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    Guest Interview:

   BA Capital Mangement

    50 California Street #9050
    San Francisco,CA 94111

    Telephone: (415) 455-4122


    Interview Quarter: 2Q1996

 James L. Melcher


Q: Jim, what first attracted you to international investing?

A: For a number of years now foreign markets, particularly in the developing countries, have provided higher returns, although they do of course entail higher risk. Also, even if one invests part of one's assets in somewhat more risky markets, the diversification lowers overall portfolio risk. Most American investors are reluctant to invest outside the U.S. If you told them that they had to diversify their money into different currencies and countries, they wouldn't be able to sleep nights. If you told a sophisticated European or Asian investor that he had to put all of his money into one country or currency, he wouldn't be able to sleep nights. The Standard & Poor's 500 Index is likely to show a slower growth rate over the next couple of years than most of the rest of the world. We may even see stronger markets in Europe. Europeans are way behind the United States in restructuring their companies to eliminate waste and excess costs, but they are starting. Many European countries are now in the process of restructuring and will be able to achieve fairly significant increases in profitability as a result. It will take longer there, however, than it has taken in the U.S. because of social problems and more restrictive regulations. Looking at the developing countries you find even more attractive investment possibilities. A good example is the fast growing countries of the Pacific Rim. Countries such as Malaysia, Thailand, Indonesia, Korea and Taiwan are showing GDP growth rates in the 6% to 8% range compared with somewhat over 2% probable in the U.S. So we have the opportunity to invest in countries with growth rates triple the U.S., yet with stock market price earnings ratios comparable to the S&P 500. It is not a difficult decision to want to place at least some of your money in these countries.

Q: Are you strictly an international manager or do you also use some U.S. companies in your portfolio?

A: We place money where we think it will perform best with the least risk. Not to say we don't take some risk from time to time, we do. But we like to keep that risk to a manageable level relative to the returns we can achieve. Therefore, we invest anywhere in the world we can achieve these goals. In recent years we've been primarily in the U.S. because we felt that it offered the best risk to return ratio. We own some foreign equities and I expect to shift additional funds abroad soon. So to answer your question, we are global investors as opposed to just international or domestic. Often we can invest in American companies which have a major portion of their business overseas and so we can participate in higher international growth with less political and currency risk.

Q: Would you explain how you use economic themes to determine which international markets look most attractive?

A: We work on a macroeconomic thesis which we are constantly updating based on economic trends, political and social changes, and other current events. Right now the overwhelming theme on which we have been focusing is that 80% of the world's population, who lived in rigidly managed economies six years ago, are now in the process of embracing capitalism. It is hard to quantify just what this means to stock and bond markets worldwide, but we know that it is big!. Basically the entire world is out trying to create wealth. So we are seeing the majority of the world's population, which was formerly unproductive, doing their best to be highly productive. This effort will undoubtedly create wealth and growth and generally enhance the value of securities around the world. While most of this growth will be outside of the U.S., many of the American companies are in a position to take advantage of it and participate in it. A good example would be the growth in telecommunications services worldwide. However, in the United States there continues to be high growth in wireless and digital data voice transmission. By comparison, however, many less developed countries are showing explosive growth as they move from primitive communications systems, leapfrogging several generations of equipment to the most modern wireless technology. This trend actually creates the best opportunities in the developed countries of Japan, Western Europe and the U.S. with companies like Motorola and Ericson benefiting from rapidly growing international sales. Many of the themes on which we base our investment decisions are obvious, such as high population growth in developing countries creating demand for better transportation, telecommunications, and agricultural products. Malaysia and Thailand for example have moved from being third world countries to strong second world countries in a matter of one generation. This growth has created a burgeoning middle class which is investing its high level of savings in equities. Much of the growth in their stock markets have come from these local investors. Therefore, in Malaysia, Thailand, Indonesia, etc., we have seen automobile distributors, cement companies, utilities, and other basic businesses show enormous growth compared with their counterparts in the U.S., as demand has risen so fast. The investment theme in this case is simply to put money where the growth is.

Q: Once you have identified a trend how do you identify a company or an industry which might benefit?

A: We use several top investment banking firms around the world as our out-of-house experts to help us identify opportunities that conform to our internally developed investment themes. I could not hire experts of the caliber that we have access to at these investment firms. They spend their entire lives in these countries seeking out the best opportunities. My job is to decide which countries to invest in and to consult with the experts in these areas.

Q: Are there any particular international markets you generally either favor or tend to shy away from and why?

A: There is no market I would shy away from all of the time, although there certainly are markets I avoid when the risk level is too high. The recent election makes Russian stocks look much more attractive than a few months ago when they were much lower. However, I did not buy Russian stocks because the risk of loss if the Communists got back in power was simply too high. Some markets simply get too expensive to stay in. In 1988-89 the Japanese market was soaring, but I stayed out. It seemed clear to me that the market was in a dangerous speculative bubble. Today the Nikei Index is selling at 60% of its 1989 peak and the economy is recovering from a recession. In addition liquidity is enormously high. I think it likely that a good portion of the $10 trillion or so of savings will find its way into the Japanese and other stock markets over the next few years. What kind of fundamentals do you look for in a company? First and foremost, good management; It can overcome a multitude of sins. No matter how good a product may be, a poor management will mess it up. Other fundamentals I look for are common to most investors; a strong balance sheet, good earnings growth, a strong product line, etc.. In addition I look for those special qualities which make it stand out compared with its competitors. Since every situation is different, we perform an in-depth analysis when we get to the point of selecting an individual stock after our macroeconomic thesis leads us to the country, the grouping, the industry, etc.

Q: Are you a follower of any particular investment style? If so, how would you describe it?

A: I believe that adhering to a particular investment style is generally limiting and sometimes dangerous. It has become fashionable among investment advisory firms to specialize in a narrow sector: small cap, international, large cap growth, momentum, etc. At any given time one of these styles can outperform the market substantially. However, none works all the time and inevitably all will periodically underperform the market. Since our clients are individuals, I have the luxury of investing in the areas and styles that make sense at that time. If I were managing large pension fund assets I would have to adhere to a certain limited style of investment. With individuals I can go where it makes the most sense. At the current time we own large cap and small cap stocks domestically as well as foreign stocks, although I have lightened up on the foreign stocks in the past few days to raise cash reserves. Some of these qualify as "value" stocks, some as "growth" and some as a combination of the two.

Q: What sources do you use for your international research?

A: As I mentioned before we have found over the years a number of analysts at international investment banking firms in whom we have a high level of confidence. They focus on specific regions or countries or even certain industries within those countries. How difficult is it to get in-depth information on foreign markets and companies? We have access to information that in many cases is as good as we get in the U.S. Obviously in some countries information is more limited. It is for this reason that focusing on market trends has worked to our advantage. We do not necessarily have to pick specific stocks in each country, but rather can buy a spread of stocks which will do the job for us. Since 90% of investment performance is based on macroeconomic judgments as opposed to individual stock selection, this method tends to produce superior results even in the absence of in-depth information on specific companies. Many countries use creative economic standards when they report earnings.

Q: How do you adjust for these differences?

A: We take into account the different accounting standards in each country and tend to relate evaluations back to the U.S. valuations we use as a benchmark. Generally, different accounting standards are factored into the prices of the securities in that country, however, and the market tends to iron out the differences.

Q: How do you cope with inflation and foreign currency fluctuations?

A: For one thing we do not tend to invest in a country with an accelerating inflation rate unless it is decreasing, which tends to enhance stock market valuations. Currency fluctuations are another matter. In countries whose currencies tend to be linked to the dollar or where we anticipate an appreciating currency we simply buy securities in the local currency. If we buy securities in a country where we think the currency may depreciate, we will usually hedge in the currency futures market.

Q: How do you determine when to divest your positions in a country or company?

A: There are several bases on which we would make such a decision. For an individual company it is either when we see a stock appreciating to the point where it is overvalued or where we see a change in the company that makes it less attractive. Another reason for selling would be a change in the industry conditions which might lead us to sell an otherwise good stock. Finally, we might sell even an attractive company, if we think the entire stock market is vulnerable.

Q: Do you have a particular approach to diversifying your investments?

A: We generally maintain 35 to 40 different positions in a portfolio. No matter how strongly we feel about any security, we will not put more than 5% of the client's assets in it. We do not want to own so many stocks that the portfolios become virtual index funds. We have enough securities for the safety of diversification but not so many that we cannot put money to work in situations which we know well and continue to monitor closely. If we cannot find attractive investments, we do not invest the money. I do not believe in being fully invested all the time; in fact our clients' portfolios periodically have substantial amounts of cash when we feel there is significant market risk.

Q: Diversification aside, how do you control risk?

A: We believe that in a well diversified portfolio the only significant risk is market risk. During our seventeen year history we have been successful in reacting to periods during which market risk become too high. And while occasionally we have raised cash when it turned out not to be necessary, usually our timing was good. In the beginning of 1981 I decided that Reaganomics was bad economics and that the stock market was due for a sharp decline. I held over 65% of my clients' accounts in cash. And while the Dow Jones Industrial Index declined over the following year and a half by nearly 20%, our managed portfolios rose approximately 9%. In 1987 I was worried not only about a speculative stock market and rising interest rates but also about the potentially disastrous interaction of program trading with the newly popular "insured investing". At the time of the crash clients' accounts were approximately 45% cash and by the end of 1987 our average portfolio had appreciated about 14%, against 3 1/2% for the Dow and losses ranging upwards of 25% for many managed accounts at other investment advisory firms. Similarly, in 1990 we were about 35% liquid because of our concern about the leveraged buy-out boom and soaring junk bonds. By the end of 1990 our accounts had dropped 6% nearly matching the S&P 500 decline, but we had abundant cash available which we used to get fully invested at bargain prices. During the period from July through October 1993 we sold all of our long-term bonds and other interest sensitive securities finishing up as the bond market approached its high. We thus avoided a major decline in bond valuations in 1994. The only time our performance suffered from our holding large cash reserves was in 1989.

Q: How did you get started in the money management business?

A: In college I followed the stock market with great interest and, since I always regarded myself as a generalist, I thought that becoming a stock broker made a lot of sense. I learned a lot on Wall Street from 1962 to 1969. However, in the beginning of 1969 I decided the market was way too high and set up a venture capital fund which I ran for several years. I founded Balestra Capital in January of 1979.

Q: What makes Balestra Capital different from other firms?

A: Balestra is a relatively small firm. We specialize in managing money for individual investors. We provide a high degree of client service, and generally maintain close contact with our clients. While I am the chief investment officer of Balestra Capital, I nevertheless interact on a regular basis with my clients, explaining our current investment stance, answering their questions, or just bringing them up to date on what's happening in the market. If I were running a much larger firm, I would have to be managing employees who would be the ones interacting with the clients. Our clients range from conservative, income oriented investors to aggressive investors. The most aggressive we put into our hedge fund. So we are more like a custom tailor compared to the large firms where you are "buying off the rack". Our clients appreciate the fact that we invest according to their individual needs, that they can call at any time for any reason and that they can meet with me and the other principles of the firm on a regular basis. The fact that we have outstanding performance is just frosting on the cake for most of them.

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