fair value. This particular stock is trading at about a 21% discount to its fair value and it's been performing well, as indicated by a strong six-month relative strength. We have it valued a little shy of $48 and it's trading at close to $40.
We've had another company called Ultra Petroleum in our portfolio for quite some time now. It's our number three holding, with a 3.2% position. When we grow their earnings out over time, they're still trading at a substantial discount. We think it's in the neighborhood of 60% below its intrinsic worth.
In choosing our investments, it's not the individual stocks that are most important. It's selecting the right industries and then digging down and finding favorite stocks. Our methodology is based on a discounted earnings model. When we use the average earnings of this company, grow them out into the future by a forward-looking growth rate, and then discount them back into the present by adjusting for risk and interest rates, that's where the intrinsic value lies.
One of the reports I looked at listed the fund's cash holdings at about 7%. Is that normal? On average we've been at about 5% in 2004 and that's where we try to keep it. Currently we're at about 10%.
Why so high? Inflows are the primary reason. The fund grew from $81 million in December 31, 2003, to approximately $420 million at the end of this past year. The uncertainty about the continuation of this theme has led me to be a little more cautious in investing new money.
So what are your plans? I know that the energy sector on average over the past year has been anywhere from 5% underpriced to 5% overpriced, and we currently have more value in the energy sector. Right now, we see it about 14% below fair value, primarily due to the selloff that's occurred since November 30, 2004. What we do depends on what the next few weeks are like. If you had caught me two months ago, I would have told you that the refining & marketing & transportation segment has been the sweet spot and appears to be the sweet spot going forward. But the selloff has muddled things.
What was driving that selloff? I think the fact that crude was coming down and that the refining, marketing, and transportation industry was up--including December '04--66.6%. Maybe a lot of people were just taking profits.
Is there a connection between the prices consumers are paying for energy and the performance of the Energy Fund? We have run some correlations between crude and energy stocks in general, not necessarily the fund. If we look over the last year, the commodity was much more volatile than Icon Energy. The Fund was up 38% in 2004 and crude was up 34%, but there was a much choppier ride for crude. When I run correlations with crude and energy stocks, if we look over the last 10 years at crude vis-?-vis the S&P 500 Energy Sector Index, there's a positive 65% correlation between crude and the Index. If we look back to 1989, it's about a 60% correlation. However, in 2004 oil in the S&P 1500 Index was 83% correlated. Crude was in the headlines a lot last year and perhaps that's why there was a higher correlation than normal.
Are there other funds that you manage? I manage the Icon Healthcare Fund, Icon Industrials Fund, and Icon Long/Short Fund and still, technically, the Icon Asia-Pacific Fund, even though we have an assistant portfolio manager who has taken a lot of responsibility for that one.
Staff editor Robert Keane can be reached at email@example.com.