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July 03, 2017 at 08:00 PM
As equity markets hit records and rattle the nerves of some market gurus, the winners of this year’s SMA Managers of the Year awards are taking the long view.
Consistency and steadiness were frequently cited as keys to success in interviews with the winning portfolio managers. As Dan Meyer of Pacific Income Advisers said, “We’re not there to hit home runs. We get singles and are consistent.”
Jon Christensen of Kayne Anderson Rudnick noted, “We want to find businesses that have some sort of sustainable advantage, companies that can grow, protect and sustain over long-term economic cycles.”
(Related: Torchbearers: The 2016 SMA Managers of the Year)
This is the 13th year that Investment Advisor has worked with Envestnet | PMC to identify managers who have built strategies with a proven, repeatable process and that outperform their benchmarks, not just this year but consistently.
To determine the winners, Investment Advisor editors meet with the executives and analysts at Envestnet | PMC to review the analysts’ recommendations. The winners were announced at the Envestnet Advisor Summit in May.
The selection committee considers finalists in seven categories and identifies two winners each in the U.S. large-cap and small-/mid-/SMID-cap categories. The remaining five winners are selected from the international, fixed income, strategist, impact and specialty categories.
From among those nine winners, we identify one manager who has gone above and beyond in delivering value and serving advisors. That sometimes means doing deep analysis and deviating from a benchmark to strike the best balance between returns and risk for the end client.
As Todd Solomon of Congress Asset Management, and this year’s Overall SMA Manager of the Year, said, “That’s the art more than the science.”
He told Jamie Green, former editor-in-chief of Investment Advisor and a member of the selection committee, “There are some quantitative measures you can use — those would be beta, standard deviation, downside capture and so on — but there are also the qualitative measures.”
The advisors who use these strategies are working with clients to help them achieve their goals, a fact that drives the team’s investment decisions. “The fear I have every day is that a client is going to call me and tell me they can’t do what they had wanted to with their money because we put their money in a risky investment,” Solomon said.
Congress Asset Management, the winner in the U.S. mid-cap category and this year’s Overall SMA Manager of the Year, uses a strategy best described as “steady as she goes.”
It focuses on growth at a reasonable risk, favoring high-quality companies with consistently strong earnings and cash flows across market cycles.
“We like companies that can grow a little bit faster than GDP, and if GDP is down they can still eke out some gains because they’re in an area that’s going to do particularly well,” said Portfolio Manager Todd Solomon, who’s been leading the management team since 2010.
“We’re talking about companies that we want to own forever; they may get acquired or get too big for our process [no longer mid-cap], but we don’t want companies that have to change their stripes to achieve success in the future.”
One example of such a stock in the strategy’s portfolio is Dorman Products (DORM), an after-market auto parts maker that sells to a number of retailers. Dorman is not beholden to any one retailer or geographic part of the country, and the company operates in a growing market, said Solomon.
The average age and number of cars on the road is growing, as are miles driven given lower gas prices, Solomon explained. “All of these things lead us to a lot of confidence that the demand for their parts is going to be there.”
The SMA portfolio of Congress Asset Management consists of 40 stocks. Over the past five years, its annualized alpha has topped 5%, and its beta has been 0.92, indicating that the portfolio not only outperformed its index but was also less volatile.
Over the past seven years, the portfolio has captured 107% of the market’s move — but just 85% of its risk — and it has placed in the top decile of its peer group, according to Envestnet | PMC.
“We’ve shown in our numbers that we can do better than the market and take less risk,” said Solomon. “That’s usually how we compete against passive investors.” The firm’s main competition is other active managers, against which it also often outperforms.
Since it’s not an aggressive growth manager, Congress Asset Management sometimes pairs off with other managers who are more aggressive, said Solomon.
“We have a very good track record, and the people that have been working on the product since 1999 are still here.”
The firm works with wealthy individuals and families as well as pension plans, endowments, foundations and municipalities. Pension plans need to make sure their members get paid; endowments and foundations have long lifespans and large cash demands; and individual rich people want to stay rich, said Solomon, explaining the strategy’s limited risk approach.
“Clients give us their assets with some further goal in mind,” he noted, and he and his colleagues don’t want to disappoint them. “The fear I have every day is that a client is going to call me and tell me they can’t do what they had wanted to with their money because we put their money in a risky investment.” —Bernice Napach
(Related: SMA Manager of the Year Todd Solomon on Beating Passive Investors)
A longer-term orientation was only one factor that helped ClearBridge’s Large-Cap Growth portfolio beat out 29 other programs to win the 2017 SMA award for large-cap equity portfolios. Co-managed by Margaret Vitrano and Peter Bourbeau, the portfolio led the category with an 8.37% gross return in 2016, beating out the Russell 1000 Growth Index by more than a full percentage point. The program has an annualized gross return for the past five years of 16.54%.
Vitrano said they select companies by researching business models to find key markers. For example, Visa, as a duopoly, is in a high-barrier-to-entry arena. Plus, “it has a nice secular tailwind of people using less cash and more plastic to pay for things. And it’s highly profitable.” She and Bourbeau also prefer self-funding businesses.
A second factor guiding the selection process, she said, is that they believe having some valuation sensitivity is a “smart way to manage risk and think about investing. It can be dangerous to fall in love with a fad or idea without thinking through the valuation of a stock.”
The team’s view on diversification also distinguishes it from competitors: It’s not via sector, but by growth drivers. She noted the Large-Cap Growth portfolio is a fairly concentrated strategy of 40 to 50 stocks, so “what you see from the outside looking in is one of the more consistently compounding portfolios vs. some concentrated strategies that can be quite volatile. Our goal is to have less volatility in that application.”
For example, within the strategy, they have some consistent compounders, such as Microsoft, Johnson & Johnson and Comcast, but in the last year they also added some energy holdings. “It’s unusual for growth portfolios to own energy, but the nice thing about energy is it tends to move in different ways than the overall market, so it adds diversification.” If the macro economy isn’t headed for a global recession, they believe some of those energy companies can be good compounders as well.
They also include what they call their “select group” of stocks, which are faster growing companies that can be expensive and volatile, like Amazon and Facebook or biotech stocks. “We think about that when we think about portfolio construction. We diversify the portfolio with companies with different growth drivers,” she said.
They don’t sell a stock on outright valuation, Vitrano noted, “but we have a clear idea of why we invested in every name we own in the portfolio. So when the thesis is played out or no longer valuable, that’s when we exit.”
Nike is an example. They owned the stock for several years, but became worried about the competitive landscape, and some of the company’s targets over the next several years were aggressive, especially in the Chinese market. ClearBridge wasn’t convinced about the growth in China, and certain areas, such as women’s apparel, had a lot of new competitors. Plus the valuation of the stock was two times the market at the time, so they sold.
The strategy’s success in 2016 was due to several reasons, such as some positive stock selection and growth driver diversification in the health care area. They had some biotech stocks, but also owned managed care companies that did especially well. Vitrano added that the portfolio’s quality bias helps protect assets in down markets, and the portfolio typically will perform well in low-growth environments. She also noted that its low turnover of 15% to 30% makes the portfolio very tax efficient. —Ginger Szala
SKBA Capital’s ValuePlus strategy, one of two winners in the U.S. equity large-cap category, uses relative dividend yield to build a portfolio of high-quality stocks that have the potential to outperform the Russell 1000 Value Index over time.
The strategy invests in 40 to 60 large-cap stocks with above-average dividend yields (compared to the S&P 500), which have the potential to provide long-term capital appreciation with relatively low volatility.
“We’re trying to take advantage of some of the dysfunctions of the marketplace,” said Andy Bischel, CEO and chief investment officer of SKBA Capital Management.
He explained, “Markets routinely overshoot the true change in the underlying fundamentals, whether it’s earnings deterioration or a valuation issue.” As a result, dividend yield — the ratio of dividend to stock price — rises because the stock price is falling.
Some portfolio managers will avoid those stocks but SKBA doesn’t, especially if the stock’s dividend yield is also high relative to its own history and there are no signs that the company is in such dire straits that it might cut its dividend.
“We’re not contrarian for the sake of being contrarian, but at turning points you’ve got to be willing to be,” said Bischel.
He describes that moment when, relative to a stock’s own history, “all of the pessimism and all of the hate for a stock because it hasn’t performed well is now reflected in the valuation. That is the right time to pick up that absolute yield,” he continued, because “you get the premium dividend yield … , which compounds into return and reduces downside volatility. You also get capital appreciation opportunity because the stock is already depressed.”
The strategy returned 18.96% in 2016, topping the Russell 1000 Value Index by 1.62 percentage points. It outperformed the median return of its peer group over three, five, seven and 10 years, according to Envestnet | PMC analysts. It typically doesn’t experience deep declines during bear markets, which means it doesn’t have to have heroic returns when the market is rallying, said Bischel.
In addition to consistency of returns, the same three portfolio managers have run the SKBA Capital ValuePlus strategy for over 20 years (two, including Bischel, since 1989; one since 1994), and all of them invest their own money in a mutual fund that uses the same strategy as ValuePlus. Moreover, 75% of the firm is owned by its employees.
Bischel said the ValuePlus strategy is fitting for a core position in clients’ portfolios or as a complement to another growth or international stock strategy because it has a lower risk profile.
“You can preserve your wealth better with better downside protection, and you can get the capital appreciation over the cycle as well,” said Bischel. “Boring is kind of beautiful after all.” —BN
(Related: SMA Manager of the Year Andy Bischel on Market Dysfunction and Fundamentals)
Process and experience conducting in-depth research of companies with growth sustainability were two key reasons Kayne Anderson Rudnick’s Small-Cap Sustainable Growth strategy won the 2017 SMA Manager of the Year award in the small-/mid-/SMID-cap equity category. The program’s 2016 gross return was 26.11%, more than double the Russell 2000 Growth Index. Since its inception in 1998, the annualized gross return has been 9.58%. The Envestnet | PMC analysts noted in their evaluation of the finalists that they were “impressed that the majority of significant outperformance was driven by stock selection” in Kayne’s strategy.
Jon Christensen, co-portfolio manager of the portfolio with Todd Beiley, said their strategy looks at businesses for the long haul. “We want to find businesses that have some sort of sustainable advantage, companies that can grow, protect and sustain over long-term economic cycles,” he said. “That comes back to business, and our task is to find high-quality businesses that can grow during good and bad times.”
Through research, the KAR portfolio team finds 25 to 35 companies, and digs into their businesses. “We do organic types of research, using third-party sources some times, but usually doing our own research,” he said. They look for small companies and business inefficiencies. “We want to find that next generation of blue-chip stocks that go from $1 billion to $2 billion to $10 billion to $20 billion market cap.”
He said that the key to their approach is having business analysts on the team. “Valuation is important, but we need people who can understand business because the No. 1 thing that can happen in businesses is they can evolve or devolve.” He said there could be a great business, but it could erode due to competition. “Our task is to make sure it’s not eroding, but sustained. Over time, you will see they made a bad acquisition, or competition position erodes, and that would be an indication to sell the stock.”
Another reason the team would sell the stock is if a company gets too large. He said when holdings get up to the $8 billion to $9 billion area is when KAR replaces it with another stock that fits the strategy. The strategy’s holding period typically is three to five years, and portfolio turnover is between 25% and 35%.
Although, or maybe because, it is such a concentrated portfolio, the team keeps a tight grip on risk management, and that’s shown in the numbers. Christensen noted that although the portfolio has been running for 18 years, it has only had three negative years. “Even in years [when] we’re negative, the index is more negative, so we are preserving capital at a more efficient rate.” He said when the market is extremely speculative or coming out of a recession, they might be trailing the market. The strategy fits best for clients who want to preserve capital and grow their portfolio. “When you mitigate downside, that helps you overall preserve capital over time. That’s our goal.” It must work as the portfolio has had strong alpha with a 0.7 beta. —GS
(Related: SMA Manager of the Year Jon Christensen on Valuation and Business Analysis)
With boots on the ground in 14 countries and a staff of 70 evaluating a bottom-up approach to emerging markets, Lazard Asset Management’s Emerging Markets Equity Select ADR portfolio won the 2017 SMA Manager of the Year award in the international and global category. Beating out 19 other strategies, Lazard not only had a stellar 2016, with a 22.37% gross return, almost double the MSCI Emerging Market Index return of 11.17%, it produced over 1.6% of annualized alpha over the last peak-to-peak market cycle (July 2007-December 2016), according to Envestnet | PMC’s analysts. Since its inception in 2004, the fund has had an 11.01% annualized return.
The depth and quality of personnel is a key reason for the fund’s success, said James Donald, managing director and portfolio manager. The fund is a relative value strategy so it focuses on a trade-off between valuation and financial productivity of an individual security. “Essentially, we are trying to find mispriced securities that have high and stable levels of profitability but for some reason have low valuations,” he said.
The bottom-up approach begins with a review of a universe of stocks to find those that are inexpensive based on a database screening. “Then we [review] financial statements for each of those companies, look at accounting and see what needs to be adjusted for various inconsistencies in accounting,” Donald explained. If they find the stocks are inexpensive, they go on to a fundamental analysis to forecast levels of profitability and derive price targets. “We then do a final stage of discounting, where we look at political and macroeconomic risks and governance risks, and price and discount for those. [Once] we have a price target, stocks make it into the portfolio or don’t based upon whether upsides are competitive with positions already in the portfolio.”
There are typically 70 to 90 holdings in the fund, with a portfolio turnover between 30% and 50%. Measures of financial productivity include return on equity, return on assets, cash return on equity and operating margin. Valuation measures include price/book, price/earnings, price/cash flow and price/sales. Though portfolio managers only select countries that are in the MSCI EMI, the weightings may be different. For example, they might have almost double the holdings in Latin America than what is in the MSCI EMI.
“We do invest in places that … might be highly risky, but we think [that] in our process, we take that into account,” Donald said. However, he added that the value investment tends to be relatively conservative for the emerging market world because “we don’t like to pay high prices for securities.”
Emerging markets “typically have high political risk and high governance risk; protection is not as high as it would typically be in most developed countries, so emerging markets aren’t for everyone,” Donald said.
