No Mimicry Here

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.