From the August 2012 issue of Research Magazine • Subscribe!

Top Fund Managers Reveal Investment Opportunities

(Chicago) Chairman and CEO Joe Mansueto kicked off Morningstar’s 2012 Investment Conference in Chicago on June 20 by noting the presence of 1,850 attendees, 75 journalists and 200 exhibitors at this year’s show. He then introduced the opening keynote speaker, famed Franklin Templeton fixed-income manager Michael Hasenstab, by highlighting Hasenstab’s status as Morningstar’s 2010 fixed-income manager of the year.

“When Michael began at Franklin Templeton, he managed $100 million,” Mansueto added. “Today, he is responsible for a group that oversees $160 billion in assets. The fund that he specifically manages, the Templeton Global Bond Fund, is second only to PIMCO Total Return in its size.”

The soft-spoken Hasenstab then took the stage and quipped, “We’re in a period of incredible uncertainty. I’d like a boring summer for a change, but it doesn’t look like it will happen. How should we separate the noise from the really key issues? More importantly, should we panic?”

A good argument could be made for panicking, he said, especially if you think the European Union will break up and China will have a hard landing; global markets could not absorb either event and “it would make Lehman look like a warm-up.”

“But if we’re able to stay calm, we’ll need to think through the ‘tectonic shifts’ happening in the world that have largely been masked by the crisis in Greece,” he noted.

As for inflation, “We have this unconventional monetary policy at central banks, which are printing money,” he warned. “If this is such a good idea, why weren’t we doing it all along? Between 25% and 30% of global GDP has been printed at banks, so this is by no means at the fringe. We need to think about the consequences of those actions, which will not be felt as much in the United States [or] Europe, rather in the rest of the world.”

The risk to emerging markets, specifically, is a flood of capital resulting in a “monetary tsunami” in those countries, which will present a major challenge. Here in the United States, the debasing of the dollar could lead to an asset-base distortion that would put upward pressure on commodities, in Hasenstab’s view.

But all this risk and uncertainty provide opportunity, he concluded. “In emerging markets, the tables have turned. Those countries that were once high credit risks, like Indonesia, now look very good, so you should upend your traditional risk models. Also, the United States, Japan and Europe printed money, and don’t look so good. But non-leveraged countries in the rest of the world weren’t printing money, didn’t have an asset bubble and as a consequence didn’t have to deleverage. We like to get yield with little or no credit or interest-rate risk. This is why Asia currently looks so good.”

 Fund-Manager Panel

“Investors are asking about stocks, corporate debt and so-called hybrid investment,” Michael Herbst said on June 21. “But with volatility, yield and equity returns being what they are, those decisions have been turned on their heads.”

Herbst, Morningstar’s associate director of fund analysis, hosted a panel of high-profile fund managers for the general session of the company’s annual conference. Featuring PIMCO’s Mark Kiesel, Invesco’s Meggan Walsh and Don Yacktman of Yacktman Asset Management, the panel touched on each manager’s investment philosophy and how they identify potential red flags, especially when investing across capital structures.

Herbst began by asking the panel what they are looking for “across the capital structure fence?” Yacktman, an equity manager, said he “tends to look at equities in the same way we look at bonds. If we are to hold on to them for a long time, what type of risk and return would we have? It’s almost like holding a bond to maturity.”

Walsh added that Invesco focuses on the potential for capital appreciation, and that she “spends a lot of time on figuring out the potential downside,” which, given that she’s a portfolio manager, was reassuring for the audience to hear.

Kiesel said PIMCO managers take a top-down approach, beginning by asking themselves what areas of the world they feel will perform best. “Currently, we feel it’s the United States and Asia,” he said, partly agreeing (Asia) and disagreeing (United States) with Franklin Templeton’s Hasenstab. “We then consider a particular company’s enterprise value and where on the risk/reward spectrum we will then perform best. It’s really very simple; it’s the best part of the globe, the best sector in that part of the globe and then where we should invest in the capital structure.”

Herbst then asked about the managers’ red flags. “We favor businesses with a high return on real assets, so we look to the left side of the balance sheet,” Yacktman said. “We look to avoid low return, low turnover of assets and companies with off-balance sheet issues like pensions. We feel pensions are the wrong way to fund retirement.”

Kiesel noted that most company balance sheets are healthy at the moment, as capital market have “been open” for the past three to four years. “Credit might not be available for governments, but it sure has for companies,” he said. “So we look at the stress-free cash flow for the company throughout an entire business cycle.”

Herbst then asked the panel about their process for evaluating company management teams, which he said was one of the most frequently asked questions from investors. Kiesel said PIMCO travels frequently to visit companies at their headquarters and specifically asks executive teams about their top three priorities.

“For instance, banks are currently building capital, which means they’re not equity friendly and are running a conservative business because governments are trapping capital inside. This means it’s a good investment for bondholders. So we’ll get on a plane, meet the managers and ask them about it.”

Walsh said it’s important to “watch what managers do, not what they say,” a point to which Yacktman emphatically agreed. “They’ll give you standard answers to your questions,” she said. “We want to see a proactive method for how they responsibly handle their cash on their balance sheets. Right now, a lot of cash is trapped overseas and managers are looking to make acquisitions in order to grow. But these acquisitions might not be good fits. So we keep their feet on the ground.”

“Behavioral patterns are instructive,” Yacktman added. “I once spoke with a CEO who said, ‘My people are always trying to get me on CNBC. I don’t want to go on CNBC. The people that watch are not our investors, and I don’t want the investors that do watch. It would be a total waste of time.’ That was music to my ears. I said, ‘Wow, this guy is focused.’”

As for where the managers are finding alpha from a valuation perspective, Walsh named the housing and homebuilders, consumer discretionary, transportation and lodging sectors. Kiesel likes energy, which he said is a good area for equity and debt investors. He agreed with Walsh that housing has hit bottom, and as a result likes Weyerhaeuser for its timber exposure. Lastly, he pointed to gaming in China.

“If you look at Macau, it’s doing five times the business of Las Vegas,” said Kiesel. “Five years ago they were essentially even. So this is another area that is good for both equity and debt investors.”

 Long-Term Take

“We’re not going to play the loser’s game,” David Rolfe, chief investment officer of St. Louis-based Wedgewood Partners, said upon being named an SMA Manager of the Year in April 2011. “Instead of trying to time the markets and getting sucked into short-term volatility, we take a long-term view and let the markets work for us. Too many of our competitors try to do otherwise, and we refuse to play that game. That, quite simply, is our investing philosophy. ”

Fast forward a year, and there’s not been much change. That adherence to the philosophy in good markets and bad is one reason for Rolfe’s success, and why he’s now celebrating his 20th year with Wedgewood. “I started with $10 million to $15 million in assets under management,” he recalled at the Morningstar event on June 21. “Today we have $1.7 billion in AUM.”

“To outperform an index, we believe that our portfolios must be constructed as different from an index as possible,” explained Rolfe. “Thinking and acting like business owners reduces our interest to those few businesses which are superior. Both of these views lead to our focused (concentrated) approach.”

So far, this philosophy has “worked through complete business cycles,” he said. “We don’t believe we have an informational advantage. We look for 20 good portfolio finds where the valuations make sense. In this way, clients don’t have to sacrifice growth to get value and vice versa.”

As for the current situation in Europe, economic issues here in the U.S. and everything else that’s happening, Rolfe wasn’t all that concerned, at least not from an investment standpoint. “As the market climbs that classic wall of worry, it represents opportunity,” he said, “especially for a concentrated portfolio like ours.” And concentrated it is, with only 20 companies allowed at any one time, a number which only 2% of all money managers are able to claim, he said.

Rolfe admitted that a possible “Achilles heel” to such a concentrated portfolio is that it’s “always one day away from an earnings disappointment.” But if he’s done his homework, he added, he shouldn’t be surprised.

 Looking for Legacy

“When you leave this company behind, what will it look like?” That’s the most important question Eric Schoenstein asks executives when performing his due diligence. The co-portfolio manager of the Jensen Quality Growth Fund and principal with Jensen Investment Management knows he’ll get the standard answers to any questions he might ask. And as the saying goes, “it’s not about what they say, but rather what they do.”

“We have a quality growth strategy begun by Val Jensen in 1988,” he said on June 21 at the Morningstar event. He said to mitigate business risk they look for companies with “a durable, sustainable competitive advantage with a high level of cash flow that delivers returns above the cost of capital.”

“In order to create value, we have to ensure the returns are above the cost of capital year after year,” Schoenstein added. “In this way, the returns compound over the long term, which leads to our long track record of success.”

As to mitigating the second factor, pricing risk, he simply said, “We make sure we don’t overpay.” Sounds great in theory, but how does it translate to research and investing day-to-day?

The fund’s “boot camp” style discipline demands that the fund not consider a company if it has not achieved 15% return on equity for 10 consecutive years (you read that right; when they say quality, they mean quality). The small number of companies that meet this criterion means “it’s a limited universe in which to shop,” another reason for the fund’s relatively low turnover.

“We have a bottom-up due diligence process,” Schoenstein said. “It’s a long-term strategy that isn’t about next week, or even next year. Hence the original question; I want to know what their vision is for the company down the road.”

While the portfolio looks to be concentrated, the managers look at it as an advantage, as “they truly have their arms wrapped around each and every position,” thus lowering the risk. Companies in which the fund invests include PepsiCo, Procter & Gamble, Emerson Electric, Nike and Microsoft.

“Globally diversified companies are doing well,” he noted. “If they’re domestically domiciled, an emerging-market component is needed. Even if emerging markets are slowing overall, they’re still growing much faster than developed countries. For this reason, emerging markets should be 20% to 25% of the portfolio.”

“We look for consistency and predictability,” he said. “Only in this way can you smooth volatility and get needed returns with less risk.”

 Managed Futures

Alternative asset management firm Longboard likes to focus on financial fun. “We observe the oceans of opportunity and catch the wave,” Cole Wilcox, CEO of Longboard, at the 2012 Morningstar Investment Conference on June 21. “The tool is right, because longboards are used to surf the large waves, of which we want to get out in front. Short boards are for smaller waves, and we’re not interested in them.”

In case it wasn’t obvious enough, he means long-term cyclical trends—the average duration of one of their trades is one year. “We specialize in ultra-long-term durations of managed futures in the ’40 Act space,” he said. “We bring a high level of technical expertise to the strategy. We noticed there was really no directly managed, sponsored product, so we responded to that need. It’s efficient and really takes advantages of those fat tails along the curve.”

Much of the firm’s distribution strategy, not surprisingly, relies on advisor and client education. “It’s an education approach first,” Wilcox said. “We want to explain to them why trend following [i.e. riding the wave] works. We want them to understand why typically there is a small minority of investment winners and a large majority of investment losers, and how they can be a part of the former.”

While Longboard has a high level of technical expertise and “pedigree” in the alternative asset space, the latest fund, the Longboard Managed Futures Strategy Fund, Class N shares, launched in late June and will seek positive absolute returns.

“The fund will hold a mix of fixed-income securities and futures and forward contracts,” according to the website. “Like other managed futures funds, it will invest globally in equities, energies, interest rates, grains, meats, soft commodities (such as sugar, coffee and cocoa), currencies, and metals sector. It may offer some emerging-markets exposure.”

Wilcox ran a managed futures hedge fund for Blackstar Funds for eight years. Blackstar counted the legendary investor Thomas Basso as its lead investor and was set up essentially as a family office to manage his money. Basso, a big proponent of following trends when trading, was president and founder of Trendstat Capital Management. He also authored two books on the subject, Panic-Proof Investing and the self-published The Frustrated Investor. In 1998, he was elected to the board of the National Futures Association.

“No other hedge-fund pedigree is doing a directly managed futures fund,” Wilcox noted. “For the advisor, it means reasonable fees and a sustainable investment process. It will be delivered in a mutual fund and will have liquidity. It won’t be a ‘2 and 20’ situation and the client won’t have to compromise on fees to get performance. They’ll have direct access to managers at a reasonable cost.”

He concluded “We’re like Southwest Airlines, we do one thing and we do it well. You know what you get and, more importantly, you know what you won’t get.” The minimum initial investment for the new fund is $2,500. Expenses will start at 3.24%, plus a 1% fee of shares held for fewer than 30 days.

 Business Value

Money manager Mark Travis will never be all things to all people, and that suits him just fine. “We have capacity constraint, where we can’t really manage more than $3 billion,” the president and portfolio manager of the Intrepid Capital Fund said on June 20. “If I ever find I’m simply hugging an index and not providing real value, I’ll go hunting or fishing or something else.”

He has a down-home, good-old-boy attitude that, while charming, masks a sophisticated individual (seemingly intentionally so) who knows how to make money for his clients. In addition to his duties as lead portfolio manager of the Intrepid Capital Fund, he’s a member of the investment teams responsible for the Intrepid Small Cap Fund, Intrepid Income Fund and Intrepid All Cap Fund.

“For 17 years, I’ve been contrarian and valuation sensitive,” said the Jacksonville, Fla.-raised Travis. “If I don’t find something good in which to invest based on valuations, I’ll go to cash.”

Intrepid Capital Funds has assets of $1.4 billion, with $370 million in ICMBX. Travis believes price is not always indicative of value, so strategy is driven by internal research that focuses on a business’s value­—not changing stock prices.

The Intrepid team brags it’s good at finding value in stocks not readily covered by Wall Street, and it typically invests in businesses with sustainable competitive advantages, high free cash flows and quality balance sheets. It also believes in financially strong companies that are market leaders in their industries, those have an ability to outperform when “catalysts for change exist” and can be purchased as a sizeable discount.

“We’re not set up with infinite amounts of capital, so we feel it’s less efficient to be fully invested,” Travis added. “With cash on hand, it means we can buy at the most opportune time.”

The fund is rated with five stars and resides in the top percentile of its peer group. As for performance, it is the envy of many of the managers at the conference: up 1.6% year to date (as of June 11); 11.1% annualized return over a 3-year period, ranking in the top 21st percentile; and a 5.8% annualized return over 5-year period, ranking in the (aforementioned) top percentile.

“We have consciously built our firm to limit what we do,” he said. “We invest in companies with a $300-million market cap up to the Microsofts on the high end. We can go anywhere; we just invested in a number of Japanese video game companies right after the tsunami. What I mean by ‘limiting what we do’ relates to the size of the fund and the possibility of growing too large.”

Travis is finding alpha in the small-cap equity space. On the fixed income side, he likes cash or treasury bills. “I feel we’re an all-weather, off-road tire,” he added, lapsing back into his southern parlance. “We like our capital to compound without worrying too much about volatility. We’re not for everyone, but I believe there’s more than one way to get to investment heaven. Let’s hope we all get there.”

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