Discipline paid off for the bear market beauties

Call them the bear market beauties: three mutual funds that outperformed the market in the last year. And there’s one common element between these funds — not being afraid to look a little ugly while peers try to keep up with appearances.

It’s not always worthwhile to look at one-year returns on fund performance. Short-term performance can be an aberration. But given the exceptional downturn, it can be instructive to see how some investment managers find opportunity in the face of catastrophic market conditions.

While the markets were selling off into the depths of the downturn, managers of the bear market beauties were letting fundamentals dictate their holdings — not market price. Among the sell-offs, each fund followed a process well before the bear market and did not deviate from it.

Discipline and experience seems to have paid off for star fund manager Bill Kanko, who steered the Hartford Global Leaders Fund to the top spot amongst Morningstar’s Global Equity fund category.

Kanko, the managing director of Black Creek Investments, outperformed his peer group over the 12 months ending July 31, 2009 by over 15%; returning a loss of just 1.3% on the year. It’s an impressive feat against the devastation in global equity markets during the past year.

Kanko employs a bottom-up investment selection process, where a single stock will represent an investment idea that he has. The Global Leaders Fund only holds 21 stocks and is not constrained by a benchmark or mandated sector allocations.

“It’s a very long-term selection process and it’s a fundamental process. We’re always trying to have a view of a company that is different from what other investors are saying,” Kanko says. “We look for companies that are leaders in their business fields — they tend to be the number one or two companies in their business area and are gaining market share, looking out five years or longer.”

While many investors were selling, Kanko went on the offensive finding opportunities, trading out nearly half his concentrated portfolio for new names. Buying the new stocks at depressed valuations allowed him to set the stage for good returns going forward.

“We don’t use big picture views to shape the portfolio. Valuations were just jumping out at us. During February and March of this year we were out doing presentations and telling people we haven’t seen equity prices this cheap in decades,” Kanko says. “We were buying when other investors were fearful and there was blood in the streets, so to speak.”

Through the fourth quarter of 2008 and into 2009, Kanko says he traded about 10 or 11 of the names in the portfolio, selling off relatively strong performers like Pfizer and GlaxoSmithKline. He found opportunities in stocks that had been punished by the markets and that had much better long term better growth prospects at better valuations.

The portfolio has shifted away from bigger companies, to include more small and mid-sized companies. At the same time, the portfolio shifted from stable growth companies to cyclical industrial companies.

“This was simply a function of what the market was serving up to us. We ended up selling some holdings that had done relatively well for us,” he says. “My favourite way to sell is to sell something to make room in the portfolio for a new idea. You find something you really want to own and make room for it by selling your least favourite idea. Based on what the market was doing, we did quite a bit of this.”

Canadian equity The top-performing Canadian equity fund available to non-accredited investors is actually an index fund — albeit one with a twist. On a year to date ending July 31, Pro-Financial’s Pro FTSE RAFI Canadian Index F-class fund was able to outperform the S&P/TSX Composite index by 11.68% using Research Affiliates Fundamental Indexing (RAFI) methodology.

Most indexes use market capitalization price to determine the weight of a stock in the index. The RAFI methodology does not use price in its selection criteria since market price may be quite different than the intrinsic value of a company. Assuming the markets are relatively efficient, a RAFI index should closely follow the performance of a cap-weighted index in normal markets, and deviate during brief periods of market inefficiency.

Preet Banerjee, a senior vice-president of Pro-Financial, says there was significant deviation between the price of many stocks in the indexes during the downturn and the value attributed to them according to fundamental factors used by RAFI.

“The four metrics are cash flow, sales, book value and total dividends paid. None of those metrics have anything to do with price. They are all measures of a portfolio’s profitability,” Banerjee says. “When [our] outperformance occurred, a lot of it came after March. The fundamental index is reconstituted every year on the third Friday of March. The fundamental weights are recalculated at that time for us to then track. Rebalancing is done on a rolling five-year average of all metrics, except book value, so if you have any year that’s an anomaly, like 2008, it only has a 20% impact on overall change to the portfolio.”

Banerjee says when Pro-Financial rebalanced its fund in March, the RAFI weightings required the fund to take a much higher weighting of financials, versus the underlying cap-weighted index. Since March, that sector has roared back.

Banerjee says one of the benefits of the rules-based index is there is no emotion to stock-picking. Many investors recognized that financials had distressed pricing, but were worried about the hysteria surrounding the industry. Banerjee says the fundamental index often “contra trades” the psychology of the market.

“Whenever the market gets wacky — after a period of mania or depression — the fund doesn’t care. It just does what it’s supposed to do,” he says. “It’s during those periods when valuations tend to be as far off their fair value as much as possible and where a fundamental index adds value. In between those times it just tends to keep up with the cap weighted index.”

Fixed income The Templeton Global Bond fund, offered by Franklin Templeton Investments, was the top-performing Global Fixed Income mandate from the last year. The fund, managed by Michael J. Hasenstab, has returned an impressive 17.9% return on the year, according to Morningstar Canada, by investing in a global basket of government issued bonds.

Canyon Chan, a senior vice-president with Franklin Templeton Fixed Income Group and a portfolio manager who works with Hasenstab on the Global Bond Fund, attributes a good deal of the fund’s success to not being constrained by a benchmark index.

“Fixed income benchmarks are weighted to the amount of debt outstanding. [If you follow the benchmark] you are investing with countries that are issuing more debt and therefore arguably fiscally irresponsible. By taking our benchmark unconstrained approach, we are free to invest in the best currencies and countries,” Chan says.

“We can adjust our weighting on the fundamental attractiveness rather than the index weighting which can run counter to fundamental or a quality based approach,” he adds. “The one downside of this is there are times where we have significant deviations from the index to the extent we’re measured against it. Over the long term, we’ve been able to generate out performance against the index.”

This allowed the Global Bond Fund to avoid taking positions in U.S. treasuries, which had substantial run-up in value during the last quarter of 2008 as investors rushed to safety.

“We’ve had no weighting to U.S. treasuries; we felt U.S. treasuries were relatively expensive and didn’t offer much value compared to other opportunities in the marketplace and other countries around the world,” Chan says. “On a relative basis we underperformed when U.S. treasuries over performing.”

Chan says the fund’s team used those periods to move into higher weighting in many East Asian bonds which were viewed as undervalued.

“We were positioning into other treasury markets around the world into those [securities] that had not priced in other central bank rate cuts. When the central banks of those countries cut they were later in terms of timing,” he says. “We continue to see a lot of interesting investment opportunities. On the currency side there are a lot of opportunities and we see a lot of developed countries posed to do well on growth during an economic recovery.”

(09/01/09)