|Q: John, you are widely recognized for your investment newsletter, The Prudent Speculator. Tell us about this publication.
A: The newsletter, which covers common stocks traded on the U.S. equity markets, was established in 1977 by the legendary value investor Al Frank. His name is still on the door, even though he has gone to "Stock Market Heaven," as he used to say, having passed away from cancer in April of 2002. I came on board in 1987, three months before I graduated from college, as a 21-year-old, wet-behind-the-ears college senior. I worked my way up the proverbial totem pole and took over the day-to-day operations in 1990 when Al relocated to Santa Fe, New Mexico and I have been here ever since!
Al launched The Prudent Speculator as a diary of his investment experiences. He had no formal financial training and had to hone his skills at the school of hard knocks, but Al learned his lessons well. Utilizing a simple value investing approach, he regularly put his money where his mouth was, launching his real-money TPS Portfolio in the inaugural issue of the newsletter in March 1977.
It is this model portfolio, which we still manage and track to this day, that forms the basis for the stellar performance rankings of the newsletter. In fact, TPS Portfolio has enjoyed annualized rates of return in excess of 20 percent over the past 28 years and the independent Hulbert Financial Digest (HFD) rates our publication the #1 performer in terms of total return for the past 10 and 15 years. We also rank second for 5 and 20 year total return performance. HFD is essentially the Consumer Reports for the newsletter biz, which is a good thing, given the wild performance claims made by some of our competitors.
Happily, we have over 10,000 subscribers to the publication, which now includes three additional model portfolios for subscribers to follow, including my own real-money Buckingham Portfolio which was launched in January 2003. Following in Al's footsteps, I too put my money where my mouth is as I firmly believe in our investment philosophy. After all, if we don't have faith in our strategy, how can we expect our customers to put their hard-earned money to work using our methodology?
Q: What else keep you folks at Al Frank Asset Management busy?
A: In addition to The Prudent Speculator newsletter, we manage about $600 million in total assets, with $350 million in private accounts and another $250 million or so in our two equity mutual funds. The main fund is the Al Frank Fund (VALUX), which started in 1998 and now has about $230 million in assets. Our second fund, launched just seven months ago, is called the Al Frank Dividend Value Fund (VALDX), and now has about $22 million in assets. Though $22 million does not sound like much, we're pleased with the launch of VALDX, considering that we didn't get to $22 million in VALUX until the middle of year four.
Regarding my role, I'm the president of the company. I'm also the chief portfolio manager, the director of research and the editor of The Prudent Speculator. Of course, we are hardly a one-man show as we have 13 team members who make our organization hum and make my job much easier! In fact, one of our employees, Mark Mowrey, has just launched our newest investment newsletter, The Prudent Speculator TechValue Report which focuses on undervalued stocks in the tech sector. While I serve as Value Editor, Mark is the Technology Editor and the driving force behind this publication thanks to his tremendous knowledge of technology trends and his extensive journalistic experience at tech-oriented magazines.
Q: Please give us a summary of your underlying investment philosophy.
A: We might be called eclectic value investors as we deliberately avoid the traditional asset-allocation style boxes. We seek bargains wherever they reside. If blue-chips are cheap, we will buy them. If technology stocks are undervalued, we will not hesitate to pick them up. Of course, historically, the inexpensive stocks that we favor have tended to congregate in the micro- and small-cap spaces, but we do not discriminate. We believe that if we limit our investment universe by market-cap or value-versus-growth distinctions, then we are likely to limit our returns!
That being said, we seek companies that are undervalued and out of favor. We look for stocks that are trading for inexpensive fundamental valuations as measured by price-earnings, price-to-book-value and price-to-sales ratios, relative to the market, their peers and where they have historically traded. We also look at balance sheet strength, debt levels, growth rates, company-specific news and industry developments. Of course, there is a heck of a lot of art that overlays the science of fundamental analysis.
Q: Why the focus solely on value?
A: The reason we gravitate toward undervalued stocks is that this has been what has worked throughout market history. If you look back through the market statistics, you'll see that value stocks have outperformed growth stocks by a significant margin, dating back to 1928. For reference, value is generally defined as companies that trade for low price-to-book-value ratios, while the growth designation is reserved for companies with, intuitively enough, high price-to-book-value ratios. According to Ibbotson Associates, the annual returns from 1928 to 2004 are 9.2 percent for growth stocks and 11.9 percent for value stocks. This may not sound like much of a difference, but $1 invested in the former at the end of 1927 would have grown to $836.40 at the end of 2004 while that same dollar invested in the latter would have grown to $10,101.83!
Other studies have shown that stocks trading for low price to sales and low P/E ratios have also outperformed. It is not rocket science. We have not uncovered some secret formula. It's basically using history as our guide. Some might also call it common sense investing. If you can buy something on sale, generally speaking, you're better off than if you overpay for it. That's usually the way that people live their lives. You want to get a good deal on that refrigerator, the loaf of bread or even the second home that you're going to buy. You don't want to pay more than it is worth. But the stock market seems to be the only place where people feel better about paying a higher price for something.
Q: There are myriad value managers out there though. What make Al Frank different?
A: While picking undervalued stocks is important, diversification and patience are equally, if not more important facets of our investment approach. We have proven to be above average stock pickers, but we don't have a crystal ball. Nobody does, for that matter, including the Wall Street analysts who follow seven companies and can't get it right in terms of whether they should buy or sell or even in terms of whether the company will beat earnings expectations.
There's just no way, so we play the percentages and we cast a big net. We have to have the broad diversification, because we don't know which of our companies are going to succeed and which ones aren't. Obviously, if we did know which would turn out to be losers, we wouldn't buy them. But the same methodology is used to select all of our stocks, including the home runs and the strike outs. Given that very few investors have been able to match the market in terms of performance, much less post 20 percent per annum returns, we are quite enamored with our approach, warts and all. In the 28 years that we've published The Prudent Speculator, 70 percent of our recommendations have proven to be profitable and 30 percent have not. But the winners have won far more than the losers have lost, suggesting that we might even be successful with a Ted Williams-type .344 lifetime batting average.
The final piece of the puzzle-patience-might be the most important. Patience for us is Job-like. On average, we hold stocks recommended in The Prudent Speculator for six-and-a-half years. This long-term thinking, while naturally tax-friendly, helps to control risk as studies have shown that the longer stocks are held, the less the chance of loss. We have often seen our stocks do nothing for a few years, only to rocket ahead several hundred percent in year three, four or twelve. Undervalued and out-of-favor stocks do not usually turn on a dime, but when they do the rewards can be tremendous.
Q: I saw that you recently spoke at a conference on "How to Reduce Volatility with Maximum Returns." What core points did you make during the presentation?
A: The performance of our investment newsletter since its inception in March 1977 is at the top of the table. We've averaged north of 20 percent a year for 28 years, which puts us on par with Warren Buffett in terms of total returns. Naturally, that kind of performance begs the question, "Why do you only manage $600 million when you have these phenomenal returns?"
Aside from the fact that we don't have a marketing machine behind us, historically, the reason that we don't manage more money has been that we're volatile. Our returns have tended to fluctuate dramatically. Just to give you an idea, we were up in our flagship mutual fund, the Al Frank Fund, 78 percent in 2003, which made us one of the best-performing funds in our mutual fund category. But in 2002 we were down 26 percent, which made us one of the worst-performing funds in our category. So it seems that we're either first or we're worst! And unfortunately, more investors would rather that you be mediocre and have a return in line with your peers or your benchmark every year than that you outperform dramatically one year and then underperform significantly the next year, even though the overall return over time is far better than it would be if you were just performing in line with the benchmark.
To further illustrate the point, in the Al Frank Fund we've averaged about 16 percent per year since the fund's inception at the beginning of 1998, and that makes us one of the top-performing funds in any style category over that time span. The S&P 500 and Wilshire 5000 Indexes are up an annualized 2.5 percent and 2.9 percent over that period, excluding dividends. So we're very happy with our long-term returns. They've been sensational. The problem, for some investors, is that we gyrate too much.
Q: So how can you attract more risk-averse investors to your strategy?
A: That question is actually at the heart of our new Al Frank Dividend Value Fund. We've been fighting the battle for 28 years, thumbing our nose at Wall Street saying that we'd rather make 20 percent a year with ups and downs than 10 percent a year with no ups and downs. But that battle grows tiresome. We will never kill the goose that has laid the golden eggs as we will always cater to those folks seeking higher returns but we are looking to grow our business, and we recognize that there are a lot more people and dollars out there that would be interested in our strategy if it weren't so volatile.
So we've done a lot of research as to what components of our strategy make us more volatile. We determined that companies that pay dividends are far less volatile than those that don't. We went back over our existing fund-"back-testing" it, if you will-looking at only the dividend-paying stocks versus the non-dividend-paying stocks. While the returns on the dividend payers would have been lower-12 percent to 13 percent annualized instead of the 16 percent the fund made or the 19 percent or so that the non-dividend payers made over time-the fact that the beta, or the volatility, was actually about in line with the market or even a little below the market makes the strategy so appealing. If you could have above-market returns with at-the-market or below-market risk, that's sort of the Holy Grail of investing, at least as far as the experts on Wall Street would believe.
To give you an idea of what that means, in the Al Frank Fund, remember I said we were up 78 percent in 2003 and lost 26 percent in 2002. Had we only been in the dividend-paying stocks, we would have made 42 percent in 2003 and lost about 15 percent in 2002. So minus 15 percent plus 42 percent versus minus 26 percent plus 78 percent, you don't need to be a math major to know that you would have been better off with the second scenario. However, the majority of investors would probably prefer the first one because even though your total return over the two years would have been lower than the more volatile fund, they would have been better than the typical mutual fund benchmark, the S&P 500, in those years.
That's the reason that we've launched this new fund. It's really just a subset of our existing research. It's not as if we're going off and trying to add a growth fund to our value fund. It's still the same methodology and the same quest for value stocks, so we're adding that one on-off switch-does it pay a dividend or not? If it does pay a dividend, it's eligible for the new fund. If it doesn't, then it's not!
Q: With our rapid pace of technological change plus market competition, what leads you to think that you can make long-term decisions when things change so quickly?
A :The more things change the more they stay the same! Equities have historically delivered the best returns of any financial asset class and we see no reason for this to change, especially given the current low-interest rate environment. Yes, there will always be volatility, but we believe that such a backdrop creates opportunity for the long-term-oriented investor to pick up undervalued stocks at fire-sale prices and to sell overvalued companies at greater-fool-type levels.
We know that no matter what the historical evidence supports, many investors will shun equities due to worries over the budget deficit, the weak U.S. dollar, high oil prices, slowing corporate profit growth, geopolitical uncertainty and/or the threat of rising interest rates. These are certainly serious concerns but they are no worse than what we have faced in the recent past. We survived Black Monday, Iraq I, the collapse of Long Term Capital Management, the Asian Contagion, Presidential Impeachment, The Tech Bubble, September 11, Accounting Scandals and Iraq II with superb longterm performance. Yes, I recognize that we have not had to endure a 1973-74 Bear Market, but many view the 2000-02 period as something comparable, and yet the recommendations in The Prudent Speculator, on average, actually made money during that turbulent time span!
Kmart chairman Edward S. Lampert recently said that he was comfortable with uncertainty. So are we-and our long-term record justifies our comfort. Reason tells us that equity investing is the way to go and that our value strategy works, therefore we won't be deflected by emotional headlines.
Q: Where are you finding value today? Can you give us some specific sectors or individual stocks?
A: Just about the same places as we always have. We remain great fans of the homebuilders, several of which are currently on our recommended list, including D.R. Horton (DHI), Beazer Homes (BZH), Centex (CTX) and Standard Pacific (SPF). We also like several of the large pharmaceutical companies, like Bristol-Myers Squibb (BMY) and Pfizer (PFE), as we believe the long-term positive fundamentals supported by an aging global population outweighs what we believe is shorter-term turmoil in the sector. And believe it or not, we think that the auto sector, while deservedly punished for many wrongs, the greatest of which is poor long-term cost management, shows great promise as well. Among the auto makers, we are buying Ford (F) and General Motors (GM). Ford currently yields around 4 percent and GM tops 7.5 percent, so we're getting paid to wait for a recovery. When that comes, we think Dura Automotive Systems (DRRA), an auto parts supplier, will see better times, too. That one's not to be confused with Doral Financial (DRL), a beaten-down favorite among the financials, of which Citigroup (C) is another current recommendation. Finally, as much as 60 percent of our current recommended list is comprised of technology stocks. In tech, we are big fans of the semiconductor manufacturers and the chip equipment makers right now, including names like Integrated Device (IDTI), Mattson Tech (MTSN) and Cohu (COHU).
Q: You probably took a greater interest in technology stocks after the Bubble burst in 2000, no?
A: Actually, we have always been interested in technology stocks, even if we haven't always known what exactly they do (or in some cases even remotely what they do). And we've had great luck with them. Over time, we learned that we might have done a bit better if we actually understood the basics of the technologies sold by the companies in which we chose to invest. As it turned out, the readers of The Prudent Speculator often wondered about those technologies, too. From that greater interest in technology sprung in mid-March of this year, our newest publication, The Prudent Speculator TechValue Report. Like the dividend strategy, our tech strategy is the same as our core Al Frank value investment strategy altered with a simple on/off switch - tech or non-tech.
Q: How can investors get more information about The Prudent Speculator and your management services?
A: Our web site, www.alfrank.com, remains the best place to find out more about our two publications, our two proprietary mutual funds and our other asset management services.