Just in time for the back-to-school season, here is a fund that takes a disciplined approach to investing. The manager stresses good old balance sheet arithmetic for the companies he buys: low expenses, plus solid earnings and reasonable valuations, producing a fund that steadily outperforms its peers. Of course, generating consistent returns is not as easy as the manager makes it look. It takes an analytical, strategic approach, and that’s just what you find when you meet David Ellison, the Boston-based president of Friedman, Billings, Ramsey & Co., Inc. Fund Advisors, and portfolio manager of the FBR Small Cap Financial Fund (FBRSX). “We’re trying to find companies with a very balanced approach to what they’re doing and have those four or five criteria that fit, build a portfolio of 60 or 70 names, and just let it run.”
Both Morningstar and Standard & Poor’s give this domestic equity fund five stars overall, and that’s not surprising given a five-year annualized total return of 24.93% for this no-load fund versus 5.14% for its peers in the S&P 500 Financials Sector Index.
How much money do you manage? FBR manages almost $2.3 billion. The two financial services funds [FBR Large Cap Financial and Small Cap Financial] are about $600 million of that.
Do you co-manage the Tech Fund? Right. It’s about $14 million. The Tech Fund is fairly new; it had its three-year anniversary in March.
What is your investment process for the small cap financial fund? You start with all the companies in that universe and look at valuations, price to book, P/E, and other ratios, trying to get at what the earnings power is for each company: what the upside is to earnings and whether they’re running on all eight cylinders or only two cylinders. The critical thing is valuation–you’ve got to have a valuation discipline. Price-to-book and P/E are two critical factors in determining what you’re going to own. The third critical factor is a low expense ratio. It’s a commodity business, so you don’t want the highest-cost operation. You focus on building deposits and having a very good credit discipline. You look to build a very sustainable engine, not at companies that are earning a maximum amount on equity or a maximum amount on assets–[but] companies that have a model that’s sustainable.
If I can own companies that are going to grow book value at 10% to 15% a year, that’s sustainable, then presumably if the return-on-book or return-on-equity stays the same, then the stock should go up 12% to 15% a year, assuming there’s no decline in price-to-book or price-to-earnings. There won’t be a lot of turnover in the portfolio because companies don’t change. If you have 600 names in the universe of banks, how do you get it down to 50? I’m going to look at the cheapest 300 on P/E and the cheapest 300 on price-to-book–that’s the starting point. Which of those have low expense ratios? Get rid of the most expensive 50, and see which ones have a real focus on the liability side–then you look at the companies and what they actually do, you can’t really do a mathematical number there. The real value of the company is the ability to raise deposits at a very low [interest] rate and a low cost, because that goes hand-in-hand.
How do you find the banks that are able to raise deposits in such a low-interest-rate environment? You look at the overall cost-of-funds, average deposits per branch, and growth of deposits per year. It’s a matter of going through the numbers and whittling down: he’s shrinking; he’s growing deposits but it’s costing him 8%, no good–forget it! He’s growing deposits and it’s costing him 50 basis points–ahh, I want that one! It’s a big mathematical hunt and peck. You want the ones that are growing [deposits] effectively; they’re spending most of their time trying to grow the liabilities [deposits] and less time trying to grow the assets, or loans. Obviously you want to make good loans, but for those you can just go out and buy FNMAs or GNMAs. If your cost-of-funds is so low that you can make money by buying CDs at other banks, then you’ve really got a franchise.
People look at [banks] and say, “Oh, they’re making a lot of loans, therefore it’s a good company.” Anybody can make a loan–what is it costing them to make that loan? How are they financing it? When companies get into trouble–banks and non-banks–it’s because their assets go bad. Banks don’t fail because their liabilities go away–banks fail because their assets go non-performing and they don’t have the earnings to cover the yield on their liabilities. I’ve been doing this for 20 years; I can look at a bank and in two minutes tell whether I want to own it or not.
When you decide to sell a holding, is it because you see it evolve outside of the box? You sell for two [reasons]: It’s moving out of the box and/or the valuation. Getting back to the valuation criteria, valuation is a very big part of the discipline, because it protects the downside. If you’re wrong on a couple of names in the portfolio and they go down 20% to 30% or something, there isn’t enough horsepower, usually, to make that up.
Are there outside factors that would affect that, for instance, quality of the loans deteriorating because of the economy? Typically that’s a big part of the valuation issue. If people are afraid of credit they’re going to move away from it, but generally it’s the old, “unemployment is at 5% and people say it’s horrible,” but 95% are employed. If you make loans with any sense of prudence, you’re not going to run into a credit quality problem. Most people don’t buy a home to default; most people don’t take out a credit card loan to not pay it off.
It’s the [companies] that go off and do crazy things like assume that making home loans at 110% of value is a good deal. All of a sudden it’s 80% of the portfolio and they wonder why they get into trouble. I don’t own those kinds of things. There’s plenty of that–I could have a whole portfolio full of companies like that–and wouldn’t be able to sleep at night. I tend to want to own the companies that are very balanced and are going to give me a decent return. I’m not looking for 80% to 90% a year–I’m looking for 10% to 12% to 15% a year, maybe more, maybe less, and I’m trying to be mindful of the downside, because this industry doesn’t give you the opportunity to make up a tough year, so I prefer to give you 80% of the upside and 20% of the downside. I’m willing to give up some of the upside and some of the high-flying names [when, for instance] everybody says, “Oh it’s great; it’s a new paradigm.” The stocks go crazy and then two years later, nobody talks about it.
The idea is to do it that way over long periods of time. That’s why you look at the portfolio–it’s pretty stable, the names don’t change, and when they do change, they change typically for two reasons: the valuation, or there’s been some change in management or strategy that moves it away from where I want to be. It’s a very disciplined approach; it can be very boring in the sense that things don’t change in the portfolio. If the stock’s up 10% on some short squeeze I’ll sell some, but that doesn’t happen but once a quarter; if there’s a takeover rumor or if the stock is up I may sell some. The names in the portfolio today are probably the names that have been there–some of the names have been there since I started the fund.
So, that explains your low turnover? And it will stay that way. That’s the style of the fund.