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March 26, 2012 at 08:00 PM
The one thing seen among all of this year’s winners?
“Dividend yield,” says Gib Watson, Prima Capital’s president and CEO, which probably doesn’t come as a surprise, given the desperate search for income in this slow-growth world.
This is the eighth year Investment Advisor has teamed with the Denver-based research firm to announce the best separately managed account managers in multiple categories. Prima, whose planned acquisition by Envestnet was announced in February (closing of the deal is expected in April; see the June 2011 cover story for more about Envestnet), looks for repeatable and sustainable processes in the products and managers they consider as candidates for this annual honor. The products must report to the PrimaGuide research application, have at least $200 million in assets and have tenured management of at least three years. Products and managers must rate highly according to Prima’s due diligence process, which uses a proprietary, systematic, multifactor manager evaluation methodology that combines both quantitative and qualitative criteria. There are 13 factors that the Prima analysts consider before recommending the finalists for SMA Managers of the Year, including performance, firm, people, process, style, customer service, tax efficiency and composite.
The goal? To identify two finalists for each award, with one of the finalists being recognized as the primary recommendation.
The categories are: Large-Cap U.S. Equity Manager; Mid-Cap U.S. Equity Manager; Small-Cap U.S. Equity Manager; International or Global Manager; Taxable or Tax-Exempt Fixed Income Manager; and Specialty Manager, which involves a specialty stock, dividend strategy, opportunistic alpha manager, all-cap, go-anywhere or tax-aware strategy.
Unfortunately, no one qualified for the Specialty Manager category this year, but fortunately, two competing firms in one category were so close in the outcome of Prima’s due diligence process that both were awarded the prize. It was just one of many pleasant surprises to come from this year’s crop.
(Read about the 2011 SMA Managers of the Year.)
U.S. Large-Cap Equity Award
BRC Investment Management
Large-Cap Concentrated Equity Portfolio
Sure, behavioral economics is a fascinating subject in the abstract; something routinely discussed at conferences and featured in magazine articles. It’s even broken through in pop culture as the underlying concept driving Billy Beane, Brad Pitt’s character in “Moneyball.” But how many advisory and money management firms actually employ Nobel Prize winner Daniel Kahneman’s prospect theory, mental accounting and the other tenets on a sustainable and repeatable basis in the models they’ve developed?
Denver-based BRC Investment Management does, and it’s a major reason they’ve taken the U.S. Large-Cap Equity award from Prima for 2012. It’s even in their name; BRC stands for Bounded Rationality Concepts, which the firm defines as “a modification of the theory of rational choice that takes into account the cognitive limitations of the decision maker—limitations of both knowledge and computational capacity.” In plainer English, it’s the reason we’re too often our own worst enemy, especially when it comes to investing.
“Our strategy is to monetize irrational behavior,” says John Riddle, BRC’s managing principal and chief investment officer. “In that respect, Kahneman and prospect theory are very important to us.”
So how do they do it?
“We can’t produce economic forecasts better than the average of the experts, so we play in a different sandbox,” Riddle explains. “We instead concentrate on what we think changes the expectations of investors and institutions by focusing on the behavior of security analysts.”
Security analysts are tasked with essentially predicting the unknowable, often far in advance, he says. By the very fact that they are human, they tend to rely on things that make them feel good and validate the calls they’ve made, which often results in a herd mentality when raising and lowering earnings outlooks. This, according to Riddle, is much easier for his firm to anticipate and capitalize on then the vagaries of the global economy.
“We’ve developed proprietary models of behavior that include raw data that is publically available,” he adds. “Everything we do is in-house; we don’t use any outside research services. We rank the beta each night and plug the information into our models.”
Riddle, along with Sharon Ward, Mark Jaeger and David DuRie, were “lifted out” of financial services and investment banking firm Duff & Phelps in 2005. BRC typically includes 30 to 35 stocks in the portfolio, “because our clients don’t need us to diversify away business risk, they need us to find alpha at understandable and sustainable levels of risk.”
The firm looks at the tail of a particular industry universe. It then takes a group of stocks in that tail and turns it over to Ward, Eric Butler and Susan Zeeb on its fundamental team. Using the skills of that fundamental team, it can identify what companies in that tail will behave most consistently with its proprietary models. And there is a valuation play; all else being equal, Riddle says the firm would rather buy companies that are cheap as opposed to expensive.
“We don’t make big sector bets,” he concludes. “Our success comes from the stock selection effect. We want to take a concentrated risk on things we understand, which is analyst behavior.”
Large-Cap Equity Award
Santa Barbara Asset Management
Dividend Growth Portfolio
“We believe dividend growth equals capital appreciation,” says Jim Boothe. “Therefore we manage a dividend portfolio of 40 companies that generates above-average yield and is balanced among sectors.”
Boothe, portfolio manager with Nuveen-owned Santa Barbara Asset Management, is a “player/coach,” meaning he takes on analyst duties at the boutique firm with four others.
“We look for clean balance sheets, a competitive advantage, very strong cash flow and a commitment to dividends,” he adds.
Santa Barbara Asset Management was founded in 1987, and on Aug. 1, 2005, the firm announced its acquisition by Nuveen Investments. Santa Barbara continues to operate independently with no changes to the investment process or methodology.
According to Prima, the firm’s dividend growth strategy’s philosophy is to seek total return from both dividend income and capital growth with lower-than-market volatility. Santa Barbara does this by investing in dividend-paying companies using three elements when constructing the portfolio: aggregate dividend yield that is higher than the S&P 500; volatility that is lower than the S&P 500; and identifying companies that grow their dividends.
Prima notes the dividend growth investment process begins by identifying a universe of approximately 5,000 companies. This universe is reduced to approximately 1,000 companies that are currently paying dividends on their equity securities. The investment universe includes both domestic and non-U.S. companies and is generally restricted to companies with a current market capitalization above $3 billion.
Santa Barbara then removes companies that do not pay tax-advantaged dividends, including REITs and limited partnerships, resulting in approximately 800 companies. The firm then applies quantitative screens to identify high-dividend-paying companies by sector and industry, resulting in approximately 250 companies. Additional screens are then applied to identify companies with high dividend growth rates.
From the remaining pool of approximately 100 companies, Santa Barbara applies bottom-up fundamental analysis to evaluate the prospects for sustainable dividend growth and capital appreciation. When selecting companies for the portfolio, the firm evaluates certain factors, including a sound business model, strong overall financial position, earnings growth, return on equity, quality of management, potential for dividend growth, market valuation and the commitment to return cash to shareholders. Using this information, Santa Barbara constructs a diversified portfolio, which generally consists of 30 to 50 holdings with broad sector and industrial representation.
Mid-Cap Equity Award
Geneva Capital Management
Mid-Cap Equity Portfolio
We recused ourselves from voting in the Mid-Cap Equity category, citing familiarity bias. We featured Milwaukee-based Geneva Capital Management on our cover announcing the awards in April 2009, which at the time was the third year in a row it took home the prize. The firm took a few years off to give other managers a shot, but it’s back with a vengeance in 2012.
“The firm was founded in 1987, and it’s used the exact same investment philosophy ever since,” says Michelle Picard, a principal and portfolio manager at Geneva. “This was before anyone really knew what the mid-cap space was. There were no Morningstar boxes back then, and it’s only in the last decade that it’s come into its own.”
They like mid-cap companies, she explains, because they’re past the volatile, entrepreneurial small-cap stage and management is focused, yet they haven’t reached the large-cap space where growth is harder to achieve due to the law of large numbers.
“We’re dedicated to finding that next great company,” she says. “One that has above-average earnings and growth with a great management focus.”
“We’ve been able to achieve great returns because of our unwavering discipline to our investment philosophy,” adds Scott Priebe, also a principal and portfolio manager at the firm. “Other managers may say they stick to a particular investment philosophy, but their results say something different. Sticking to our philosophy means we perform very well in broad-based bull markets, but not as well in speculative bull markets. But it doesn’t matter; we don’t change what we do. As a result, we outperform significantly over the long term.”
A speculative bull market typically appears near the end of a broad-based bull market, when high-beta, lower quality stocks outperform.
“When you see that large discrepancy between the performances of higher quality versus lower quality stocks is when we begin to lag on a relative basis, like in 1999, 2003 and 2009,” Picard says. “But we still have strong absolute returns so our clients are happy. And we have a solid, long-term track record over 25 years.”
Both Picard and Priebe count the firm’s collegial atmosphere and strong management from founders Amy Croen and Bill Priebe as ingredients in its success.
“We like to have fun, and everyone brings something to the table,” Picard concludes. “We have a high level of respect for each other. We have experienced management, but we also have young, fresh faces that have a different perspective that we find helpful.”
Small-Cap Equity Award
Kayne Anderson Rudnick
Small-Cap Growth Portfolio
To say it’s been a wild ride in the small-cap space is an understatement, which makes Kayne Anderson Rudnick’s win in the small-cap equity category all the more impressive.
“We’ve weathered it well,” says small- and mid-cap manager Jon Christensen matter-of-factly. “Research is our life blood; we view ourselves as analysts as well as portfolio managers, and because of our position, we usually talk directly with CFOs at the companies we buy on a consistent basis.”
Christensen and his team (which includes co-managers Bob Schwarzkopf and Todd Beiley) look for 25 to 35 stocks that have a sustainable competitive advantage and can develop, protect and nurture their market share.
“We like them to have niche dominance and be self-financing, which leads to high cash flow and low amounts of debt,” he adds. “This allows them to generate good returns in good market cycles as well as bad.”
And of course he looks for a strong, competent management team, people who are good stewards of cash.
