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   Interview

    Guest Interview:

   Farrell-SL Investment Mgt., Inc.

    101 East 52nd St., 3rd Floor
    New York,NY 10022

    Telephone: 212-319-3944
    Fax: 212-319-6575
    E-mail: contact@f-sl.com

 

    Interview Quarter: 2Q1997

 James L. Farrell Jr CFA

 Chairman & Portfolio Manager

Q: Can you describe the products and services that Farrell-Wako offers?  

A: I would be delighted to. Farrell-Wako is a global equity manager offering investment management services focusing on the US and Asian Capital markets. Specifically, the firm offers a US Large Cap Strategy, a US Small/Mid Cap Strategy and a Japan Strategy. These strategies, which I call "Alpha", employ a bottom-up multi-dimensional valuation approach which combines the disciplines of growth and value investing. The Large Cap focuses on all companies with a market cap greater than $1.5 billion. The Small/Mid Cap focuses on all companies with a market cap of less than $1.5 billion. The investment objective for all the Alpha strategies is to provide consistent above-average real returns with below average risk relative to active managers. The strategies are fully invested in equity securities at all times, and market timing is not accepted.

Q: How much money does each of these products currently have under management?

A: Our large cap currently has $141 million. Our small/mid cap currently has $94 million and our Japan Alpha has $165 million.

Q: Please tell us a little about your background and how you originally got into the management business.

A: I was previously Chairman and Chief Investment Officer of a New York-based independent investment counseling subsidiary of an insurance company. Also, I have extensive experience in portfolio management and applied financial research at a major U.S. bank and the College Retirement Equities Fund (CREF). Additionally, since 1976, 1 have served as the Chairman of the Institute of Quantitative Research in Finance, better known in the industry as the "Q Group". Lastly, I served as adjunct professor of Finance at both NYU and Columbia University

Q: Would you please define your overall valuation process?

A: Sure. We have in place a disciplined stock selection process heavily dependent on valuation uniquely combining fundamental and quantitative analysis. The strategy's primary emphasis is on bottom-up individual stock selection based on a multi-dimensional valuation process. Individual dimensions of value are combined into a composite rating that has a greater predictive power and consistency than any one individual dimension of value. Additionally, we employ a systematic portfolio construction process combining both multi-factor risk and alpha values, in conjunction with specific financial and economic information relative to each company evaluated. What do you mean when you talk about controlling macro risk in a portfolio? Mr. Farrell: Our macro risk model is one of the most important predictors within our strategy. Simply stated, it measures the risk portion of the industries themselves from a broad perspective. This allows us to lower the weightings in an industry that is currently out of favor - or conversely, to raise the weightings for those that are attractive.

Q: How many statistical and technical measures do you use?

A: We use about 40 statistical and technical measures, which have been developed and refined over the past 25 years.

Q: What do you mean when you talk about the multi-dimensional valuation process and its application to growth and value oriented stocks?

A: It is true, the research valuation process is a multi-dimensionaI one. It encompasses a multitude of individual "predictors" that have been tested using information coefficient techniques. In developing the US Alpha Strategy, we tested a multitude of these predictors and determined that some 40 represented the best "qualified" those that showed positive predictive power. We in turn grouped these individual predictors into several distinct dimensions of value. Examples of such valuation dimensions are: long term fundamental (LTF) - including projected earnings momentum and relative value methods, short term fundamental (STF) - including cash flow and asset valuation methods, fundamental analytical approaches (FA), methods to assess market dynamics (MD), and factors related to economic dynamics (ED).

Using this multi-dimensional valuation technique we can value each company in our universe. The individual predictor dimensions of value are combined into a composite valuation indicator known as an alpha rating. The alpha value is a highly important indicator of attractiveness. It has greater predictive power than an individual predictor of individual dimension of value. Combining dimensions of value provides a synergistic effect of enhancing the predictive power of combination beyond the summation of the components. Concurrently, the combining process provides a greater stability of results.

Q: Could you tell us something about the book you wrote on investment analysis and any investment associates you are currently involved with?

A: Well, being the Chairman of the "Q Group", as I mentioned. I have a unique position and distinct advantage in keeping current with leading edge technology and state of the art investment management. Membership includes a number of recognized leading thinkers and renowned practitioners in the world of investments today. Subsequently, our clients are the direct beneficiaries of this added value association. Regarding my book, I simply wanted to pass on, through my experience, a means for identifying both strengths and weaknesses in today's investment process and to provide a mechanism for improving the deficient areas.

Q: What do you mean when you talk about assessing the risk relationship among securities and asset classes?

A: To control risk within the portfolios, a primary condition is to first understand its sources. As a prerequisite, then, we remain fully invested at all times and do not become involved in market timing. Sector rotation or asset allocating is certainly not a component of our strategy. We take the extra steps necessary to diminish risk by being broadly diversified across all sectors within the equity markets.

Q: Would you address Farrell-Wako's overall investment philosophy and goals?

A: Our philosophy is grounded on the fact that market dynamics change. To produce reliable returns a manger must: 1) avoid portfolio style bias and its cyclicality, 2) understand the sources of portfolio risk and return, and 3) have a combination of perspectives utilizing fundamental research, quantitative methodology and investment experience. The investment objective is to outperform a benchmark index over time and to do so with consistency. This is accomplished through the use of a disciplined stock selection and portfolio construction process. Our focus is on large/small capitalization stocks avoiding a bias to "growth" or "value" issues so that the portfolio has a market-like character. Our approval is heavily oriented toward valuation and we select stocks that are attractively valued and yet have above average growth potential. In essence, we have been quite successful in using this methodology in obtaining high growth at a discount to the market.

Q: Briefly describe the process used to systematically value and rank your small and large cap universe.

A: By using a large body of current market and fundamental data, we begin the process of systematically valuing and rating over 3000 listed stocks. As highlighted before, this is accomplished by applying the multi-dimensional valuation approach of over 40 statistical and quantitative predictors that have been developed and refined over the past 25 years. The stocks evaluated are analyzed from a variety of perspectives such as long and short term fundamentals, market dynamics, economic conditions, trading patterns and research analysts' recommendations. The outcome of this valuation is an alpha rating which is a gauge of relative stock performance over the next year.

Q: What are the key elements in your decision-making process?

A: The most important factors in the model concern risk and return. In building a portfolio. the focus is on high ranked (alpha) stocks, but consideration is also given to four aspects of stock risk: I) market risk, 2) macro risk, 3) fundamental analytical approaches, 4) methods to assess market dynamics, and 5) factors related to economic dynamics. By considering several sources of risk and the alpha valuation of individual stocks, we can, in turn, develop a portfolio with a combination that has a favorable return prospect and a controlled risk profile. For all investment strategies, the final buy/sell decision is determined by me. In the final step, I provide a qualitative overlay to insure that the model is true and correct.

Q: What do you mean by forecast alpha value?

A: Simply stated, it is the relative attractiveness and projected performance of a stock (plus or minus) over the next year. It serves only as a gauge and the highest are earmarked for potential inclusion within the portfolio.

Q: A key tenet in your approach is the control and monitoring of portfolio risk. Do you use optimization within the process?

A: Yes, we utilize portfolio optimization techniques to determine the combination and weightings of securities that provide the portfolios with optimal risk-return characteristics. The optimization techniques utilize the return forecasts we have generated for individual stocks and a proprietary multi-index risk model. The multi-index risk approach takes into account major effects impacting stocks - general market, growth, cyclical, stable and energy. The optimization techniques seek out stocks having the most favorable returns and balances these return opportunities against the riskiness of the stocks. The intent is to hedge against market and group risks, as well as to reduce specific risk as much as is consistent with the objective of obtaining a high return. We attempt to keep the beta between .95 and 1.05 for the portfolio. Our portfolios are well-diversified, or hedged, with respect to group risk. The weights of the portfolio are virtually the same as the weighting in the overall market. The portfolio typically contains between 60-70 stocks in an effort to control market and major group risk closely. This means that specific risk is controlled while the opportunity for the construction, yet show favorable valuation characteristics.

Q: What universe does the stock selection process utilize and how regularly do you buy and sell stocks?

A: Our universe consists of over 3000 stocks, which includes 600 large cap stocks, all the stocks in the S&P 500 and Russell 2500, and other notable stocks. Those stocks with the highest alpha (ranking) indicate the most attractive "buys" and become candidates for the portfolio. The converse is true for low alpha stocks. By requiring the sale of stocks showing poor relative ranking within our universe, we can better avoid major losses. Before securities are actually purchased or sold for the portfolio, each stock is reviewed independently by the research staff. Portfolio rebalancing is conducted twice a month.

Q: What are the valuation dimensions and how do you weigh the importance of each one?

A: The five dimensions of valuation that I use within the process basically serve an information organizer on an individual basis. Collectively, they assist in creating "order out of chaos" in a universe of 3000 companies (which I mentioned). Each stock is submitted to this rigorous evaluation so that a comparison can be made across all industries as well as sectors. This procedure allows for a level playing field and a balanced approach for selection criteria used within the process. In regards to their importance, all are but not necessarily equally weighted. For example, the Analysts Ratings wouldn't be as critical as having accurate information on long-term fundamentals on a company.

Q: How do you go about constructing a portfolio?

A: We believe in combining systematic investment techniques with an underlying high quality, structured fundamental research effort. By considering several sources of risk and the alpha valuation of individual stocks, FWGI develops a portfolio combination that has a favorable return prospect and a controlled risk profile. Once FWGI has determined alpha return forecast and adjusted them for the level of predictive capability, portfolio construction is a matter of ensuring that the predictors are properly embodied in the portfolio. FWGI employs systematic portfolio construction guidelines which enable the portfolio construction process to be implemented in a controlled and disciplined fashion. We first attempt to control the risk associated with the market and group components of return. In order to control the risk associated with market timing, we keep the portfolio as fully invested in equities as possible - maximum of 5%. Correspondingly, we keep the beta of the portfolios at I or within a range of 0.95 to 1.05, in order to maintain the market risk in line with the market as measured by an comparable index To control the risk associated with major groups, we maintain a well-diversified portfolio. In particular, the portfolio is not overweighted with respect to a particular group or, alternatively, that it is not tilted too heavily in the direction of one of the major nonmarket factors. Conversely, we ensure that the portfolio is not underweighted with respect to the major groups or, alternatively, unduly tilted away from one of the major factors. The third major guideline is to ensure that the portfolios include a sufficient number of stocks (60-70) spread over about half the industries of the comparable indexes. Holding a sufficient number of stocks supports diversification by reducing specific risk. Also, holding a sufficient number of stocks is consistent with the fact that our predictive ability is modest. The procedure for managing the process over time and for new accounts involves repeating the process. In particular, we continue to generate return forecasts for individual stocks and combine them with the appropriate weights to develop an updated list of stock-return estimates. Portfolios are invested fairly quickly, less than two weeks with identical commonality of holdings (unless restrictions apply). FWGI does not employ the use of futures, options or packages of stocks.

Q: How do you go about doing a sector or industry weighting?

A: In generating the portfolio, several weighting constraints are established. One is that no individual security would represent more than 3% of the portfolio weighting, with the exception of a stock which Li may represent more than a 3% weighting of the comparable index benchmark. An additional constraint is that weightings of the portfolio in the growth, cyclical, stable and energy groupings would be in line with the comparable index benchmark. Given these constraints, the objective is to obtain a maximum return while minimizing residual risk (standard error) at a beta of 1. We obtain a beta value for the overall portfolio by simply using the individual beta value and the weight of the company in the portfolio to calculate a weighted average beta for the portfolio. This cross sectional beta provides a way of estimating the exposure of the overall portfolio to general market risk at a given point in time. We attempt to keep the cross-sectional beta of the portfolio in line with a practical guideline calling for a 0.95-1.05 beta range for the portfolio. On balance the portfolio is well-controlled with respect to market risk. With regard to group risk, we measure exposure by simply comparing the weighting of the portfolio in these major sectors with the weighting of that sector in the overall market to determine whether there is under weighting or over weighting with respect to the market or an acceptable proxy for the market. Our portfolios are well-diversified. or hedged, with respect to group risk. The weights of the portfolio are virtually the same as the weighting in the overall market. The portfolio optimization procedure ensures the control of this kind of risk most efficiently. Overall the portfolio is more highly diversified than the typical actively managed portfolio because of the conscious decision to control market and major group risk closely, as well as the intent to hold a reasonably large number of securities in the portfolio. The portfolios typically contain between 60-70 stocks. This means that specific risk is controlled while the opportunity for the weighted average projected alpha of 3.0% to be realized is maximized.

Q: Please describe to us your sell discipline.

A: As previously mentioned, each stock in the portfolio is assigned an alpha ranking. When this positive ranking begins to decline, the stock is considered to be a candidate for sale. Matter of fact, every stock in the portfolio is for sale at a base price. Additionally, when the fundamentals of a stock begin to deteriorate or if the company credentials start to break down, the stock is liquidated. There is no buy and hold strategy within the discipline so valuation monitoring of each stock in the portfolio is performed on a continual basis.

Q: Who are some of the other principals in your firm and what are their functions and backgrounds?

Mr. Farrell: Patrick Sullivan is Director of Sales & Client Services; Takeaki Nagashima. President and Treasurer. Pat has over 20 years of sales experience while Mr. Nagashima is responsible for the day to day operations of our firm.

Q: Is there a maximum size of assets under management you can take before your performance begins to suffer?

A: It's more of a question of service and dedication to our clients rather than performance fall off. By that I mean we can effectively manage up to two billion in our large cap and about 750 million in the small cap before it becomes too cumbersome. Performance can easily be affected when portfolios grow beyond their boundaries. This can also affect the discipline itself but I won't let that happen. When applicable I will cap both products so that performance does not suffer. We see that happening all too often in the marketplace today. Your performance with both large and small cap portfolios has been consistently outstanding.

Q: How will you continue to provide added value?

A: This disciplined investment strategy has been in place now for more than 25 years. It has stood the test of time in both up and down markets, the way it was designed to do. I constantly monitor this strategy as it relates to the dynamic, ever changing market conditions. Subsequently, the discipline is "fine tuned" when and if required. As a result, I consider this process as one applicable "for all seasons." It has been stress-tested and has demonstrated its effectiveness as the results have indicated. We remain very confident it will continue on course.

 
 
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