Thornburg-managed portfolio beats sector average
Five months ago, Investec launched an American fund with a twist: the portfolio was to be outsourced to a US-based investment group, Thornburg.
At launch, Investec was quick to stress the strong long-term performance track record of Thornburg when it came to investing in large-cap US equities. In particular, much was made of the $1.6bn Thornburg Value mutual fund's ability in the previous seven years to produce compound annual returns of some 7% above that of the S&P500.
In a bid to fill a gap in its UK retail range, Investec has searched globally to find a US equity team to manage an American fund on its behalf.
In particular it wanted a large-cap, blend style manager who could provide a core product, and opted for Santa Fe-based Thornburg.
At the same time, Investec also transferred the management of its existing offshore American fund to Thornburg. This portfolio was previously managed internally by Nick Mottram, who is head of equities at Investec.
The contract with Thornburg parallels the arrangement with Investec's European funds, which are managed by Albert Morillo and his team at Blackrock.
The Thornburg Value fund, launched in October 1995, holds some 35-40 stocks and is managed by a team of nine, headed by manager Bill Fries, with Brian McMahon as the company's chief investment officer.
This large-cap portfolio has been used as the basis for the Investec American fund ever since it started trading in October 2002.
Since launch, Investec's American fund has got off to a reasonable start considering stock market conditions. Over the period from its launch on 23 September to 2 February, the portfolio is ranked 29 out of 90 funds in the North American sector, after losing 9.69%, compared to a sector average return of -10.66%, offer to bid.
Brian McMahon talks to Investment Week about how he runs money.
Do the onshore and offshore portfolios exactly mirror the Thornburg Value fund?
They are nearly identical. The only slight difference is cashflows and the fact they had different starting points.
The sterling denominated fund is £17m, yet Thornburg Value fund is $1.6bn.
Is it the same managing both at such different sizes?
We manage the funds in a similar manner. They tend to have similar buy and sell operations. Having said that, whatever the buy or sell operation is, it happens more quickly in the Investec American fund, compared to the Thornburg Value fund, simply because of the size.
How do you narrow down the universe of stocks you look at?
We start with all US companies with a market cap of more than $1bn. Then we have a quantitative screening process, which considers companies on several parameters.
These include price/earnings, price/book and price/cashflow. The result of this is a list of 100-150 stocks, where we will conduct the fundamental research.
At this stage of the process we will conduct in-depth company visits, analyse the financials and markets, and identify likely drivers.
After this we look for three key categories of stock.
What are these categories?
The first is basic value, which are typically stocks of financially sound companies. These are well-established businesses trading at low valuations relative to the company's net assets or potential earnings power.
The second category is the consistent earners. As the name suggests these are the companies with steady earnings and dividend growth that are selling at attractive values.
These two categories would each represent around 40% of the portfolio and companies within them would have a starting position of 2%-3% within the fund.
What about the third category?
The third category is emerging franchises and we hold a maximum of 25% of the portfolio in this category. Essentially, these are value priced companies in the process of establishing a leading position in a product, service or market that is expected to grow at an above average rate.
Initial positions would account for 0.75%-2% of the portfolio.
This is really a framework for considering valuations. It's not so much that we are trying to divide the fund into different sectors.
Rather, we are trying to make sure our search for the best values in the market is comprehensive.
I would assume the emerging franchises would involve smaller companies but this is a large-cap fund?
Emerging franchises often involve smaller companies, but these are not necessarily small caps.
The emerging franchise concept we have is not based on the size of the stock as much as the growth of the product or service that is the company's core business.
A good example is Comcast, the largest cable television company distributor of digital content. The franchise part of it is they have 22 million homes to which they distribute. The emerging part is this content and possibilities for formulating and distributing content. We don't know exactly where it's going, but we do know the technological possibilities are increasing significantly year by year.
What is an example of a basic value stock?
Wilmington Trust, the dominant corporate and retail bank in Delaware with more than 50% market share, is a good example.
This is a unique corporate bank providing highly individualised niche products. It is expanding opportunities by establishing bases in other tax advantaged locations outside Delaware. It is trading on a P/E of 14.7 times earnings, has a yield of 3.1% and a price to book ratio of 2.8 times.
The reason we got interested is that it showed up on screens in the second quarter of 2002, having a combination of declining stock price, cheap valuation and a good development of the business fundamentals against that backdrop.
What is an example of a consistent earner?
Health Management Associates (HMA) operates acute care hospitals in non-urban America's south-east. It has the proven formula of centralised, efficient systems, local management and increased services.
HMA is trading on a P/E ratio of 15.7 times and has industry leading profitability.
The reason we like HMA is the demonstrated record of steady growth and that is what we look for in consistent earners. What we seek out is steady growth of revenues, of profits, of cashflow and a good balance sheet. The five-year average growth of revenue was 18%pa.
As we examine the business there is no reason why that rate of growth would slow down, rather we expect it should accelerate. This is the kind of characteristic that we look for.
How much turnover occurs in each of these categories of companies?
We don't track the turnover by category. But I would expect there would be higher turnover within the basic value area.
What would turnover be overall?
Turnover in the fund would be about 50%-70% each year. We sell a stock for three reasons.
First, a company may hit its target price. Unless we revise that price, this company will be sold.
Second, a stock could be sold if circumstances indicate the business case for initially owning it is flawed and that we made a mistake in our premise.
Finally, I would sell a stock if something better came along.
Do you also set price loss targets?
Not formally but obviously if price action indicates there is the possibility that someone knows something that we aren't taking into account, then we will dig harder to try to understand where the selling is coming from and why.
Do you also apply any top-down decisions when constructing the portfolio?
An overall view is always there but I wouldn't say it drives where the pure value is to be found in the market.
We are more interested in the whereabouts of these value gaps. We need to create a diversified portfolio and don't want a portfolio where the value is in one corner of the market. Obviously, the macro environment is always a factor in determining where the value is and it certainly influences what expectations are for earnings and cashflows of different companies.
To this extent we do look at top-down factors.
What benchmark do you use?
We use the S&P500 for performance benchmarking. For portfolio construction we try to go where the value is and we don't expect to mirror the S&P500 in how the portfolio is constructed.
Thus, we are not tied to sector weighting and there are no sector or stock constraints.
Where are you most overweight?
We are most positive on the financials sector at the moment. This represents 21% in the S&P500, but 29% in our fund. I would stress, however, that within financials we are diversified. We have not only sector diversification but within certain sectors we also seek some diversification. For example we hold MBNA, the big credit lending company.
And your most underweight sector?
Industrials is the sector that I am most negative upon due to a lack of value.
How many of you are there on the team?
There are nine of us and it is a group that works well together. There are no stars and we are not looking for stars.
FUND MANAGER: Brian McMahon
Joined Thornburg Investment Management in 1984 and is chief investment officer and president of the group.
He holds a BA in Economics and Russian Studies from the University of Virginia. After receiving his MBA at Dartmouth College's Amos Tuck School, he joined Norwest Bank in 1979 and held various corporate finance positions before leaving in 1984 as a vice president.
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