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    Guest Interview:

   Messner & Smith Investment Mgt.

    530 B Street, Suite 300
    San Diego,CA 92101

    Telephone: (619) 239-9049
    Fax: (619) 239-0838


    Interview Quarter: 2Q2007

 Kevin J. Dukesherer, CFA

 Director of Research/Portfolio Manager

  Kevin, please give us some background on Messner and Smith?  
  The firm began in 1984 in a merger between its two founders, John Messner and Ellis Smith, both of which had independent investment management practices. John started out in New York as an analyst with White-Weld, and then William D. Witter, where he worked with several of today’s well-known value managers before they were well-known. Ellis, meanwhile, managed a corporate pension for a large private company here in San Diego, and once had the pleasure of a private meeting to discuss investing with the late Ben Graham, who many consider the “father” of value investing. So both John and Ellis, and myself for that matter, were exposed to the philosophies of value investing from some of the best in the business, then and now.  
  What investment firms have you worked for in the past and how did the experience you gained from them lead to your role with Messner & Smith?  
  I began my career with Harris Associates in 1989. I was fortunate in that I couldn’t have landed in a better position to begin my career as a value investor than working with Ralph Wanger, the legendary manager of the smallcap Acorn Fund, Bill Nygren and Robert Sanborn of the Oakmark Fund, and the many other successful value-oriented managers who were with Harris at that time. I left Harris for the investment banking side of the business, which gave me the opportunity to do more focused research; then returned to investment management about ten years ago. John and Ellis hired me to help get our smallcap strategy off the ground five-plus years ago. The three of us now manage all portfolio strategies as a team.  
  Explain why you use investment themes to develop investment strategies?  
  A core principle in value-investing is that you buy businesses at a discount to their fair value. This often times requires patience – waiting for these undervalued businesses to return to at least fair market value. By looking for investment themes, which are in essence investable long-term trends, we can better take advantage of longer holding periods. If the long-term trends are in our favor, businesses which were bought at a discount not only return to fair value but may also experience stronger than expected growth, which allows us to stick with our holdings over a longer growth phase and realize even higher earnings multiples when we eventually sell. The longer holding period also helps us keep portfolio turnover low, which in turn cuts transaction costs and improves clients’ after-tax investment returns.  
  Could your “theme” approach be described as making you a top down manager with a primary emphasis on industry selection?  
  Not really. First and foremost, we are looking for undervalued businesses to purchase for our portfolios. We take a bottom-up approach to finding many of our investment ideas – many don’t necessarily fit into a macro investment theme. Of course that doesn’t stop us from looking for themes, and at times those themes align very well to make certain industries look more attractive than others. But we never invest in a business just because it fits a theme; it must still pass the same bottom-up scrutiny as all of our other holdings. Many of our themes actually come to light from our bottom-up work, in that we’ll identify long-term, under-appreciated growth drivers that will extend to other businesses in similar or ancillary industries.  
  What fundamental investment characteristics are you looking for in companies?  
  These are the characteristics that suggest to us both value and safety. Value comes first – we have to see potential value, meaning the business is trading for less than we think its worth. That’s one reason we focus exclusively on midcap and smallcap stocks. A lot of large cap stocks are safe, but not many offer exceptional value relative to their growth potential, which is why large caps tend to under-perform midcap and smallcap over time. Value can mean many things, depending on the industry and where the company is in its business cycle, but a healthy yield on operating cash flow and/or free cash flow, a low P/E or P/Sales multiple, and assets or businesses that are under-achieving their potential return are all things we look for. Then, we look for safety. “How stable is the business likely to be over time?”, “does the company have a strong enough balance sheet to pull through a difficult period?”, and “how sustainable is their competitive position?” – all are questions we need satisfactory answers to.  
  Why do you consider yourself a value manager even though you own a lot of stocks that would be classified as growth?  
  Our investment philosophy is that of a value manager; we only want to buy undervalued businesses. But that doesn’t mean we discriminate against businesses that are likely to grow over time. To the contrary, we like growth so long as we don’t have to pay a full price for it. The Russell 2000 Value benchmark is made up of securities that have a combination of the lowest price-to-book ratio, and the lowest projected growth rates. We find this to be a rather strange definition of value, what they are really defining is “not growth”, as opposed to value. All else being equal, the more a business grows, the more value it is going to have. We don’t believe you can capture a value philosophy in a quantitative-driven benchmark, or a quantitative-driven investment strategy. Value can come in too many forms to box up that easily in a couple of ratios. But to get back to your question, if we are correct in our assessment of the long-term outlook for the businesses we buy, many of them will turn into growth stocks over time – which we are quite happy about – and we are in no hurry to eliminate them so long as they remain reasonably priced with their fundamental outlook intact.  
  With a sector or theme approach, how do you tell whether your sector has gotten either over or undervalued and what is your annual turnover rate?  
  Annual turnover is usually in the range of 25% to 45%. With respect to when a theme or sector gets overdone, valuation multiples on the individual businesses within a group usually says it all. Looking at these multiples in the context of likely growth rates and overall risk in comparison to other areas of the market with similar characteristics drives our thought process in selling.  
  Which types of investment styles do you offer?  
  All of our portfolios are managed with the same value philosophy. We have four strategies in total for clients with different risk preferences. We offer Midcap (our original equity strategy, which we also call our Theme/Value strategy), Smallcap, SMID (a combination of the former two) and a Balanced strategy which includes fixed income securities along with the same equities we hold elsewhere.  
  I noticed that your smallcap strategy has had strong returns and low volatility, even though smaller companies are commonly assumed to be higher risk. How do you get such low volatilities?  
  All of our equity strategies have since inception achieved lower volatility than their respective benchmarks. We think part of the reason is our management style – low turnover, and a tendency to buy and sell incrementally rather than in an all-or-nothing manner – and another is the type of companies we buy. By that I mean we generally buy companies that generate strong cash flow, have good balance sheets, and have a strong likelihood of ongoing operational success and growth. Smaller companies are generally thought to be riskier, but if you eliminate the highest risk companies in terms of those with poor balance sheets, questionable business models and high valuations, and further reduce risk through effective diversification, our historical results have shown that you won’t necessarily see higher volatility than the larger cap indices.  
  Please try to give a more in-depth explanation of your buying and selling strategies.  
  We set price objectives for all of the stocks we buy, and review them regularly based on price changes and the fundamental outlook. For a purchase, we’ll need to see the opportunity for a substantial percentage return over the next year or so, ideally 30%-50%, and a favorable longer-term outlook that would allow us to hold the position for at least several years beyond that. Our strategy is to buy at a discount, but as I mentioned before, we’re in no hurry to sell. We do tend to reduce position size, though, as stocks near our price objective, but typically we eliminate positions entirely only when they exceed what we think are rational prices or when fundamental risks make the return potential look unattractive.  
  How and where do you find your own investment ideas?  
  There is a wealth of mostly easily-accessible information available – conference calls and investment conferences, public filings, company and industry websites, and really an overload of other information available on the internet in addition to the traditional Street resources and database information. Finding potential ideas and information isn’t the hard part – assimilating that information and developing an accurate perspective of individual businesses and valuation is the real challenge. In addition to research we do that originates at the company-level, we also try to soak up information about general socio-economic trends that will give us a better handle on the big picture. It’s very easy to get drawn into short-sighted thinking in a market that reacts impatiently and focuses mostly on the next few quarters’ outlook. Our approach includes spending time observing the world around us and looking for changes and trends that will be applicable to investments over longer time periods. In doing so, I think we are better able to anticipate how well a company may be doing 2-3 years from now, and assimilate portfolios that will perform well over that time frame. Many of our ideas have come on the heels of a poor outlook for an upcoming quarter, when stocks are sold down to bargain levels. Growth investors are notorious for being “long-term” investors only so long as growth is steady or accelerating, which often times gives us a chance to buy into growing businesses at value prices.  
  Is your research in-house or do you use additional outside resources to help you?  
  We access the typical Wall Street resources – databases, research reports and investment conferences for general company information, but also develop trade sources and personal contacts. New investment ideas are only brought forth internally and must be agreed upon by the entire portfolio management team before action is taken. This puts the responsibility on each one of us for every portfolio decision, and assures that all portfolio purchases and sales pass scrutiny from each of us who have different perspectives and specialized knowledge to draw upon. John and Ellis have been together for more than 20 years, and I’ve been a part of the team for six years now. Each of us enjoys the investment process, and working with each other, and I think that shows in the strong investment results the firm has achieved. In terms of relying on outside analysts for ideas, we never do that. Street recommendations, for the most part, coincide with a business that is clearly performing well, or in some cases, reflect hope for an idea in which an analyst may feel “stuck” from a past recommendation that soured before they could get out of the way, or in others may be in part influenced by a past or potential investment banking relationship. None of these situations make for a very attractive entry point. Better entry points come from stocks that either the Street doesn’t like, or doesn’t care much about one way or the other because they are self-funding businesses or they lack a story that can excite investors into action.  
  What is the highest percentile you are willing to hold in a particular sector or individual company as a percentage of the overall portfolio?  
  Our MidCap and SmallCap portfolios usually have between 35 and 45 holdings each. We consider a “full” starting position in these portfolios to be 3%, but the range in position size at any given time is often anywhere from 1% on the low side to 4-5% on the high side. When positions approach or exceed 5%, they often are reduced simply to control portfolio risk. In terms of sector weightings, we are usually allocated across at least 9 of the 10 major market sectors. We are sensitive to industry weightings as well to achieve adequate diversification and control risk in shifting economic and market conditions. Our SMID portfolios include each of our MidCap and SmallCap ideas, so they have will have a proportionately larger number of holdings and smaller percentage position sizes.  
  Your performance in your “theme/value” portfolios seems to have weathered the difficult 2000 to 2002 market downturn. What was your secret?  
  We’ve always looked for companies with good cash flow and decent balance sheets, and we only buy those which we think are at or below their fair business value. At the tail end of the internet bubble in 2000 the most vulnerable companies didn’t have positive cash flow; many, especially those in what was then a burgeoning telecom sector had horrible balance sheets, and most sold nowhere near fair business value on a realistic view of potential future cash flow. When the internet bubble burst and the bear market took hold, investors eventually flocked back to companies that had positive cash flows, in other words, real sustainable business value. That resulted in strong relative performance for our investment strategies.  
  Do you ever use macroeconomics to raise cash in an overbought market?  
  Our intended strategy is to stay near fully-invested, with approximately 5% or less in cash holdings. At times, our cash levels drift somewhat higher as we exit positions that look fully valued while waiting for attractive entry points on new ideas. We don’t want to force new purchases just for the sake of being fully invested. At times, we see lots of bargains, and other times we don’t. We think our clients are better served when we stick to our discipline and buy when prices reflect good value. I see it as a flawed argument when investors assume that having any cash in a rising market is a bad idea. Even in a rising market, not all stocks are going up at the same time, and having cash available to make opportunistic purchases can be beneficial to portfolio returns in addition to reducing overall portfolio risk.  
  Why do you believe that you don’t fit a style box?  
  Style boxes, and the benchmarks which are used to judge managers across different style boxes, just aren’t that reflective of our portfolio strategies. Even worse, while we understand the rationale behind them, they unfortunately seem to be taking on a life of their own to the detriment of actual investment considerations. The initial concept, I believe, was to separate the two major schools of thought on equity investing, value versus growth investing, to allow large investors to allocate to and measure managers with different styles. That was further delineated by company size which is really a proxy for perceived safety, with larger companies being thought of as safer than smaller ones. The unfortunate part, the unintended consequences of how style boxes and style performance measurement has evolved, is that a lot of managers now are managing in such a way to appeal to consultants’ desire for managers that fit neatly into those style boxes, and those who match up with the variances or weightings of their benchmarks. Why is this unfortunate? The first reason is that it makes managers more the same. If a consulting firm or fund is allocating to different managers for the purpose of diversification, it is likely to see reduced diversification and variance across managers because it is actually incentivizing managers to be more the same by wanting them to fit into predefined style boxes. The second issue is that it creates an incentive for managers to focus on relative performance over and above the consideration of risk versus expected return, which not only in theory may reduce expected return for the amount of risk, but also creates exaggerated market moves because more managers are behaving similarly, which increases overall volatility and market risk. A third issue is that of incentivizing managers to follow benchmark weightings, which in the case of the Russell Indices, is quantitatively-driven without regard for prudent sector weighting and risk control. The bottom line is that although each of our strategies does fit into a particular style box philosophically, the style box benchmark in our view doesn’t really reflect the intended meaning of the style. And with so many managers managing to better fit their style box or match up with the benchmark, our strategies end up looking like outliers at times. This is a passionate point of discussion with us, because we believe our management style is more in keeping with our clients’ best interests, as opposed to just our own best interest in trying to maximize our asset base.
  What kinds of clients do you have and what kinds of investors are best suited for your investment style?  
  Our client base includes both public and private retirement funds, as well as high net-worth retirement and taxable accounts for individuals. We think our portfolio strategies are best-suited for investors that have a longer time horizon, those that want the higher expected returns of midcap and smallcap equities but also are sensitive to risk and wealth preservation and thus prefer the relative safety of a value philosophy and a management team that has managed successfully through many market cycles. We believe we’ve generated consistent, solid returns over time, with less volatility than our benchmarks because we stick to our philosophy of buying companies below their fair business value, hold on to them until in many cases they’re priced like growth stocks, and because we don’t chase short-term performance by trying to catch a hot sector or mirroring the benchmark weightings. We also believe our strategy is well-suited for investors using multi-manager strategies, since our strategies could very well provide lower co-variances than typical managers in our category.  
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