It's times like these when clients may ask advisors all kinds of questions; they may ask what kinds of investments have the potential to do better over the course of flat or down markets or whether a value or growth investment style tends to benefit on the way out of bear markets. Value investing outperformed growth investing during the 2000-2003 bear market, but were you aware that both large-cap and small-cap value investing topped growth investing for the period from1969 to 2006, according to Morningstar? Clients may really want to know these things but underneath it all, aren't they really asking for some comfort in a time of uncertainty? All we can be sure of is what has worked well in the past under similar circumstances. To that end, perhaps it's a good time to look at value funds with long-time portfolio managers who have fared well through varying market cycles.
Considering themselves "analysts first," co-portfolio managers J. Dennis Delafield and Vincent Sellecchia pick stocks, one by one, with an eye to what might go wrong as well as right, according to Sellecchia. The New York-based team has been investing together since 1980, and running the no-load $600 million Delafield Fund (DEFIX) as co-portfolio manages since its inception in 1993. "We're very focused on risk. We've run the account on an absolute basis rather than relative basis," notes Sellecchia. Indeed, the fund had only one down year during the Internet crash, (in 2002 the fund was down 7.46%, but the S&P 500 was down 22.10% that year, according to Morningstar) at a time when the S&P 500 was down for three years in a row, from 2000-2002.
More recently, the fund has had average annual returns of 17.65% compared with 11.33% for the S&P 500, for the five years ended April 7; and 9.16% versus 6.84% for the three-year period, according to Morningstar, which gives the fund a four-star rating. Co-portfolio manager Vince Sellecchia talked with IA by telephone from his New York office in early April.
How much money do you manage overall at Delafield?
Delafield Asset Management has about $1.3 billion under management, of which the fund is about $600 million; we have two sub-advisory relationships, but the bulk of the remaining assets are high-net-worth individuals and institutional investors.
Morningstar classifies the fund as mid-cap, but S&P says small cap--would you clarify?
We're difficult to put into a box. We consider ourselves investors and we go where we think there is opportunity, but you'll find us in the small- to mid-cap area of the market because that's the area where there's less research focus. You probably have 30 people on the street looking at IBM and Microsoft--we add very little value to big-cap names unless there is something going on: there could be an inflection point with the company, there could be some turmoil surrounding the company. So, we're all-cap managers, but our emphasis is clearly on the small- to mid-cap side. I don't know what the median market-cap is today but it was around $2 billion three months ago, which would clearly put us in the small-cap arena. [Morningstar] moved us from small cap to mid cap; that was a function of three things: One, our names performed better, so the valuations of the overall portfolio moved up; our largest holding at the time was Thermo Electron. Thermo went through a merger with Fisher Scientific, which caused the market cap of that company to move up sharply. We also have an investment in Honeywell, and Honeywell was really a one-off situation, a bigger-cap name where we thought there was a compelling valuation to buy it. I would say that we've [for the most part] stayed in this small- to mid-cap area throughout our existence.
What's your investment process?
We consider ourselves analysts--not portfolio managers. The portfolio management side is really the residual of the work we do on the analytical side. Dennis and I are co-managers on the fund; we go out along with our analysts to meet with companies, visit competitors, suppliers; do all of the basic analysis work ourselves. We do the spreads, the valuation work, and from that we look at the opportunities that are out there and decide whether in fact this is a company that we feel comfortable with. We have to feel comfortable with the management team: that the management team is clearly on the shareholders' side, that they're capable managers--both in terms of running the day-to-day operations for the company as well as deploying capital. Our focus has always been on individual companies and not sector analysis, and for that reason we tend not to correlate well versus, really, any of the benchmarks out there. We have virtually zero exposure to financials.
I was going to ask about that--can you talk about when you reduced that?
We've never really had much of an exposure to financials, and part of the issue is, at least from my perspective, it's difficult to find out what's in the portfolio until after the fact. For a time, being underweight in financials clearly hurt our performance; it's obviously been a positive--not being in that area--over the last year or so. It's difficult to analyze from the outside so I've tended to stay away from the financials. That's not to say that we won't invest [in financials] from time to time, but, by and large we like to find companies that we can really get our hands around, understand what makes them tick, understand what the compelling, special situation is.
If you were to ask me, "How would you categorize yourself?" I'd say, "We are value managers with a special situation focus." We are attempting to buy companies where we think there might be a fundamental change, but it's not obvious to the rest of the world and certainly not obvious in the marketplace, and [where] we can buy that stock before the valuation reflects that potential change, and hopefully that special situation aspect will allow that company to prosper regardless of the economy.
Our focus has always been on attempting to minimize risk, so we're very careful of what we pay when we go into an investment. Oftentimes our first purchase might be our highest-cost purchase, and as we become increasingly confident in the investment we will average down. Conversely, one of the best ways to minimize, or to limit, risk in a portfolio is to constantly monitor the valuations of the names in your portfolio and to the extent that they begin to take on an element of market risk we begin to trim back holdings. So we will accumulate as we set up positions, and normally what we will do is we will distribute our stock into the marketplace as we [opportunistically] exit a position. It's unusual for us to suddenly say, okay, the stock's at 36; I'm going to sell the entire position.
So, slowly divest?
Yes, we'll feed it out as, hopefully, the market moves higher. Now, we will be more abrupt in our selling pattern if we realize we've [made a mistake], or the fundamentals aren't evolving as we had hoped, or if we're fortunate enough to have one of our companies be the target of a bid--we normally will sell to the arbitrageurs rather than wait for the deal to unwind and close.
Are there well-known investors or mentors who have influenced you--other than your partner [Dennis Delafield]?
Mario Gabelli. I was Mario's first analyst, back in the late '70s. I was working with Mario, and then I met Dennis. At the time [Gabelli's] shop was much more of a sell-side brokerage group. Mario is an extremely astute investor, and we've remained very good friends over the years.
What makes your fund different from its peer group?
I noted your fund continued to do well even in the early part of this decade when many of the stock averages were down.
It goes back to the discipline that we've had over the years and attempting to manage the portfolio with one eye on what we can lose. For our clients, we're very focused on risk. We've run the account on an absolute basis rather than relative basis. Whenever we get into an investment we're very worried about what we can lose. [With] many firms, their first criteria is what they can make in an investment. We clearly try to understand what the downside is in an investment, and hopefully we've done the proper analysis so that we know what the downside risk is, and we also have a good understanding of what we can make if the investment works out as we had hoped.
We're a little bit different in that we're small, mid cap, but we're really all cap. We will hold cash, and that is something that many people really have a problem with. It's not as though we're holding cash because we're trying to time the market. The cash is really the fact that we may not have wonderful new ideas at any point in time so instead of putting it in the market to be fully invested, we'll put it on the sidelines, and we'll use the cash in a pro-active way, to take advantage of volatility in the market. Going back to the end of the first quarter of '07, we had 24% in cash; at the end of the year we had 9%. At the end of this quarter we had about 12% in cash. We have been very willing to put money to work, but we're just simply not going to put money in the market if we don't think the valuations make sense.
Of course, when things are so crazy in the markets, the cash might help give you a little cushion, too?
It does. Especially from the standpoint of: if you're seeing the market very volatile to the downside, to the extent that we have cash we don't have to do triage on the portfolio. We don't have to disturb existing holdings, we can simply pull down the cash--and also you always want to have a little bit of cash in case there are redemptions and this has been a tough market for small-cap managers. So, the cash--I really don't view is as being defensive--we're very willing to use it in an offensive manner when we find opportunities.
The other issue is, we don't focus on sectors; we don't look at the world from a top-down perspective. Everything is driven from the bottom up and since we're the analysts and the portfolio managers there's a very short chain of command here. When people look at us, they take a look at our sector weightings and oftentimes that's the issue that comes up immediately--the lack of financials, a heavy weighting in industrials or certain consumer names--but again it's not that we're looking at any industry that drives us toward industrials or consumers, it's that we may find an attractive retailer and in the course of doing our work on that retailer we will go out and visit the competition and maybe some of the suppliers and we may find the competitor equally as attractive, and we will build up a position in both.
And there will be people who might say; "That's what active management should do because if we wanted the index we'd buy the index," right?
Yes. I would say we are clearly on the [opposite] side of passive management.
And it's worked out well for you, for the fund.
Thank you. It's been the same philosophy and the same approach since the firm was started in 1980--Dennis started the firm in 1980 and I joined a few months thereafter. The other unusual aspect is that we've been together for 28 years.
Having been together so long, but also having come through 1987 and the early '90s--when certain localities went through a real estate crunch, or contraction--do you see any parallels between the markets then and what's going on in the markets now?
The common aspects are uncertainty and fear. If I look back to the late '90s where we did have some underperformance--that was during the tech bubble, where it really didn't matter how much work you did--it was the individual investor who was buying the Internet names and those stocks were going up 30%, 40%--seemingly every week--and we were totally out of sync with that market. We stuck to what we knew and we clearly lagged the market. We didn't understand what was going on with the marketplace at that time, so as a value investor we were left shaking our head, and eventually the cycle reversed itself and the excesses were washed out.
Today, clearly there's an issue with the credit markets and the ramifications it's having throughout the economy. As an investor sitting down and taking a look at the wind-down of Bear Stearns, basically over a weekend, it's difficult for us to analyze the situation because there are so many issues at work, so many pieces of paper that they have within a Bear Stearns or a UBS, that from the outside you're never going to be able to value properly, so you don't know where it's going to stop. What you have seen is that, clearly, the consumer has been buffeted by almost daily bad news as it relates to the major banks taking write-downs or markdowns. From a consumer standpoint, they have pulled in their horns, they're a little bit uncertain as to what the future's going to hold. Couple that with increasing energy prices, and mortgages in many cases being upside-down--I can understand why the economy has clearly slowed and we may in fact be in a recession right now. There are certain areas of the marketplace that I would say have been in recession for a period of time.
Do you mean geographically or by industry?
Industries. It may be a difficult period for a number of quarters. The housing area clearly has to work off the unsold inventory levels and consumers have got to feel healthy again before they want to return to the marketplace--and there's got to be the availability of financing.
And the actual trading of short-term securities again?
For a bottom-up [investor] does all of this create opportunity?
The macro does have an impact on, for example, the entire retail sector. [If] the consumer feels uncomfortable about visiting the mall, retail comps are going to be down. We continue to look for opportunities amidst all of this turmoil. We may be able to find retailers--just to pick an industry--or industrial companies that have been hit to such an extent that their valuations are very reasonable and really don't reflect what we think will happen on a going-forward basis.
What's key to our analysis is, we're constantly looking for companies that we think can better themselves. It can be an average company becoming better-than-average, but what we try to identify is that rate of change, and that really comes about as the company improves its cost structure, improves its cash flows, talent, employees, its free cash flow. What we're trying to find are special situations and many times a special situation can be a company that we identify that is going through some turmoil. The earnings at a given point in time might be fairly de minimis, the company could even be losing money, but what we're trying to do is to look out a couple of years and say, "Once this company fixes itself, gets it operations where they should be whether that entails closing down plants, selling off businesses, making management changes, what will this company be earning a couple of years out, what will the free cash flow be?" Based on that we will attempt to value that earnings stream.
So, generally your outlook for these companies is pretty long term?
We clearly are looking to generate long-term capital gains, and a holding period could be two to three years. If a company is in the process of going through a transition it takes time for the management team to put in place the required fixes to make this a more profitable enterprise.
Is there a company that worked out better than your thesis indicated?
There's a company that we've had an investment in for a while called Kennametal [KMT], it's a large holding; it's in the industrial area, a metal cutting company. The primary product is the carbide insert that would go into a machine tool. It will cut or shave metal from engine blocks, it can make holes; it's an integral part of industrial America. These carbide inserts normally have a life of an hour or two so it's a consumable item. We initially got involved with this company going back a number of years ago; they had purchased a company we had a large holding in, called Greenfield Industries, [which] was basically a roll-up of a number of machine tool, metal turning companies; they made high-speed steel twist drills. [We] began to know Kennametal a bit and they paid clearly a very rich price for Greenfield, and in retrospect they paid too much. We followed the company over time and we realized that they had a wonderful franchise but the franchise wasn't being optimized and needed to see a change in focus. Ultimately that change in focus came about as they brought in a new CEO, and he brought in other people and he really changed the culture of the organization. The company, which had been very levered by doing this Greenfield deal, was able to de-lever very rapidly, make acquisitions, and change the structure of the company.
Today it's a very profitable company, generating large amounts of free cash flow, making selective acquisitions, and the stock has performed exceedingly well over that period. It has backed off; the stock had split two-for-one several months ago, but it did reach a high of around $45, $46, and it's backed off over the last several months to the low $30s, really due to the marketplace--the fear that the industrial cycle will begin to wind down. But, it's a company that has done a great job of consistently improving their earnings, cash flow, operating margins, return on investment, and to the extent that they've had assets that really don't fit--especially regarding their distribution business--they've been very willing to part with those assets. The CEO left and the president took over and has done a wonderful job continuing to improve the overall profile of this company. It's a holding that we've had for quite awhile, now, because he's continued to improve its fortunes.
Is there a company that has not worked out as you'd expected?
Retailers [are] an area that has been as hard-hit as the financial area. We have a position in Foot Locker [FL], and in Collective Brands [PSS], and I would say they both are being impacted by the same issues, namely traffic. In both cases, we bought the companies based on valuation, thinking that we're buying them at a relatively low multiple of EBITDA, generating good cash flow, and we feel very comfortable with the management teams here and the strategies that they've put in place. Foot Locker is a little bit longer-term holding, we bought it several years ago after they had a spat with Nike, we bought it down around a little bit lower than here, and the stock ran to the mid- to upper-$20s and we pared back quite a bit of our holdings because we thought, at that point, the valuation was becoming reasonable. It has done a 180 in light of the weaker-than-expected earnings because of the consumer traffic, and in both cases, Collective Brands and Foot Locker, we have continued to add to the position as they've been under pressure, because we're comfortable with the strategy and the program that management has laid out.
So the thinking is that in the long term, you've averaged down in your position cost and that will benefit the portfolio moving forward?
Yes. Foot Locker has more cash than debt, so we've got an outstanding balance sheet, and I think the dividend yield is about 5% now, so there really shouldn't be--we hope--much in the way of further downside from here. Collective Brands made an interesting acquisition last year, of Stride Rite Corporation, and we think there is much in the way of cost and distribution synergies that will substantially improve the earnings over time, but in the interim, you've got a company going through this integration against a backdrop of a very difficult retail environment.
What kind of investor is this fund for?
If you look at our style of investing we should do well in markets that are flat to down. In very strong markets we won't do as well, we'll lag on a relative basis. It's a very eclectic portfolio so it may not be the normal market-type names that will run with a market that's up 10% in a quarter. To the extent that the market is moving up very rapidly and valuations are beginning to get rich, we will begin to embrace cash, so the cash may be a drag as the market begins to run. Conversely, as the market pulls back and there are more opportunities, you'll find us putting that cash to work, so we're clearly contrarians.
What else do advisors need to know about the fund?
We have our own money in the fund. This is truly a bottom-up, stock-by-stock built portfolio, and hopefully it's a portfolio that has a number of wonderful special situations that will allow it to take on a cycle of its own rather than simply paralleling what the stock market's doing. Our focus may be mundane and fundamental but it's going back to assessing value in relation to earnings power, emphasizing free cash flow, and spending quite a bit of time evaluating management. As it relates to that it's much more art than science.
Senior Editor Kathleen M. McBride can be reached at firstname.lastname@example.org.