Q: Stan, what is the relationship between Nikko Global Asset Management USA (NGM USA) and Nikko Global Asset Management, Ltd. (NGM LTD)?
A: NGM Ltd., located in the UK, is the holding company for all of Nikko Global Asset Management’s regional offices, including New York (NGM USA), Hong Kong, Singapore, London and Guernsey. The way we operate is that once the regional allocations have been decided upon, global portfolios are distributed to the appropriate regions for investment. We feel that the investment professionals in each particular region have an advantage in knowing the markets and culture of the area. As a result, NGM (USA) handles all investments for the US equity market, along with the Canada and Latin America markets. When it comes to client servicing, the local office is responsible and will call on regional managers for presentation on a periodic basis. As might be imagined, NGM (USA) services all North American clients
Tell us a little about Nikko the parent company and its core businesses.
A: NGM Ltd.’s parent company, Nikko Asset Management Co. Ltd., was formed by the merger of Nikko International Capital Management Co. Ltd. (NICAM), and Nikko Securities Investment Trust & Management Co. Ltd. The latter company managed Japanese equity and fixed income assets for institutional clients, while the former managed Japanese mutual funds or the retail aspect of the business. The reason for the merger was to gain economies of scale to better compete with foreign investment companies currently entering the Japanese market. The combined assets under management of the two companies are US $80 billion. o You manage US equities. What portion of your assets are managed for US clients and what portion are managed for overseas clients? A: As of April 1, 1999, about 20% of our US equity assets are managed for US-based clients and 80% are for overseas clients.
Q: Is it fair to assume that you share clients and research with your other regional locations?
A: For global and international mandates we have a Global Investment Committee comprised of the Chief Investment Officers from each of the regional locations. This committee meets quarterly, alternating between Tokyo and London, discusses the economic and market situations in each area and makes regional allocation decisions.
Q: Did you inherit your investment style when you came to Nikko, or is it something you brought with you?
A: The investment style was introduced prior to my joining NGM (USA), but it was first implemented at NGM (USA) and we have been managing money in this style for ten and one-half years.
Q: Your stocks include the S&P 500 universe. What is your Earnings Discount Model, and how does it measure relative “value” within the S&P 500?
A: Our universe consists solely of the S&P 500. That is, we do not buy issues outside the S&P 500. The reasoning is that since we use consensus figures and the S&P is widely followed, this gives us some depth in analyst coverage. Additionally, it helps us avoid mistakes in that if we bought a stock, say a chemical issue, outside the S&P that went down while the corresponding segment of the S&P advanced, we would run the risk of losing twice. An important point of our approach is to try to avoid mistakes, and win by not losing. The Earnings Discount Model attempts to arrive at a current value by discounting cash flow using a stock-specific discount rate. The models we use are not proprietary and belong to Salomon Bros.
Q: How does your Growth Momentum Model work?
A: Growth momentum is the projected change in expected growth. In essence, we want our portfolio’s expected growth to be higher than the benchmark or the S&P 500. All stocks are ranked 1-10 with 1 being the highest ranking, i.e. having the highest rate of change. We actually calculate the growth momentum measure for the portfolio and the S&P 500 and compare the two to assure that we do indeed have better growth momentum than the benchmark. We also do the same for the “value” measure. By measuring the value and growth momentum, each time a change is effected we attempt to reasonably assure our clients that the process and results can be repeated over time. So far we have been successful with regard to overall return and have done this in a risk-controlled way as the accompanying charts indicate.
Q: How does your Risk Attribute Model measure each stock’s sensitivity to the economic environment and the S&P 500?
A: The Risk Attribute Model (RAM) uses multiple regression analysis to measure the sensitivity of each stock in the S&P 500 to six macro-economic factors. Therefore, if we create a portfolio with similar sensitivities to these macro-economic factors, the two portfolios will track one another (thus controlling risk) except that our portfolio will have better “value” and better earnings momentum than the S&P 500. Of course, we will measure these two attributes versus the benchmark so we know we’re not flying by the seat of our pants.
Q: Could you specify which macroeconomic factors are used? Of those, which do you consider to be most important?
A: The weights of the macro-economic factors are proprietary to Salomon Brothers. However, they are constantly tested as to their ability to explain market movements, and those that have the highest correlation will have the greatest weight.
Q: Please tell us how your optimizer combines these three models to create portfolios.
A: The optimizer is a large matrix, programmed to create a portfolio within a number of constraints. In our case we have 143 constraints to create our portfolio. For example, the portfolio has 11 sectors (as does the S&P), no sector can be more than 20% of the sector weight of the benchmark(if an S&P sector is 10% than our boundaries are between 8-10%), no group can be more than 40% of a sector, and so on.
Q: How often do you “re-optimize” your portfolios, and what would you say is your annual turnover?
A: The portfolios are optimized monthly with a turnover constraint of 10%. Theoretically, annual turnover is capped at 120%. In reality it has run about 30-40% in past years, although last year’s turnover was 51%. Of course, on an ad hoc basis, if something unusual were to happen with a issue we would make an immediate determination. If a stock declined because an analyst lowered his or her opinion from a strong buy to a buy, or some similar happenstance, we would take no action. However, if it is deemed that the ‘news” will affect a company’s cash flow than we will make a suitable substitute. Because this is an actively managed portfolio, with models used for discipline and consistency, there is a good deal of subjectivity - the implication being that at times we totally reject the re-balancing.
Q: Is there a minimum or maximum number of securities that you will hold in a portfolio?
A: Over the 10.5 years we’ve been running this strategy the number of stocks have ranged from 90 to 130. The decision to own more or less stocks is another objective one. If we expect greater volatility we will tend toward the higher end of issues held; with low volatility we will own fewer stocks. Moreover, we are not only looking to outperform the S&P but also to beat the competition. Therefore, should the S&P become easier to beat we will likely have fewer stocks in the portfolio thus increasing the tracking error. Nevertheless, the tracking error has not risen appreciably above 3%.
Q: When do you sell a stock?
A: Generally, through the monthly optimization process, stocks become overvalued. The optimizer will always look to substitute a more undervalued replacement. Another discipline we employ is based on price. Should an issue hit a new low in a market or group that is increasing in price, we will generally sell 50% of the issue. Part of the discipline is knowing oneself. In my case I overcome the fear of selling at the bottom by selling half. This makes it easier for me to adopt a more dispassionate view with regard to the remaining 50%.
Q: Your performance numbers are surprisingly consistent in beating the S&P 500 over the past 10 years. What in your approach makes it so consistent?
A: The fact is that the portfolio buys only S&P stocks and is as diversified as the S&P, but it tends to have better “value” and earnings momentum. In other words, we don’t make big bets. We are relying on the fact that the S&P 500 is hard to beat so we don’t have to take a lot of risk to beat the competition. Another factor leading to consistency is the fact that we look for positive price trends, I believe BARRA would call this factor “success”. The way we work it is that if two stocks are close in “value” and momentum and one issue is in a downtrend while the other is performing well on a relative basis, we’d rather own the stock in an uptrend. Furthermore, our sell discipline which I’ve already described is helpful in remaining consistent.
Q: How do you control investment risk?
A: As far as cash is concerned, we remain fully invested at all times, i.e. there is no element of market timing in the results. As for risk versus the S&P 500, we do not solve for a portfolio with a particular beta. Rather, the constraints inherent in the set-up process are designed to construct a portfolio that closely tracks the S&P. Our tracking error over time has been mainly between 2% and 3%. It should be pointed out that the basic premise of our style is to admit that the S&P is hard to beat and particularly hard to beat over time so if we can create a portfolio that moves like the S&P but own better stocks we should win. Better stocks would be those that in the aggregate have better “value” and earnings momentum and where possible better relative strength in relation to the benchmark or in our case the S&P 500.
Q: The US market has experienced a spectacular bull run over the past decade plus. How do you explain the strong performance?
A: The strong performance of the US is a factor of economic strength and the expected cash flows attendant to that strength. The reason for this increase in cash flow might lie in the fact that the US, while not a perfect example, is more market-driven than other nations and the market is a better allocator of resources. Europe has experienced growth over the recent past but still has double-digit unemployment. The Far-East has seen cronyism, less freedom or more government control (Hong Kong is an example), and the failure to create a transparent economy. The US has benefited as a result.
Q: Do you expect this vigorous growth to continue? If not, how does your firm plan to weather a down market?
A: It’s no secret that the economy moves in cycles so it’s quite obvious that at some point the US will enter a down cycle. The problem is one of timing and most of us are not good at this at least on a consistent basis. What most institutional accounts are counting on is the long-term rate of return for stocks. Our job is to provide some value above that rate which is probably around 11%. Therefore, if the market declines we would expect to decline less. In other words we are not going for an absolute rate of return. One way of looking at how we do in down markets is to run something called an upside/downside capture analysis. Consultants have told us that in down markets we tend to capture 83% of the move while capturing 113% of the upside movement. This is since we began using this strategy back in October 1988.
Q: What are your research sources?
A: Keep in mind that we operate in a very efficient part of the market, so the use of consensus earnings estimates from IBES is generally sufficient. However, we do also use Street research, attend company meetings and have companies into the office for one-on-ones. If research were the answer, then performance should correlate well with the number of analysts employed by investment managers or perhaps dollars spent on research. Based on the fact that the S&P 500 beats most of the large cap investment managers, particularly over time, I don’t think you’ll find a meaningful correlation. Although I haven’t independently verified it I offer the following table. The figures come from Indata and are from their Pension-Equity Universe that currently has 682 portfolios with an aggregate value of $314 billion. The data are as of March 31, 1999.
Q: Stan, tell us about your investment background and what led you to become head of NGM USA.
A: Prior to coming to NGM I managed the in-house pension and profit-sharing department at Thomas J. Lipton, the tea company and a sub of Unilever. It was at Lipton that I became keenly aware of the need to control risk and provide superior returns. So when this system was introduced in the late 80s it was quite appealing. Interestingly, over the 10.5 years we have been using this management style, the constraints have not changed beyond the cosmetic. The S&P used to have 16 sectors and changed to 11 and we followed suit. The same is true where groups are concerned; the S&P went from about the low 90’s to 114 and we did likewise. The big change has been with the hardware. The product started out being done on a workstation at Salomon Bros. who then faxed it to us for approval. In 1993 the process became PC friendly but it took about an hour to run an optimization. Now it takes a matter of a minute to accomplish the same thing.
Q: Who are the other members of your portfolio management team and what are their backgrounds?
A: Our investment team consists of three people: a Senior Research Analyst, an Assistant Portfolio Manager/Trader, and myself. Our Senior Research Analyst, Paul Bienstock CFA, came to us last July from Rochdale Investment Management where he was their senior analyst. Paul is a Chartered Financial Analyst with a BA from Brandeis University and an MBA from NYU. He has more than 8 years of experience as an analyst. Joyce Nissim is our Assistant Portfolio Manager and Trader. Joyce has a BA from Columbia University and has been with Nikko for 6 years.
Q: What types of client accounts do you have? What proportion are corporate pension accounts versus other account types?
A: Our clients include corporate pension, endowments, Taft-Hartley plans and high net worth Individuals. About 50% of our clients are corporate pension plans.
Q: What does NGM USA offer its clients that other managers either do not or cannot?
A: NGM (USA) offers our clients a disciplined, risk-controlled investment style that has consistently outperformed the S&P 500. Our process enables us to measure the portfolio every time we make a change to it, so that we always have better earnings momentum, better value and similar macro-economic sensitivity to the S&P 500. This in turn enables us to have confidence that we can continue to deliver superior, risk-controlled performance compared to other managers.