Q: Thacher, I take it that 1838 has a history behind its name.
A:We trace our heritage back to 1838 when Francis Drexel established Drexel and Co., Inc. in Philadelphia. From the time his sons first began to offer private portfolio management, through a century and a half of serving investor needs, the firm prospered and built a fine reputation for investment management. Today we continue that tradition in the form of a partnership. with all our investment personnel participating in the firm’s ownership. We have 17 investment professionals who average 15 years with 1838 and an average of 25 years in the investment business.
Q: How much money do you manage and what kinds of accounts do you handle?
A:1838 Investment Advisors manages assets that now total almost $5 billion. Our clients use our services for both large cap and small cap equity accounts, as well as fixed income and balanced portfolios. Among our accounts are both public and private employee benefit funds; accounts for endowments, foundations, medical facilities, insurance and other corporate clients. We also manage personal accounts for high net worth individuals.
Q: How are your investment responsibilities structured and how do you manage portfolios?
A:For each of our disciplines we have built a team of investment professionals so that we can leverage the skills of many individuals into an interactive process. The large cap equity group has eight members contributing to bottom-up approach of selecting stocks that exhibit good quality, but may have seen their stock prices dropped to extreme valuations as a result of a misperception of change affecting their profitability. Five members of our group are responsible for the actual research in the various equity sectors. They do the work to take our valuation model recommendations and investigate the fundamental considerations that will lead to a portfolio recommendation. The small cap group works on a similar structure. The three investment professionals who comprise that team all do research work, as well as evaluate and maintain the securities in the portfolios. They are taking advantage of market inefficiencies in the small cap market to identify undervalued and out-of-favor stocks that show good promise for rebounding. The final team is the fixed income group, which numbers six investment professionals. Again, responsibilities for security research and portfolio management are shared by the team. Their objective is to find relative value in the fixed income markets and turn it into a total return that meets clients’ goals with less risk than the market itself.
Q: For your equity accounts, you state that superior performance is driven by a combination of superior earnings growth and multiple expansion. Please explain what you mean by this.
A:While our fundamental research on stocks starts with a list of companies that are historically undervalued and may be perceived to be “out of favor,” it is the real dynamics of what is happening within a company that we have to determine. What we are looking for are companies that are growing their earnings by 10-15% or more on an annual basis. In the marketplace today, we focus on companies that are growing units sales, as opposed to companies that are just raising prices. This real growth in earnings should provide a scenario where the P/E multiples would expand. If the earnings are growing at a rate where the Price/Earnings Ratio is lowered, we look to capitalize on the price increase which would be necessary to expand the multiple to a current market level. We will also look to capitalize when the market allows a sector or industry command a higher multiple. If we select companies whose earnings are experiencing a real growth in earnings, the stock price should have to grow to reach the higher ratio.
Q: You refer to “normal” valuations in your analysis. Please explain when a stock is normal according to your definition versus being either over or under valued.
A:The foundation of our stock selection process comes from the observation that individual equity characteristics regress to the mean. Among the most important characteristics to us are the stocks’ historical prices, dividends and earnings. All the characteristics we follow have a “normal” value. We have a proprietary model that plots theses observations as they revolve around the norm. It is the spread between the norm and the point-in-time observations that allows us to determine whether an equity is fairly valued or whether it is over or under valued.
Q: You describe your use of fundamental analysis as a way to capitalize on misperceptions. How does your investment methodology do this?
A: After we have acquired a universe of equities that appear to be attractively priced, the fundamental analysis process allows us to dissect the physical characteristics of these companies. We examine the quality of management, the company balance sheet, market share, new technologies, production facilities, marketing, etc. Often times an under valued equity is wrongly associated with problems that effect other companies in their business, or they may have corrected a situation that was perceived to have been problem. If a company is fundamentally sound and is priced significantly under a fair market valuation we think there may be the opportunity to capitalize on a misperception in pricing.
Q: Do you use asset allocation to help clients achieve their investment goals?
A:Our philosophy with equities revolves around the historic returns of stocks. For a real investor with a time horizon of five or more years the best performing asset class has been equities. The client and their advisors will need to determine how much of their total assets need to be in equities. Our philosophy dictates that we remain invested for the long run. We feel that attempting to market time only allows you the opportunity to be disappointed when you’ve taken a defensive posture and the market moves strongly upward; which is what history shows us over and over. If a client is looking to balance a portfolio between equities and fixed income, historically a balance of 60% equities and 40% fixed income provides a comfortable way to maximize return while limiting risk. However, we will work with the client to define a more aggressive or more conservative mix depending on their expectations and risk tolerances.
Q: Let's examine the differences in strategy between your large cap and small cap portfolios. What would be the most notable difference between the two styles of management?
A:While both disciplines take advantage of value in the marketplace, the large cap process follows a core approach to building a portfolio. We are going to look for participation in all of the twelve major sectors of the S& P 500 since that is the index most clients use for performance evaluation. We may slightly weight these sectors above or below the index weighting, but we will always maintain positions in each sector. As we rank the equities in each sector on their attractiveness, it is the top third that we will normally find the most undervalued. For liquidity purposes, the capitalization of the companies we purchase will typically average $12-16 billion. A portfolio will contain approximately 45 quality companies that are fundamentally sound, but currently undervalued. The small cap portfolios will hold more positions, because we are dealing with companies whose capitalization ranges from $50 - $800 million. While we are looking for growth in these companies, we also have a strong commitment to preservation of capital. The selection process is based on low P/E with solid and improving fundamentals. These companies tend to be less closely followed by investors and may be out of favor with Wall Street. Stock selection in the small cap portfolios will be made on the fundamental attractiveness of an issue. We are not emulating the sector balance of the index. In fact in some sectors we may have little or no participation. Utilities would be a good example. A small cap utility would be one that has undergone a severe problem. We are not looking for turn around situations, just improving companies with solid fundamentals.
Q: Explain how the process behind the small cap philosophy is carried out.
A: Because of the large universe we start with, our first step is the use of a screening process that reduces the list to about 1000 stocks based on low P/E and market capitalization characteristics. We are now, essentially, looking at stocks in the lowest two quintiles of P/E multiples. The list is reduced to 450 stocks by using four relative value quantitative screens. We are interested in price-to-book, price-to-cashflow, return on equity and balance sheet considerations. It is this list on which we now have to do bottom-up fundamental research. Our small cap team will visit these companies as well as use data that we have amassed through brokerage research; and direct networking with suppliers, competitors and customers. From this work we will have to select about 100 stocks that we would consider for inclusion in a portfolio.
Q: How do you find low P/E, small cap stocks when the market has had a run up similar to the early 90’s?
A: Just like in real life, not every one goes to the head of the class when times are good. Just because the markets have been good doesn’t mean that all stocks have performed average. I want to focus back on what I just said about our screening process. We are interested in the the bottom two quintiles of P/E multiples, because good market or bad, over the last 20 years the highest rates of return have tended to come from the two lowest P/E quintiles.On a relative valuation basis the stocks in these quintiles will provide us with the most appreciation potential.
Q: How do you control risk in your investment process?
A: Controlling risk can be looked at a number of different ways. By investing in undervalued securities you already have the advantage of a relative price adjustment. When the equity market heads lower you expect that most stocks will go lower because they are the same asset class. If a stock has already seen an adjustment to an undervalued position, it shouldn’t have as large a percentage decline as a security that is pricey or overvalued at that time. Our diversification of portfolios also helps us control risk. Our large cap portfolio also benefits from the huge liquidity of the issues that we purchase. If there is a need to sell an issue, larger trading volumes enable us to make a more timely exit. The small cap stocks are limited to smaller positions, because we often have less liquidity. As a result we have more names in the portfolio to insulate the capital if a problem would arise with any given position
Q: Please describe how your sell discipline works.
A: The sell discipline for the large cap stocks can be initiated by any of three situations that arise. If an equity reaches a fairly valued situation it can, on that basis alone, be considered as a candidate for sale. If there is a significant change in the fundamental soundness of the business, that too can be a reason we would sell a position. We also have to make judgments about the timeliness of one company versus another company within the same sector. If it appears another security will perform better in the short run, we may sell a stock to take advantage of this situation. If any security we own under performs its sector by more than 25%, the analyst who follows the company must come back to the equity group with one of two recommendations for action. The position may be sold if little potential for a rebound, or the position may be increased on this weakness. For the small cap portfolio, the best sell decisions comes from the stock hitting the target price that was set when the position was purchased. If there were a growth in the capitalization of any issue past the original parameters of our discipline that would cause us to sell it as well. On the other hand, if we see any deterioration in the fundamentals that led to our purchase, we could put any issue in the portfolio.
Q: You describe your fixed income approach as top-down, but moving to bottom up. Please explain what you mean by this.
A: Before we even begin to look at the individual securities that we want to consider for a portfolio, our process looks at the dynamics of the economy and what forces are going to be effecting the fixed income market place. To determine the right interest rate exposure for a particular clients needs, we examine data on economic indicators like; inflationary activity and relative strength in the U.S. economy, what the Federal Reserve monetary policy is and how it will change. We channel all this information into a proprietary model that helps us determine the proper yield curve strategy. With that prospective as a base, the bottom-up approach can proceed to the selection of issues that will perform best in this scenario. All this leads us to a portfolio structure that will best meet our clients goals in the near term. We feel our process removes some big risks for the client by not trying to time the market and by not making long term forecasts on the movement of interest rates.
Q: What are the three major investment decisions you make in building a fixed income portfolio?
A: The first decision is what the average maturity will be in the portfolio. Our clients goals will determine which index we will be targeting, but our average maturity will be with in +/- 25% of that targeted index. Pushing average maturity out over 125% of the index’s average maturity places unnecessary risk for the portfolio, and conversely taking maturities under 75% of the index removes significant opportunity to capture principal appreciation. Thus our average maturity would be somewhere in the intermediate maturity range. Once we know how long the average maturity will be, our next consideration is to the distribution of maturities. For example, if we wanted a 10 year maturity, the portfolio could be all in ten year bonds, or the distribution could be split 50% in 1 year bonds and 50% in 19 year bonds. While it may look the same on average, these “bullet” and “barbell” strategies enable us to capture profits as the economy travels through its cycles. The final step in the portfolio structuring comes with the allocation between various sectors of the bond market. Of course we will buy U.S. government bonds ( Treasuries and Agencies), but our allocation may also include high quality corporate issues as well as asset-backed securities. Within each sector we take advantage of the particular skills of our specialists to come up with the best valued securities for the portfolio.
Q: Is this where you add value to your clients' portfolios?
A: Yes. By having a systematic and disciplined approach to the natural changes between bonds and sectors of the marketplace we will find those extra nickels and dimes that help build the total return of a portfolio above the coupon return. Specifically, our approach to adding value would include the following techniques: Bond swaps allow us to trade or swap similar securities where we have located another security that would strengthen the portfolio yield, credit quality, call protection, liquidity, or capital preservation. Short term trading lets us take advantage of short-lived swings in the market that are created by news or events. Investors often create emotional overreactions in the short term. Though we would only involve 5 - 10% of the portfolio in this type of activity, buying into an over-sold market and selling into an over-bought market can add more total return over a very short period of time. Usually this kind of a situation only lasts for days or maybe a few weeks. Credit analysis is probably one of the real best examples of how 1838 can add value in the security selection process. Through our internally developed credit models, we analyze corporate cash flows and project a corporation’s future requirement for bond financing. This work helps us determine which corporations have fundamentally improving rather than deteriorating credits. What we hope to be able to do is pick up on improving trends with issuers before the market in general comes to the same conclusion.
Q: What enables you to do this investment research and how much do you rely on outside sources?
A: Our fixed income group consists of six skilled professionals who all have specialties in different sectors of the marketplace. Everyone participates in the group’s research efforts. Buy decisions are initiated by the specialist in a particular sector and brought to the group for consideration. Any member of the group can initiate a sell decision and bring it to the table for timely finalization. The majority of our research is done in house 1838 does augment its own work with research from approximately 15 Wall Street firms.
Q: Who are some of the principals in the firm and what are their backgrounds?
A: When you ask me to single out people in the firm, it’s hard because everyone is important to the end product of our management services. All of our professionals are quality individuals with many skills coming from both their formal education as well as years of practical, real life experiences in the financial markets. Let me give you a little information about the principals who oversee the major units of the firm. My responsibilities as Managing Director encompasses oversight for all of our business activities. Along with an MBA from the Wharton School of the University of Pennsylvania, I have twenty years of financial and management experience. Jay McElroy earned an MBA from Harvard University and began his financial career 40 years ago with Morgan Stanley. In his 28th year with 1838, Jay heads up the firm’s high net worth individual group. George Gephart, who heads up the large cap equity group, also has an MBA from the Wharton School of Finance & Commerce. His career spans 15 years of investments for institutions and individuals. Ed Powell brings 35 years of investment expertise to the firm. His 20 years of work in the area of small cap equities qualifies him to head that group. Marcia Myers heads our fixed income group. She has 15 years of work in fixed income management and an MBA from the Loyola Graduate School of Business. John Springrose utilizes his 20 years of experience in the financial business to head up our client servicing group. John received his MBA from the University of Chicago.
Q: How does being employee owned help your clients?
A: At a time when more and more investment firms are being bought up by larger institutions, the fact that we are still self owned makes us a little unique. Since our equity is invested right alongside our clients' equity, the success of our portfolio work means just as much to us and our families. Not only do we provide incentives with a compensation structure that rewards outstanding performance; our employees see day-to-day operations from the perspective of an entrepreneur, because we have a personal stake in all that we do. 1838 is not just a business for our team, it also represents our personal pride as investment professionals. When there is pride of authorship in a successful venture, the output is a high quality, consistent management of client assets. 1838 has always been proud of the consistent returns we have provided our clients, and we plan to continue that tradition well into the next century.