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   Interview

    Guest Interview:

   Balis Lewittes & Coleman LP

    575 Lexington Ave., 7th fl.
    New York,NY 10022

    Telephone: (212) 350-4400
    Fax: (212) 350-1430
    E-mail: mat@blcinc.com

 

    Interview Quarter: 1Q1998

 Mathew Coleman

 ----

 

Q: Mat Sr., please explain your investment methodology.

A: I concentrate my assets in a select group of primarily large capitalization companies and then together with my son, manage the overall risk exposure of the portfolio by holding cash and/or various instruments such as index options to hedge against volatility or potential downside. We measure our performance day to day, tick by tick and our clients expect us to preserve their capital as well as make it grow.

Q: Why do you hold primarily large capitalization equities?

A: There are three primary reasons that we feel large capitalization equities will continue to be the principal beneficiary for investment dollars. 1) Large institutions demand the liquidity conditions that are offered by large capitalization companies. Institutions require a place to invest that can absorb huge cash inflows and conversely, allow for an exit when redemption requires. High market liquidity is an integral part of our investment criteria because we operate in a context of a market place where the actions of large investors often move the markets and define its performance. 2) International investors will generally concentrate their assets in companies that they are familiar with and that satisfy a comfort level. They expect to be holding positions for longer periods of time and want to be certain of the longevity and viability of their holdings. Such investors are less swayed if small capitalization companies grow faster or represent better value than large capitalization companies. The international investor would prefer to forfeit that incremental growth for what he perceives is a lower downside potential and the competitive promises of economies of scale. International demand has been and will remain concentrated in large capitalization companies. 3) Large capitalization companies often have substantial brand equity. Generally, we can find them to possess demonstrated and competent management, industry sector dominance, and superior financial strength. These factors are an integral part of our investment criteria. Like Warren Buffet, we put a heavy weight on the value of brand equity. These large capitalization companies have the strength and resources to weather the rough seas that we will inevitably see again.

Q: How do you differ from a large capitalization index fund?

A: Our strategy differs substantially from that of large capitalization index funds. We believe that at the margin, performance can be enhanced if market trends such as sector rotation are observed and acted upon. It is our view and our long standing experience that we can increase returns, lower risk, and maintain acceptable parameters of diversification by observing these trends and by anticipating them. Secondly, we believe that in the present market environment, index funds are dangerous. They are dangerous for the investor and they are dangerous for the economy in general.

Q: Why are index funds dangerous?

A: The underlying theory behind index funds is that the stock market cannot consistently be beaten. Stock picking doesn't work according to the index manager. He believes that the best way to invest in the stock market is to invest fully in an index and concentrate on lowering as much as possible the cost of running the fund. We submit that the biggest bet one can make on market timing is to buy an index fund. It's a bet on the perpetuity of the bull market. This strategy works well in the kind of market that we have recently experienced, where capital inflows have acted like a rising tide to lift all boats. (Frankly, in fact, one can only say that creativity has not recently paid the investor excess returns). An analogy is driving full speed ahead down a wide straight rode with a bevy of complacent passengers. In this case, investors. Eventually there will be some turns in this road and unpleasant results will ensue. When that happens, index funds will be forced to liquidate holdings to meet redemptions and that will exacerbate the decline and losses. The average investor will be unable to reach his fund promptly. There are insufficient warnings as to the dangers posed by the index funds to investors and that is a serious and pending social problem.

Q: Can you give us a couple of recent examples of where you have gained an edge from observing market trends or industry sector rotation?

A: A clear example where stock picking gave an edge to our investors can be seen in the energy sector. In 1997, we were heavily weighted in the oil service companies and drillers. The sector saw accelerating earnings and anyone who concentrated their assets in these stocks benefited. This is a fact. Subsequently, we reduced and then entirely eliminated our holdings in that sector. The catalyst was the declining oil prices seen late last year. We saw that as questioning earnings visibility and were not inclined to hold these stocks. We recently have begun to repurchase shares in this sector (at lower prices) because oil prices seem to have stabilized. During the first quarter of 1998 the growing perception was that Asia will not be such a drain, after all, on the growth of our economy. This is contrary to the view held just three months ago. We cannot know how ultimately this will play out, but certainly it is the case, that in the late first quarter of 1998 movement occurred back into deep cyclical stocks. We are monitoring this trend closely and have allocated a small and measured part of our assets selectively to cyclical stocks. We are prepared to increase these holdings if evidence emerges that economic growth is in fact, accelerating. Another example of this kind of sector rotation is within the financial sector. With stable interest rates, we are heavily weighted in financial stocks, However in the case of banks, we are concentrated in the domestic super regionals and not the multinationals with Asian exposure.

Q: How do you identify the sectors and stocks that you want to concentrate your assets in?

A: We use a top-down process that attempts to identify macro-trends and patterns that we expect to influence the market place for at least six months. We then try to identify the industries and stocks that will likely be the principle beneficiaries of those trends. Part of that assessment is an extensive analysis of the fundamental condition of those industries, companies, and their prospects. We believe that a company has an intrinsic value that should be below the markets valuation. We look for that. The lack of seasoned strong management is without a doubt the most common determinant in the elimination of investment candidates. The most important component of our investment process is a disciplined approach to investment management. We try not to be arrogant about our assessments. The market is the judge of the quality of our assessment. We let it guide us. If it tells us that we are wrong, then we act as decisively as possible to correct our mistake. We try not to fall in love with stocks. We can sell holdings regardless of our basis. We think it is foolhardy to hold onto positions where the fundamental or technical conditions become suspect. If we cannot identify suitable investment opportunities then we are comfortable holding cash.

Q: What role does market timing have in your investment methodology?

A: Statistical study shows us that it is unlikely that an investment manager can effectively and consistently time markets. However, if the market is beginning to deteriorate for fundamental reasons, it is probably a safe bet that the market will continue its downward decline until those factors are fully priced into stocks. We would act on this basis, not because we are trying to time the decline per se. Rather, we believe that when the rising risk of financial loss outweighs the potential for reward, it is prudent to be conservative and protect capital. History has demonstrated that during certain periods of time, markets have performed badly. Our clients depend on us to be prepared when history repeats itself.

Q: How do you compete with bigger players?

A: I manage my own money, the firm's capital, and that of my clients. Many of my clients have been with me for twenty years or longer. I have been in the business for 35 years, 30 of which were with two dominant organizations. I feel confident that I don't need a large and bureaucratic organization to do my job properly. My access to information is the best that it has ever been. I see little correlation between size and quality of management. Why should I bother competing with the bigger players?

Q: How would you choose a manager?

A: If I were looking to place my assets with another manager, I would choose one with integrity, talent, and one who provided me with impeccable service. Further, my choice would be predicated on a manager who I felt, did not subvert my interest to his own.

Q: Mat Jr., what role does risk management play with you and your dad?

A: Risk management plays an extremely important role in the management of our investment portfolios. We find that our clients have a much lower tolerance for downside risk than upside risk. They want to make money but they hate to lose it. The best way for us to meet their goals is to try to make more money on the upside then we lose on the downside. My father described our general approach to stock selection. This covers the upside. The next phase of management is to determine what kind of risk exposure we wish to have for the downside. After a major correction, at the beginning of a bull move, or after ten years without a 20% correction we have to make a general risk assessment. Clearly the risk of being in the market today is greater than it was ten years ago. We make decisions continually about how much risk is in the market and how much relative risk we want to expose ourselves to.

Q: What do you mean by relative risk and how do you measure it?

A: There are two kinds of risk. Relative risk is the riskiness of a portfolio as compared to a benchmark, for example, the S&P 500. This can be measured by a portfolio's beta. Beta is the correlation co-efficient of a portfolio to a benchmark. Example, Portfolio A has a beta of 0.5 meaning that it has been approximately half as volatile as the S&P 500 index. Portfolio B has a beta of 2.0 meaning that it has been twice as volatile as the index. Our average beta for the last two years has been less than 0.5, less than half as volatile as the S&P 500. Our standard deviation has also been quite low.

Q: What do you mean by standard deviation?

A: The second kind of risk is absolute risk. One measure of absolute risk is standard deviation. Standard deviation is the volatility of a portfolio around its average return. For example, portfolio A has an average daily return of 0.1% and a standard deviation of 0.3%. This means that the portfolio has earned a daily average of $10,000 on a $1 million investment, but in approximately 65% of the days, its earnings have fluctuated between losses of $20,000 and gains of $40,000. Portfolio B has the same average return of 0.1% with a much smaller standard deviation of 0.1%. Portfolio B has earned between $0 and $20,000 per day with the same average earnings of $10,000. Clearly, the earnings of portfolio B are much less volatile for the same average return. Most reasonable investors would opt for this one. Unfortunately, most investors have no idea of the risks that they assume until they face big losses. I believe that most managers also don't know what risks their clients assume. Our daily standard deviation for the last two years is just 0.1% around a mean of .07%. The average daily earnings have been approximately $7,000, and 65% of the time earnings have been between losses of $3,000 and gains of $17,000 on a $1 million investment.

Q: Why do you measure these numbers daily?

A: Actually, we measure these numbers continuously, tick by tick. The effect is to give us a kind of play by play analysis that escapes most managers. We see if there is a weakness in our portfolio as it begins to develop, not just after it's there. The objective is to understand our portfolio's behavior in its entirety not just the behavior of its individual holdings. We often hold securities that are negatively correlated. This means that some parts might be doing well and others may intentionally be losing money. If the portfolio were to be behave as it should, then we would expect to see strong performance after adjusting for risk. We call this performance result alpha.

Q: Tell us about alpha.

A: A positive alpha is an excess return. If you are half as risky as the market and you consistently earn much more than half the return, then you probably have a positive alpha or excess return. There are three components to calculating alpha. The first is the risk free rate that can be earned with no risk such as on the 90 day treasury bill. The second is called the risk premium. If the risk free rate is 5.0% and the S&P 500 grew by 12.0% then its risk premium is 7.0%. If portfolio A has a beta of 1.5 then it must earn 1.5 times the risk premium to justify taking 1.5 times the risk of the S&P 500. Otherwise an investor would have done better to use 50% leverage and invest in Spiders that mimicked the S&P 500. We try to have 20% of our returns as alpha. In the case above, Portfolio A would have to achieve 15.5% to have an alpha of 0 and 19.38% versus the S&P 500's return of 12.0% to have 20.0% of its return be excess or alpha.

Q: Why do you aim for 20%?

A: It's an arbitrary number that would be respected generally by our peers. Moreover, we invest our own capital alongside of our clients. That is the performance that we wish to achieve for ourselves.

Q: You work with your dad. What is that like?

A: It works well. He has substantial industry experience. He spent 15 years at Lehman Brothers as an advisor to institutional investors and 15 years at Bear Stearns as an advisor to high net worth individuals. Over the years I have observed him put the interests of his clients before his own. His stock picking is exceptional and recognized. Highly regarded peers in the industry consult with him regularly for his views and judgements. I have about 14 years of experience in the industry most of which was spent abroad in Europe and Australasia. I have a different skill set from my father and together, we do a pretty fine job for our clients, each contributing our best.

Q: Is that your whole organization?

A: No. Balis Lewittes & Coleman, Inc employs 30 people and engages in four broad-based investment strategies: Income Generation (taxable and nontaxable), Long-Term Growth (a buy and hold strategy), Private Equity (a specialized long-term strategy), and Active-Risk Based Management. Small specialist teams oversee these strategies. Together, the firm is able to give clients a full scope of diversification.

Q: What do you see as the driving force for this market over the last 16 years?

A: There have been three market drivers that have stood out in the US. 1) The first and most important has been that the US stock market has become a substitute savings vehicle for the masses. No longer do average people want to save their money in savings accounts. They are seeking higher returns in a process called disintermediation. Large capital inflows have been supporting the markets upward move for years. The trend will likely continue for the foreseeable future. 2) The second major force has been a trend in productivity gains that has facilitated corporate re-engineering and management ability to drive profits from both sides of the balance sheet. This is the first of two fundamental justifications for the market's performance. 3) The final driver is that the real value of rising corporate earnings has also been impressive. As long as inflation and interest rates remain under control and corporate profits continue to grow so will the market.

Q: Mat Sr., what do you expect to see in this market over the next few months and beyond?

A: My sense is that interest rates hold the key right now. The first quarter of 1998 experienced some backup in rates to just above 6.0% on the 30-year Treasury bond. The threat that interest rates could begin to move upward from that level late in 1998 hangs ominously in the background. If business conditions remain robust and interest rates do rise further, that could precipitate a correction approaching 10%. I would conjecture that the market will mark time by staying in a broad trading range until new information on the earnings and inflation fronts materialize. If rates decline and corporate earnings continue to rise the market, I submit, will go to new highs. However, I would add one caveat regarding a higher market. Lately, there has been a growing consensus that this bull market is unstoppable. Certain technical signs point to increasing speculation in the market. This could bring about a short-term blow-off and a painful correction, even if interest rates and corporate profits remain positive factors.

Q: Do you have any other thoughts?

A: An advantage of age and maturity is having lived through market cycles. In context, we all should appreciate that markets fluctuate. From 1966 to 1982 the Dow Jones Industrial Average moved up and down but ended that sixteen year stretch where it began, at 1000. Nowadays, investors are transfixed on the one way movement of stock prices. I am concerned that many investment advisors are unfamiliar with, untested by, and ill equipped to deal with down markets. These "pied pipers", if you will, can ill serve their clients, and when the next bear market inevitably arrives, the losses suffered and the lack of preparedness given to investors can result in devastating consequences. It is incumbent on each investor to identify his own investment objectives and to do due-diligence when selecting his investment advisor. Keeping to a sound long-term plan that will satisfy the building of assets and security, will enable him to withstand periods of market adversity in good form, and in fact use market declines to add to his stock holdings.

 
 
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