For the year ended August 31, 2005, the $291-million fund gained 15.6%, versus 4.3% for the S&P 500 Financials Sector index, and 8.9% for the average sector fund investing in financials. For the three-year period, the fund registered an average annualized return of 21.1%, versus 10.3% for the index, and 11.6% for its peers. Over the five years, this portfolio's 21.3% average annualized return has trounced the index, which rose 2.9%, and the peer group, which gained 7.6%. The strong performance was achieved with less volatility than its peers, and very low turnover.
In May 2005, Forward Management LLC, a San Francisco-based investment manager, adopted the three mutual funds run by Emerald Asset Management, adding the "Forward" name to each portfolio as a result. The transaction did not result in any changes to the way the funds invest, nor to the management teams. Mertz, who is based in Based in Lancaster, Pa., has run Forward Emerald Banking & Finance since its inception in 1997.
The Full Interview:
S&P: What is your investment philosophy?
MERTZ: We use a strictly bottom-up, fundamental research-driven process to identify small-cap financial companies -- anything with market caps under $2-billion -- that enjoy competitive advantages in niche markets. We are basically looking for companies exhibiting growth that exceeds our peer group, i.e., other small-cap financials.
We are also looking for stocks that are undervalued. Wall Street largely ignores these kinds of companies, creating pricing inefficiencies. Like their large-cap counterparts, small-cap financials are usually viewed as value plays, but we are growth managers.
S&P: What niche markets in financials do you like to invest in?
MERTZ: Our main subsectors are community banks and insurance companies. To a lesser extent, we also buy asset managers, real estate investment trusts (REITs), and brokerage firms. Our largest allocation is in community banks. Within this industry, we are seeking the prime commercial business lender in their respective region, or a bank that dominates some specialty niche. We also like community banks that are extremely good, low-cost deposit gatherers; i.e., they have the ability to raise their deposits, whereas their rivals may not.
S&P: What are the fund's top holdings?
MERTZ: As of June 30: United Fire & Casualty (UFCS), 3.5%; Selective Insurance Group (SIGI), 3.2%; MB Financial (MBFI), 2.6%; Central Pacific Financial (CPF), 2.5%; and Prosperity Bancshares (PRSP), 2.5%. We typically keep between 100-125 stocks in the fund. As a risk control measure, no single holding can represent more than 5% of total assets.
S&P: How large is the universe?
MERTZ: Small-cap financials represent quite a large universe. For example, The Russell 2000 Index includes 400 financial services companies, while The NASDAQ Bank Index comprises over 500 banks.
S&P: Is the portfolio diversified by geography?
MERTZ: Yes. We are very diversified by region. For example, we own banks in Hawaii and California. But back in 2000 during the tech downturn, we had no exposure in California because we saw the economy would get hurt. We moved back into California in 2003 when the economy started to rebound.
We also have a lot of exposure in places with good banking markets like Texas, Chicago and the Southeast. Florida has a very good banking environment, but it's very expensive. We have limited exposure there because the valuations are currently unattractive.
S&P: How much of the fund is exposed to community banks?
MERTZ: We currently have about 67% of our assets invested in community banks. Over the nearly seven years that we've run this fund, we have always had a significant exposure to this subsector. The allocation has typically ranged between 60% and 80%.
S&P: What makes community banks such attractive investments?
MERTZ: These companies are market-share gainers in their particular regions. They're taking market share -- as measured by loans and deposits -- away from their larger competitors. We see this trend continuing for at least five to ten years.
S&P: What's behind this trend?
MERTZ: We are seeing a great deal of consolidation among the larger banks, leaving opportunities for the smaller banks to deliver more personal service. Small community banks have been able to pick up business as more depositors have been dislocated by the bigger bank mergers.
Small community banks are sometimes themselves attractive takeover candidates by bigger banks, but we don't necessarily invest in a bank stock for that reason.
S&P: Can you discuss one of your favorite community banks?
MERTZ: Texas Capital Bancshares (TCBI) is a Dallas-based bank, with operations in Houston also. This company is viewed as a "businessmans' bank," for which we forecast robust 20% year-over-year loan growth. The growing strength of the energy economy in Texas creates a good backdrop for banks like this to operate in. Texas Capital boasts a very good net interest margin, and we think they can continue to be one of the fastest-growing stocks in our portfolio.
S&P: How will hurricane Katrina impact smaller insurance companies?
MERTZ: The insurance industry as a whole was able to raise their rates after 9/11. With rate premiums going up for the past few years, a great deal of reserves has been created, allowing insurance companies to pay out the claims associated with last year's hurricanes. I also think they'll be able to handle the catastrophic claims associated with Katrina. After the losses of Katrina have been assessed, insurance firms, large and small, will likely raise their rates even further. Over the last five to ten years, insurance companies have been able to diversify their risk, even the smaller firms.
S&P: Can you discuss one of your favorite insurance names?
MERTZ: Selective Insurance (SIGI) is a New Jersey-based company that has been negatively perceived by the market because the auto insurance market in that state has performed so poorly due to tough state legislation. Selective has been profitable in a difficult environment, by diversifying their product base. Over the past five years, the company has reduced its exposure to auto insurance -- it currently accounts for only 7% of their overall business. The negative perception hurt their stock price, which made them attractive and a great opportunity. We think they have a solid management team and we believe they'll grow nicely.
S&P: Aside from community banks and insurance firms, what are some other types of stocks in the fund?
MERTZ: We have companies like E Trade Financial (ET) and AmeriTrade Holding (AMTD), which provide brokerage and banking services over the Internet, among other financial services. We also hold ADVANTA Corp. (ADVNB), a credit card service provider. With respect to REITs, we presently own only two names because overall prices in the industry have been bid up on yield basis.
S&P: Why does the fund have such low turnover?
MERTZ: We invest with a long-term investment horizon. We're patient with our holdings and don't get worried about short-term problems. We look for companies with solid business models, strong management and consistent execution. However, with banks, we closely monitor their net interest margin spreads and non-performing assets. If a bank is pushing for loan growth, but they're doing it at the sake of good-quality loans, we'll unload the stock.
S&P: Would you sell a stock if its market-cap became too big?
MERTZ: Not necessarily. For example, we own Mercantile Bankshares (MRBK) of Baltimore, which currently has a market-cap of $4.4-billion, which puts it squarely in the mid-cap arena. Despite its size, it's still perceived as a local bank in Baltimore, which is a very parochial community. Mercantile continues to be a nice grower, but at some time, we'll roll back our exposure.
S&P: How are you responding to the Fed's commitment to credit tightening?
MERTZ: This is a concern, whether you're a large bank or a small one. It depends on how good you are at deposit-gathering and how much of your loan portfolio is based on loans that can repriced quickly. Specifically, commercial loan portfolios are adjustable and, as such, their assets (loans) are repriced quicker than your liabilities (deposits).Contact Bob Keane with questions or comments at: firstname.lastname@example.org.