Q: Please start with an overview of Advisory Research.
Advisory Research, Inc. (ARI) was founded in 1974. We are a Chicago-based investment advisor and currently have 34 employees, including 19 investment professionals. We manage approximately $5 billion in total assets. The client base that we work with includes corporate pension plans, foundations, endowments and ultra high net worth individuals. We are a value manager and our equity products span the capitalization spectrum from micro cap to large cap equity strategies. We also manage approximately $500 million in yield-oriented investments and have a new International Small Cap Value strategy.
Q: What is your overall investment philosophy?
ARI is a disciplined money manager committed to value investing. We invest in stocks that we believe are undervalued on a price-to-book basis and possess significant net asset values relative to their market values. We further seek to minimize downside risk by investing in companies with low leverage. The companies that provide us the best opportunities are those with undervalued assets that are typically off the radar screens of most firms or have been abandoned by the investment community.
Academic research has proven that over full investment cycles value stocks outperform growth stocks. By employing a “bottom-up” security selection process, we seek to identify favorable value-oriented companies from what is an already attractive universe. We utilize fundamental financial analysis and research to choose securities for our portfolios. Our quantitative methodology combined with the seasoned judgment of our investment team is what we believe has produced returns in excess of the market over time.
Q: What is the process behind your investment research?
Initially, the key criteria for potential investments is the presence of a strong balance sheet with significant underlying assets, a history of profitability and a debt level that is focused on the shareholder. Finally, the business has to be well-understood by our team so that we can determine its ability to unlock value in the years ahead.
Once candidates are identified, the investment team will produce fundamental financial analysis on the companies. The financial analysis includes intensive research starting with the balance sheet. We perform a line-by-line review of the balance sheet to establish our own assessment of the net asset value of the company. ARI’s qualitative business review includes company visits, management interviews and competitor analysis. This effort seeks to identify senior management teams that have a clear understanding of their company, a commitment to shareholders and a reasonable business plan to unlock the value of the company. We also seek out information from competitors, suppliers and others knowledgeable within the industry. Finally, we evaluate future company actions such as cost reductions, acquisitions and divestures, management ownership and stock buy-backs to gauge the execution and commitment of management.
It is important to note that we produce our own fundamental internal research and do not utilize Wall Street research.
Q: I know you have quite a few services but can you give us a list of the products you offer?
Our strategies cover the entire capitalization spectrum and include Micro Cap, Small Cap, Small/Mid Cap, Mid Cap, Large Cap and All Cap. We also manage an International Small Cap Value strategy that opened this year and follows our same investment philosophy with an emphasis on micro cap and small cap companies outside the U.S. In addition to our equity offerings, we also offer investors a low-volatility fixed income product as well as a high-quality and high-current income producing strategy.
Q: Picking several of your products, please describe their strategies and application?
Below we have highlighted three of the most sought after strategies we offer:
First of these is our Small/Mid Cap Value strategy. This strategy was an outgrowth of our Small Cap Value strategy that began in 1987. The Small/Mid Cap Value strategy now has a 6-year track record and has had outstanding performance. We manage approximately 30-40 securities in this portfolio with a market capitalization range of $500 million to $15 billion at time of purchase. From a return perspective, this is an area of the market where we have seen a great deal of opportunity. We currently manage over $850 million in the Small/Mid Cap Value strategy in both separate accounts and commingled limited partnership vehicles.
Our All Cap Value strategy draws from our Small Cap Value, Small/Mid Cap Value, and Large Cap Equity strategies to create a portfolio of 50-60 positions across the capitalization spectrum. Allocations to the All Cap Value portfolio are based on bottom-up security analysis. We seek to purchase companies that represent the best value opportunities regardless of their market capitalization. This strategy was launched in 2002 and has outperformed its benchmark, the Russell 3000 Index, since inception with significantly lower levels of volatility.
Our newest strategy is the International Value Fund, launched January 1, 2006. This strategy is typically invested in developed countries outside the United States and has a focus on micro and small capitalization companies. Using the same value investment philosophy as our other equity strategies, investments are made based on bottom-up security analysis and are independent of currency movements and macro economic events. Because of liquidity and trading constraints, smaller original positions are established resulting in a portfolio of 70-95 securities. Our excitement for this product is influenced by the abundance of academic research that supports our book value approach in the global markets. The valuations and opportunities we currently see are tremendous and this will likely be a significant strategy for the firm in the very near future.
Q: Do you have a strategy that ties together your investment products?
As described above, our All Cap Value strategy utilizes our firm’s overall investment philosophy and draws from our Small Cap Value, Small/Mid Cap Value, and Large Cap Equity strategies to create a portfolio of 50-60 positions across the capitalization spectrum.
Q: Is the investment process the same for all products?
Our investment process is typically the same for all of our products. We seek profitable companies with low price-to-tangible book and low levels of debt. Fundamental financial analysis then confirms if the company is a true value through a line-by-line review of assets and liabilities to determine net asset value.
There are a few differences in the process across capitalization ranges. With the micro cap companies, we are able to focus almost exclusively on the balance sheet during our analysis. As we get to large cap companies, we need to spend more time on the income statement, in addition to the work we do on the balance sheet. This has a lot to do with the fact that there are efficiencies in the large cap market where you have to cast your net a bit wider and do your research a bit deeper to isolate companies with the value characteristics we discussed above.
In the micro cap market there are some inherent inefficiency. We find more securities that are selling at a significant discount to the cash on the balance sheet and the absolute value of the company. The key to our success historically has been our ability to adjust and adapt our strict financial analysis to the market cap ranges that we’re operating in under the different product categories.
Q: You describe yourself as long-term investors. Please give us your average holding period.
Our average holding period is 4-5 years. This is consistent across all of our portfolios. In that respect, we have very low turnover. It’s low because we are not driven by short-term events. If you buy inexpensively enough, you also know that it will take some period of time for the companies to develop.
Q: Would you describe your sell process?
There are four key factors that cause us to sell a security. First, we will sell a security when full valuation is reached (that is when the price of the security and the underlying value of the balance sheet and income statement have been fully met). The second factor that causes a sale in the portfolio is when there is takeover activity. You tend to see a sizeable number of takeovers in market environments like we are in right now. This activity causes a level of forced turnover in our portfolio and that turnover is often disappointing to us because we think the upside of these securities is far in excess of what is being paid but, that being said, we always like the profit! The third factor that can cause turnover is what we refer to as the “Darwinian” process. This process occurs when we find a security that we want to own and we think that security is cheaper than another security we currently own, but do not believe has as much upside potential. The fourth and final factor that causes turnover is a disappointing fundamental change in direction of the company. More specifically, this would be a fundamental change in the course and nature of the business that makes us think that the opportunity for the value we saw in the stock at the time of purchase no longer appears to be present.
Q: What are your goals for the growth of the firm?
ARI’s plan is to grow profitably at a pace that is consistent with our ability to deliver superior investment performance to our clients as well as to provide a high level of client service to meet the needs of our constituents (clients, consultants, intermediaries, etc.). Although historic growth has come from various initiatives, growth in the near term will likely be generated organically as we focus on raising new assets in existing products.
Q: Which products have grown the most in size in the last few years both through appreciation and contributions?
We have seen the largest growth in our Small/Mid Cap Value and our All Cap Value strategies. We started managing the Small/Mid Cap strategy in 2000 and the All Cap in 2002. In both cases we had clients who were so impressed with our management style and performance in other strategies, they asked us to expand our expertise and manage different asset classes. The Small/Mid Cap Value strategy is an expansion in capitalization from our Small Cap Value strategy. The All Cap Value strategy combines holdings of our Small, Small/Mid, and Large Cap products. In both of these strategies, as well as firm wide, we have seen growth in both individual and institutional assets and we see many clients use us in multiple strategies.
Q: Do you encourage the diversification of your client’s funds across multiple products, and if so, how do you decide your allocations?
The foundation of Advisory Research was built on high net worth individual clients. That business has greatly expanded over the years through referrals based on great performance and client service. Some of these taxable individual clients will ask for our advice and expertise in allocating their money across multiple strategies. We perform a careful review of the client’s individual goals and objectives as well as their income, savings and tax situation before creating these customized portfolios. The goal of the high net worth individual group is to preserve capital and build wealth. That philosophy dominates how we manage money across all capitalization sectors of the market; therefore, clients are excited to diversify their assets through multiple Advisory Research products.
Q: What are the advantages to bottom-up stock selection?
If you were to ask us what the market is going to do this week, this month, or this year, we would have no idea. But if you were to ask us if the companies we own today are going to be more valuable two years down the road from now, we would give you a pretty confident ‘yes’ on that. This is the advantage of bottom-up stock selection. We are not good at predicting the future of market cycles or sectors. We are good at fundamental security analysis for long-term investments. This is borne out when you look at our turnover statistics. Our turnover tends to run in the 20-25% range, so we are holding a security, on average, about four to five years. That’s been a pretty constant pattern for us over the years. As I mentioned above, these turnover numbers would be even lower except that we are subject to a fair amount of turnover associated with acquisitions. Outside companies, having recognized the same value that we see in our portfolio holdings, come in and buy our companies and look to do transactions that are accretive to their earnings and to their book value.
Q: What goes into determining “value” when you buy a company?
We focus on investing in quality companies with strong net asset values and fundamentals that offer a level of protection in declining markets, as well as the opportunity to participate in appreciating markets. Purchase decisions are based on the implementation of ARI’s investment process, which focuses on a disciplined approach to bottom-up security selection:
First, the investment team identifies a pool of securities with attractive value characteristics. Measures include low price-to-tangible book, high return-on-equity, and low long-term debt levels. Then, financial analysis includes intense research using the balance sheet as the focus. A line-by-line review is conducted with the purpose of determining our own net tangible book value of the company. Liabilities and other items that may affect the assets of a company are evaluated and the appropriate mark up/downs are made. Additionally, our qualitative business review includes company visits, management interviews and competitive analysis. In this step we are seeking to identify senior management teams that have a clear understanding of their company, commitment to shareholders and a reasonable business plan to unlock the value of the company.
Q: How do you deal with investment risk?
In executing our bottom-up, active investment discipline, we use prudent diversification and sector limitations as a risk control in the portfolio construction process. Our Small Cap, Small/Mid Cap, Mid Cap, and Large Cap strategies tend to operate with about 30-40 securities in the portfolios. We take a position size of approximately 2-4% at time of purchase, which we will allow to run to 6-7% after appreciation. Then we will pare back if the risk factor of the security rises to an abnormal level or sell the position in the portfolio.
We also have sector constraints. Even though we are bottom-up investors, we still pay attention to the sector exposure in the portfolio because we do not want to become too concentrated in any given sector. We have set a maximum of 20% in any sector at time of purchase with the exception of financial services. Given that they’re such a big part of the value universe, we do allow that sector to go up to 40%, but we make sure that we’re adequately diversified between banks, S&Ls, brokerage, and insurance companies.
Q: The world has changed with the increased speed of communications. How have these changes affected the way you invest your client’s portfolios?
Our investment philosophy was established in 1974 with the founding of ARI. Since then, both the investment philosophy and the process for investing client’s portfolios have not changed. With the advent of the Internet, access to company news and reports is much faster. While this helps with analysis, our investment process is not based on short-term information changes, but instead it is based on fundamental bottom-up analysis of securities. For example, if we hear that one of our holdings missed earnings this quarter by a penny or two a share, it is not information that is relevant to our investment decision. However, we do look for information regarding a fundamental change in the course and nature of the business that may cause our valuation of the security to change.
Overall the increase in communication speed/capabilities has primarily improved our reporting capabilities and client service functions. The investment process benefits from increased speed, but the basis of our investment process has and will not change.
Q: Please give us a brief background some of the key people in your company.
ARI utilizes a team management approach for all portfolios and products. All ARI portfolio managers and research analysts act as generalists in executing the investment process in order to promote the team environment.
The following are a couple of the senior professionals of the firm that have been active in the management of portfolios and in the overall development of the firm.
Brien M. O’Brien, 27 years of investment experience, serves as CEO and President of Advisory Research, Inc. (ARI). Prior to joining ARI, he was the founder of Marquette Capital, an investment advisory firm that merged with ARI in 1996. A former vice president at Bear Stearns, Brien began his career with Oppenheimer & Co. He is a member of the board and a past president of Jobs for Youth/Chicago and a member of the board of the University of Chicago Health System. Brien graduated with honors from Boston College with a B.S. in finance and theology.
David B. Heller, 45 years of investment experience, serves as Chairman of ARI, which he founded in 1974. He has an extensive background in the securities industry, having previously served as president of Ralph W. Davis & Co., a member of the New York Stock Exchange. Earlier in his career David served as vice president, treasurer, CFO, director and member of the Executive Committee of A.G. Becker & Co., Inc. David has served as a director for a number of public companies and is a former governor of the Midwest Stock Exchange and the Chicago Board of Options Exchange. David holds an M.B.A. from the University of Chicago and a B.A. in political science from Harvard University. He also completed two years of doctoral work in public policy at the University of Illinois.
James M. Langer, CFA, 14 years of investment experience, serves as a Vice President of the firm. Prior to joining ARI, he served as an investment consultant at Marquette Capital for five years. Jim's career in finance began at the Center for Research in Security Prices at the University of Chicago where he worked on several academic research projects. Jim holds a B.A. in economics from the University of Chicago and an M.B.A from the Kellogg School of Management - Northwestern University.
Kip L. Meyer, CFA, 10 years of investment experience, serves as a Vice President of the firm. Prior to joining ARI, he served as a manager in the strategy practice group at Accenture. Earlier in his career, Kip was a territory manager at Queen Carpet (acquired by Shaw Industries). Kip holds a B.A. in english and government from the University of Notre Dame and an M.B.A. with honors in finance and economics from the University of Chicago.
Chris D. Crawshaw, CFA, 17 years of investment experience, serves as a Managing Director of the firm. Prior to joining ARI, he served as a senior client service officer for Pacific Income Advisers. Chris’ career in finance began as an institutional investment consultant where he practiced for over 8 years. Chris holds a B.A. in finance from the University of Tulsa and an M.B.A. in finance from DePaul University.
Q: What advantages are there to an employee-owned company?
With an employee-owned company, the interest of our employees is directly aligned with the interest of our clients and we are not forced to satisfy outside interests. For this reason, both our clients and our employees tend to be very happy. Our clients have the opportunity to meet with our team of professionals at any time before or after investment, and they know they will get personal service when they call. Our employees are proud of the work they do and the service they provide to our clients and are motivated by the opportunity for ownership in the company.
Q: How would you say your firm differs from other investment firms?
What differentiates our firm and provides a sustainable competitive advantage relative to our peers is our disciplined and tested research process. We believe in buying inexpensive securities relative to their current public market value, with low levels of debt, positive momentum and whose income statements are showing improving profitability. These factors combine to create great long-term investments. We find these great values by doing extensive research in-house, without reliance on outside sources. Our senior professionals average 15 years of investment experience. Their expertise gives us an edge in this research process.
Q: In closing, is there anything else you would like to add about Advisory Research and what you offer investors?
The investment philosophy and process used by our team at Advisory Research, Inc. has been around since the firm was founded in 1974. Because this process is linked not only to the performance of our strategies but to the integrity of our firm, this is something that has never changed and never will. As an absolute value manager, our main focus is on downside protection. Capital appreciation is a fantastic outgrowth of our investment process, but we’ve found over the years that inexpensive companies relative to their tangible book value are the backbone of good investments and good performance. In this way, our clients truly understand what we do and feel comfortable investing their money over the long-term with ARI. While we have had growth in our firm, we still feel we are relatively small. We have focused on growing our assets at a pace where we are able to deliver superior performance as well as first-rate client service. For these reasons, we believe we are able to offer the perfect product to our current and potential investors.