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Little Fish, Big Fish

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In a sector as diverse as financial services, it’s sometimes difficult to understand why all the companies in the sector are lumped together. Home to banks, brokerage firms, insurance companies, leasing companies, and asset management firms, this sector’s performance often leaves half its companies flourishing while the others struggle for breath. The ability to play on this sector’s instability is one reason why Anton Schutz, manager and founder of the Burnham Financial Services Fund (BURKX), has thrived in an economy where so many have floundered.

“You literally have to break this sector out into specialties because there are so many opportunities,” says Schutz, president of Mendon Capital Advisors Corp. in Rochester, New York, which runs the fund for Burnham Asset Management. “You have to look at the entire picture, including interest rates and the economy.” With one trader and two analysts, BURKX invests in companies overlooked by most other funds. “In the smaller-cap ones there are few analysts following them,” he says. “This gives you an edge.” But Schutz’s search is not limited to lesser-known angels. He looks for both small- and mid-cap firms that appear to be temporarily undervalued and to those that may be targets for acquisition by larger companies. And while he remains almost fully invested, with less than 7% in cash and equivalents, his turnover rate hovers somewhere above the 500% mark (his peers currently average a 177% turnover).

For the three-year period ended February 28, 2003, Burnham Financial Services Fund/A had an average annualized total return of 38.6%, versus a total return of -13.7% for the S&P 500 Composite Index, and -8.4% for all equity sector funds, according to Standard & Poor’s. This fund ranked first within the entire universe of 769 funds in S&P’s peer group. Both Morningstar and S&P have awarded this fund five stars.

“It’s interesting to me that headlines are saying mergers and acquisitions are way down, and financial services are in the ninth inning of the game. In 1990, there were 15,000 banks, and today there are 9,000. We’re in the middle inning of the game, and there is a lot more [playing] to be done.”

BURKX is the only fund Schutz manages, and he has a large amount of his own money invested in it. But before you begin pitching this fund in your next client meeting, remember its high expense ratio, 1.60%, its 5% front-end sales load (waived for advisory platforms), and that high turnover rate.

On a visit to New York, Schutz talked about why financials are the place to be, why it’s profitable to look at companies that are down but not out, and which investors he expects would benefit most from his fund.

Your company’s literature says this fund is based on “proprietary research techniques.” Can you tell me what that includes? A lot. There is a tremendous amount of data and intuition that goes into it, but it all starts with a macro view. First, you have to look at the entire picture. Then you look at the financials sector, which is really a series of subsectors, and decide which parts you want to be in. Then you take a bottom-up approach and pick the names you think are going to outperform within those subsectors.

The second part of the research is more actuarial. The smaller-cap companies, like the savings and loans, actually have a “lifespan.” The reasons these companies go public for the most part is to enhance the wealth of the depositors and the management. When these companies do go public, at six months of age the managers are granted 4% of the company’s stock as options. At one year, they are granted to buy an unlimited amount of stock back; typically these companies have way too much capital and the regulators force that on them when they go public. Then at three years, they can sell the company without asking the regulators for permission.

So you can literally go out and age a portfolio and harvest companies at these various stages. At six months you can buy stock because it is not very liquid, but [there's] room for gain. Then you want to buy again at one year.

Your fund seeks opportunities among lesser-known financial institutions because fewer analysts typically follow these companies. Yes, in the smaller-cap ones there are few analysts following them, and this gives you an edge.

Today, I am going to visit a bunch of bank CEOs who are playing golf. I am a terrible golfer, but if it gives me a chance to spend four hours with them, I am happy to absorb as much information as I can. Every bit of information helps, even the smallest. There are subtleties like body language, and even the physical appearance and health of a management team that matter. When you think about these people who are in their late 50s and early 60s, they are starting to think more about golf and less about making money. And you start to think that maybe these guys are sellers.

I think it is also important to get into the minds of the buyers and understand who they are. I tend to focus on the small-cap banks, but it is the mid-cap banks that also are very important to me, since they are the buyers of these companies. Are they looking to do deals? Geographically, what type of footprint would they like to have? Then you can overlay that into these aging companies, and what you end up with is a geographic and actuarial list of companies that you like.

States like Connecticut have been very good to me in that respect. There are only two companies left there in the $500 million to $2 billion in assets range, and I own both of them [Alliance Bank and Connecticut Bank Shares]. I think the inevitable is going to happen and both companies are going to be gone. And then I will have to go hunting in a different state. Massachusetts has had a lot of good activity as well. You have a lot of older management teams and billion-dollar franchises that are now starting to [sell].

What are your holding requirements? Do you have a certain amount allocated to each subsector? There is no mathematical model, but what I try to accomplish is based on that macro view. One of the easy calls in the last couple of years was to get as many interest-sensitive companies in the portfolio as possible. They were the savings and loans, the pure mortgage originators, and the mortgage REITs. All three are very high dividend payers and you didn’t have to do any bottom-up research. Now you can’t be so generic.

When I look at some of the savings and loans I have added to the portfolio in the last six months, they are some of the most recently converted companies with a ton of capital, which they could potentially under this new [dividend tax] legislation return to the shareholders. But that is not the only reason I own these companies. They are very safe because of the capital, obviously we know buybacks are coming in the options, and if this legislation does pass, these guys are going to pay out tremendous dividends. I think the Street hasn’t necessarily caught on to their potential. The Street has looked for companies with high yields, but I am not sure they are looking for companies [that have only] the potential of high yields.

Looking at the subsectors, I will take small-cap banks and lump them somewhat together, then I’ll look at all aspects of a sector like insurance, which includes life insurers and property and casualty. I like companies that are beaten out badly. That intrigues me because they will trade at lower multiples and nobody wants them. For example, the broker/dealers are trading anywhere from one-third to one-half of where they used to trade. I am in two of those companies and I am closely monitoring them. The other thing I do that I think is pretty unique is to sell covered calls. I can’t do that on my small caps, but I can do it on my broker/dealers, my insurance companies, and asset managers. That clearly helps in a choppy market and it helps that when the volatility is high, I get to harvest.

Do you maintain the same number of holdings every year? It fluctuates. In periods where money comes pouring in, the holdings will go up because there are more opportunities. And then there are periods of contraction when no new money is coming in or getting redeemed, so I’ll be looking to prune the portfolio. Usually it stays between 50 and 70 names, and right now I am close to 60. [S&P currently lists the fund's holdings at 152, which includes all of Schutz's call options.]

This is a highly concentrated fund. What are some of the benefits and drawbacks of investing in such a fund? If I have a position that I feel very strongly about, where the downside is limited and there is a large upside potential, I would build a 5% position on that. If the fund were to shrink, I would not sell a name I liked; I would sell a name I didn’t like as much. So the core position could actually grow. I generally won’t add to a position that is around 5%, unless I think there is a positive near-term event. If I have money coming into the fund, I look for the best opportunity that day. I don’t go across the board and say, “I have $2 million in and I am going to take my 60 positions and break them all up and add shares.” Clearly I don’t like all 60 of my companies the same.

Obviously a drawback [to that approach] would be if something pretty bad happens. But the interesting thing about this space is that these companies are easier to value. They have some historical parameters, and because it is a consolidating industry, if something goes wrong, then it becomes food.

This fund’s performance has held strong since early 2001. Have you changed your management or investing styles? I have definitely held true to my style. When I first began running money, I had more of a buy-and-hold approach. I think, though, that the 1998 time frame taught me a whole lot of lessons about buying something and knowing it is going to work out down the road. If I own a $45 stock and [the company is] going to miss earnings and drop to $40, even though I think it is worth $60, I am going to leave and I will buy it back at $40. I am not going to try to manage taxes that way. I am absolute-return focused. If I can be tax efficient, I will, but I would be better off at $5 and have my investors worry about taxes than take that kind of a hit to the fund. Many people in this business think that if something is worth $60 and it goes down $2 or $3 they don’t care. But I am looking to make small returns here and there and compound those returns; those small returns turn into big returns.

Who is your ideal investor? Where do you see this fund in someone’s portfolio? I think I have an interesting mix of investors. I have a fair amount of Mom and Pop investors and those are my favorites because they put the money in and it stays there. Clearly I have some professional advisors who come in and stay with me. A good 50% of the assets are from advisor platforms, and a number of them have been with me for a while. I have been running this fund for three and a half years, and I have had some consistency in generating returns. And given my ability to evolve in different markets, this fund should certainly be a component in many people’s portfolios.