An Interview With Walter Harrison, Portfolio Manager, Granum Value Fund
by Maria Crawford Scott
Mutual funds that are value-based have managed to ride out this market better than their growth-based counterparts. This is not surprising—value investing is typically a more defensive approach, since the purchase of a security that is selling at below-market valuations has a margin of safety that can serve as a partial hedge against market declines.
One value-based fund, however, has benefited from a different type of hedging strategy in which it sells short the shares of certain index-based, exchange-traded funds. Short selling is done in anticipation of price declines—an investor sells shares of a security he does not own by borrowing the shares from a broker (with a cash margin backing the loan), and then repays the stock with an equivalent number of shares purchased at a later date and, hopefully, at a lower price.
The strategy, of course, could turn against the fund if the markets suddenly turn positive. So far, however, the approach has had a positive impact on the funds return. It has been among the top 25% of all large-cap funds for the last year, three years and five years as of June 30.
One other item to be aware of when examining this fund is its extremely high current expense ratio of 3.18%, due in large part to a performance-based advisory fee (and discussed in the interview below). A funds total return figures are net of expenses, but fees are a drag on future performance.
In early August, portfolio manager Walter Harrison discussed the management of the fund with Maria Crawford Scott.
What is the funds investment objective?
Our investment objective is to deliver greater-than-market returns with less-than-market risk over the long term.
In terms of the philosophy, we are long-term value investors, although we happen to be value managers who believe that growth is an important component of value investing.
We look to find value wherever we can find it—with the exception of the tiniest of companies, we dont exclude anything. Our portfolio is only made up of about 40 stocks, but it is roughly equally distributed between small, mid, and large cap.
Having said that, there certainly could be times where we find better value in the large-cap area, in which case somebody taking a snapshot of our portfolio at that point in time might conclude that we were large cap. But the greater point is that we are not cap [market capitalization] driven, we just want to buy value.
The truth is, I think there has been an artificial line drawn between growth and value. We consider growth to be an important component of value. What we like to do is to find companies that can generate earnings at a greater-than-market rate over an extended period of time. Thats the growth portion. In order to do that, they obviously have to have good financial returns so that they can continue to redeploy some of the assets in the business and continue to grow. They also have to be in a business that has the market out there into which they can grow.
In addition, we want to buy these companies with superior financial characteristics and superior growth to the market at discounts to the market. So, its really a two-pronged approach. Were looking for superior growth at significantly inferior market multiples.
When we look at our top 15 holdings, which is over 50% of the assets of the fund, theyre going to compound their earnings from 2000 to 2003 at about a 15% compounded annual rate. The S&P 500, on the other hand, will have down earnings. Yet our top holdings right now are selling at only 11.9 times this years earnings and 10.7 times 2003 earnings, versus the S&P, which is selling at over 21 times this years earnings and 18.5 times 2003 earnings.
These are superior companies, with superior management and superior growth, yet with significantly lower multiples than the market. Thats why we consider it to be a value fund.
We think other investors have to eventually buy our stocks because, to us, their characteristics are so compelling. Heres a brief example: There are only two companies in the S&P 500 index that have compounded their earnings every year at a double-digit rate since 1987: Home Depot, which is currently at 17 times next years earnings, and Fannie Mae, which is at 10.2 times next years earnings. Fannie Mae is our largest position.
No, we do not. If we had this discussion three months ago, I would have told you we didnt because Home Depot was at 30 times earnings. However, its been coming down, and now that its below the market multiple, with such excellent characteristics, were in the process of doing our work and we may well hold it at some point in the future.
In the very early stages, the multiple that a company sells at is very important. If a stock is selling at any sort of a premium to the market multiple, we have no interest.
If a stock is selling at some sort of reasonable discount to the market and the earnings story sounds plausible, we then go back and take a closer look. We research the balance sheet and the income statement to make sure theyre not playing games. We check to find out how tangible the book value is. We look at not just earnings relationships, but total enterprise value to get a handle on how a company might trade in the private market. We build earnings models, we look at the return on equity, we look at the return on assets, and we try to understand the real dynamics of the business. And then we follow that up with further management meetings to convince us that, in addition to having the return-generating capability to enable them to grow their earnings, they also have the management competence.
The answer is yes and yes. We are a diversified portfolio—we dont have more than 25% of our fund in any given industry group. But were not attempting to replicate the S&P. We want to find value, so we will frequently end up with concentrations different than the S&P. Currently, for example, we have a larger concentration in the financial services area.
However, we have the ability to hedge both market and industry-specific risk. Most times, over the long sweep of history, one wants to be exposed to common stocks. But there are times in serious bear markets when that doesnt hold. We have been in a serious bear market in parts of the market including the Nasdaq and the S&P 500. So we have about a 24% position of various shorts to take out industry and market risk to help us navigate these troubled times.
The evolution of the exchange-traded funds has been a blessing to us in that regard. For example, because we have such a high exposure in the financial area, we are short the financial exchange-traded funds (the symbol is XLF). We havent shorted it enough to bring us down to S&P weightings, but we do use it to take out some of that risk.
In addition, we think that there is still significant market risk [on the downside], so were also short the SPDRs [the S&P 500 exchange-traded funds], the mid-cap SPDRs and the QQQs [based on the Nasdaq 100].
It would obviously inhibit returns. But were not net short—we have about 78% invested on the long side, and 23% on the short side, so we have all of our money working, but we have a net long exposure of about 53% or 54%. Wed still make money, but just a little less. And keep in mind that that is just our hedge position today.
But the proof of the pudding is in the eating, and over the last 12 months the S&P is down around 20% and were only down 7%. Bear markets are riddled with these counter-trend rallies, and well underperform on the rally, but as long as the market risks are still there, wed prefer to hedge.
As a mutual fund, we cant employ leverage, so whats really happening is this: We really have over 75% of our money invested on the long side [stocks the fund owns]. But then we have another 24% sold short, and those shorts have cash margins backing the positions. On one level of looking at it, were really using all the money that our investors have put into the fund.
No, I would not. Were not trying to time various swings in the market. But I am trying to time what I have become increasingly convinced is a once-in-a-generation bear market, and I continue to look to see when it will be time to begin to back away from that protection.
What Im saying is that we still dont have the valuation underpinnings to take the market risk out of the market. We do have the valuation underpinnings in our portfolio, 11.9 times this years earnings, 10.7 times next years earnings—those are the sorts of valuations one normally sees at a bear market bottom. The problem is, in a bear market, theyll throw the baby out with the bathwater—a bear market takes my holdings down, too. Were trying to take some of that market risk out.
Market timers dont care about the fundamentals, and they dont care about the valuations. They may even go to cash. I see value in certain stocks, but I dont see the kinds of valuations in the market that would indicate the bear market is about to end, and I dont want the market to drag down my stocks.
No. But if we still thought that there were areas of the market that had risk, then we might be short a sector. For instance, if we found some very cheap stocks in the semiconductor/capital equipment area that met our value criteria and yet the overall semiconductor/capital equipment area was still rich, in that instance, we would still have some sector-specific shorts.
Several things. One, we would sell if our perceptions change—either we made a mistake, in which case we would sell immediately when we discover it, or the underlying fundamentals actually changed. Second, if it meets our objective we sell it. We set 18- to 24-month objectives on all of our companies. Third, if we find something else that looks to be a much better fit for the portfolio than an existing position, we would sell.
The base advisers fee is 125 basis points, which is reasonably standard. But what we have is a fulcrum fee, based on year-over-year comparisons with the S&P. If we underperform the S&P, our fee can go from 125 basis points to as low as 50 basis points. If we outperform the S&P 500 by over 500 basis points, our fee goes up by 75 basis points.
During the bubble phase, the S&P was up a lot, and we were up a little. Since we were underperforming the S&P, we only took a half percent management fee. Now, because were so far ahead of the S&P 500 over the last three years, the fulcrum fee works fully to our benefit.
The performance of the fund is net of the fees, so were not taking it and causing the fund to underperform—the fund has to end up ahead of the S&P net of those fees or we dont get the performance fulcrum fee.
The rest of the expense ratio is explained by the 12b-1 fee, which is 0.75%.
My outlook for the market, over the extremely long term, is that the markets are going to be fine. But there have to be some adjustments in the way people think about stocks.
The long-term, 100-year return on common stocks was 10.5%: 3% was real growth, 3.5% was inflation and 4%, believe it or not, was the dividends. Assuming we continue a 3% real growth, inflation is only 1.5%, so all of the sudden that gets us down to 4.5% capital gains and now dividends are still less than 2%. All of the sudden that means that the long-term returns from common stocks, moving forward, arent going to be 10.5%, theyre going to be 6.5%. I dont think most people realize that.
Having said that, in a very low inflation environment, 6.5% is still a sufficient return. But people have to get their expectations geared around that.
Intermediate term, I think there is still market risk. The long-term multiple on common stocks has been 16 times earnings. Perhaps with inflation going from 3.5% to 1.5% that means the long-term multiple should be 18 instead of 16. But bear markets dont end at fair valuation—they tend to overshoot on the down side. So I still have to assume the market would have to get somewhere below that before we get to the valuation sentiment underpinnings that would then enable us to start looking forward to the next upmove in stocks.
But you have to remember, that next upmove, over the long term, is going to be much more like 6.5% to 7% compounded rather than 10.5%.
To put that into perspective, the 10-year bond got down to 43-year lows yesterday. So, if you can get 7% out of stocks versus 4% out of a 10-year bond, thats still reason to invest in stocks long term. We just need to get down now to fair valuation, and I dont think were there yet.