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   Interview

    Guest Interview:

   Logan Capital Management

    One Liberty Place Suite 5200
    Philadelphia,PA 19103-7301

    Telephone: 215-569-1100
    Fax: 215-851-9444
    E-mail: admin@logancapital.com

 

    Interview Quarter: 4Q2001

 Rich Buchwad

 CFA

 
Q: Please give us an overview of Logan Capital.

A: Logan Capital Management, Inc. (“Logan”) is a privately owned, Philadelphia based investment advisory firm founded in 1993 to offer customized portfolio management to private and institutional investors. Within six years, Logan’s assets under management had grown from under $60 million to approximately $1 billion. Logan’s clients include private investors, insurance companies, charitable and other institutional investors, and retirement plans. Prior to August 2000, Logan was primarily a growth manager. In August 2000, we joined Logan to add a value style to their product offering. As a firm, Logan can now offer both growth and value products to clients, thereby providing a balance of styles where appropriate.

Q: What equity products does the value team manage?

A: Our primary vehicle is Logan Concentrated Value (“LCV”), which is a unique, proprietary investment product we developed and have managed since its inception in December 1995. In addition, we have several other quantitative products under development.

Q: What makes LCV unique?

A: LCV is a concentrated portfolio holding 10 very large-cap value stocks selected through a proprietary quantitative process. Given that virtually all mutual funds and separate account managers hold considerably more stocks, LCV is clearly unique in that respect. More important, though, is that LCV’s returns have beaten its benchmark, the Russell 1000 Value Index, 85% of the time on a rolling three-year basis since inception. What is counterintuitive, though, is that despite our concentrated approach, we have been able to accomplish this with less risk than the market.

Q: What is the advantage of a concentrated approach?

A: We have studied this subject extensively, and recently authored a white paper, “Using Concentrated Portfolios to Beat the Market." This research continues to confirm our counterintuitive thesis that a concentrated portfolio can provide superior returns with less risk than its benchmark over time. A traditional portfolio may have 50 or more stocks, many of which do not represent the manager’s best ideas. The main justification managers have for holding many stocks is to reduce risk. However, we have found that by applying carefully selected screens, risk can be reduced to below market levels in concentrated portfolios. This concept is the foundation upon which we base LCV.

Q: Why does LCV have a portfolio of 10 stocks? Why not 5 or 15?

A: While we were developing LCV, we conducted extensive research over a period of 18 months to determine the optimal number of stocks for a concentrated, large-cap value portfolio. Our research indicated that with our approach, a portfolio of fewer than 10 stocks might result in an increasingly unacceptable level of risk with no incremental benefit of additional returns. Conversely, 15 or more stocks would have significantly less return potential. Our conclusion was that a portfolio of 10 stocks had the most attractive risk-reward ratio.

Q: When you say it is less risky to hold only 10 stocks versus a more diversified portfolio, how do you measure that?

A: In our research and our actual results, we have found that LCV’s 10 stock portfolio is less risky than the market as measured by both standard deviation of returns and downside protection. The standard deviation of the portfolio is consistently well below that of the Russell 1000 Value Index and the S&P 500, which again seems counterintuitive since they both have significantly more stocks than does LCV. In terms of downside protection, LCV declines less than half as much as the market, on average, in periods when the market declines. Downside protection is something that clients and advisors have really come to appreciate about LCV.

Q: How can LCV have less risk than the market given the greater number of stocks in the indexes?

A: That’s a key question and it really goes to our investment philosophy.

Q: Well then, can you describe your investment philosophy?

A: To begin with, we are value investors seeking a margin of safety in our portfolios. Our fundamental belief is that a quantitatively selected concentrated portfolio of very large-cap value stocks with relatively high dividend yields can provide higher-than-market returns with lower-than-market risk. We believe excessive diversification dilutes a manager’s best ideas and leads to average performance. As Warren Buffet has said, “I can’t understand why an investor would put money into a business that is his twentieth choice rather than simply add that money to his top choices.”

Q: Why do you focus on very large-cap value stocks?

A: Size tends to be a good indicator of both financial strength and the ability to survive through difficult economic periods. Moreover, we believe that out-of-favor large-cap value stocks with above average dividend yields have lower than market risk because their stock prices are depressed at the time of purchase and do not reflect inflated expectations. Consequently, if there are earnings disappointments or other negative surprises, the effect on a large-cap value stock’s price will typically be much more muted than would be the case of a very high P/E stock that disappoints. Thus, the stocks in our portfolio by their nature have less volatility than broader market indexes, hence, lower risk.

Q: Why are dividends important to your process?

A: We became interested in the importance of dividends after reading a research study performed by Ben Graham in 1976. He demonstrated that a high dividend yield strategy substantially outperformed the market over long periods of time. In addition, many academic studies have since shown that high dividend yield stocks hold up better than the average stock in declining markets, thereby reducing risk. In addition, a significant portion of the long-term return on stocks has been derived from dividends. By receiving a meaningful part of the portfolio’s return “up front” in the form of dividends, we start out with an advantage relative to other managers, as well as to LCV’s benchmark. Also, dividends are real cash whereas as earnings can be subject to manipulation by management. Consequently, we believe dividend yield is a reliable and a stable valuation metric since it is not as volatile as other factors such as per share earnings or book value.

Q: Aren’t dividends dead?


A: Over the last 75 years, more than 40% of the total return of the S&P 500 has come from dividends, so clearly they have been an important component of total return. We have found that people focus on and appreciate dividends much more when the total expected market return is nearer its historical rate of 10%, compared to the more than 20% annualized returns of the late 1990’s. At a lower level of expected returns, dividends constitute a larger and more consistent percentage of total return. As a result, we think they remain an important factor in the investment decision process.

Q: Why do you use a quantitative process?

A: We believe a completely quantitative approach eliminates emotional biases in decision-making. One of the greatest difficulties for investors is to remove emotion from the process. Our process removes that emotion by providing strict buy and sell rules that require us to buy stocks when they are out-of-favor and prevent us from falling in love with stocks when they should be sold. Moreover, our process prevents LCV portfolios from experiencing any style drift, which has seemed an all-too-frequent occurrence among value mangers over the last few years. By applying our process consistently and unemotionally, we improve LCV’s odds of success over time while staying true to our style.

Q: Can you describe your investment process?

A: We use a proprietary, disciplined quantitative process to identify large-cap stocks that are undervalued relative to their peers, have very strong financials, and have relatively high dividend yields.

Our process begins with a database of all stocks traded on U.S. exchanges. The only sectors we screen out are electric and gas utilities and real estate investment trusts. Next, a capitalization screen is employed to reduce the universe to only large-cap stocks. The minimum market cap is designed to rise and fall with the market. Typically, this screen reduces the universe to approximately 150 large-cap stocks.

Key to LCV’s investment process are the proprietary multi-factor screens used to eliminate financially weak companies and control investment risk. These screens test for strong cash flow, conservative financial leverage, modest valuation and relatively low stock price volatility. The investment process does not use any financial projections, as research has shown that most projections have a wide margin of error.

The proprietary multi-factor screens reduce the purchase candidate list to 30 to 40 companies. All companies that have passed our screens have sound balance sheets and strong cash flows. These stocks are then ranked by dividend yield, which we view as the final valuation screen. The ten highest dividend-yielding stocks, subject to sector constraints, are selected for the portfolio. This process results in a portfolio of stocks that are undervalued and out-of-favor. We run the screens daily, so new money coming in is invested based on the rankings that specific day. Once selected, each individual portfolio is rebalanced semi-annually at mid-year and year-end.

Q: Why do you rebalance your portfolios semi-annually?

A: We have found that semi-annual rebalancing adds meaningfully to returns versus annual, quarterly or monthly rebalancing. In addition, semi-annual rebalancing minimizes trading and commission costs compared to more frequent turnover.

We consider ourselves long-term investors and want our clients to think of us as such. On a daily basis, there is an overwhelming amount of information available to us on the stocks in our universe, the economic outlook, etc. However most information is “noise” and has no impact on the true long-term value of a company. If we traded more frequently, we would just be reacting to information that has questionable incremental benefit.

Q: Do you sell stocks between rebalance dates?

A: The only time we will sell a stock between dates is if there is fraud, material accounting irregularities or if the viability of the firm is in question. Otherwise, we have found that proceeding on our normal timetable is the most effective course.


Q: What is the turnover of the portfolio?

A: Our average portfolio turnover has been about 45% since inception. Our average holding period for stocks that have been sold has been approximately 18 – 24 months. Some stocks have been held since inception.

Q: And how tax efficient is the portfolio?

A: Over 70% of capital gains have been long-term. Our after-tax return is approximately 80% of pre-tax returns.
Q: Getting back to risk, how would you summarize why LCV is able to have so much less risk than the market?

First, the result of our disciplined investment process is a portfolio of value stocks that, in many cases, are already relatively out-of-favor and have low investor expectations. Consequently, negative news is less likely to have a significant impact on the price of the stocks in our portfolio. Second, LCV limits itself to very large-cap stocks that have substantial liquidity and greater than average price stability. Third, the companies we are investing in have the financial strength and stability to weather difficult economic environments. Fourth, LCV selects stocks that have a high dividend yield. Above-average dividend yields not only add to returns, but also help to cushion stocks in market declines.

Q: What are the typical valuation characteristics of your portfolio?

A: Typically, the portfolio’s dividend yield is 1.5-2.0x the Russell 1000 Value’s yield and 2-3x that of the S&P 500. In addition, the P/E is typically below the value index and well below the S&P 500. What some people find interesting is that the portfolio’s beta has averaged approximately 0.60 since inception. As we’ve said, we have a very stable portfolio.

Q: Can you describe your representative client?

A: Our clients include both high net worth individuals and institutional investors. Clients come to us both directly and through intermediaries such as financial consultants and brokers.

Q: How has asset growth progressed?

A: Since joining Logan, asset growth has accelerated substantially. For instance, in the first 18 months after joining Logan, assets that our team managed doubled to approximately $100 million. Given the consistently strong performance of LCV and the solid marketing team at Logan, asset growth continues to accelerate.

Q: Why have investors elected to invest in LCV?

A: They invest in LCV because it: (a) has achieved better-than-market returns with lower-than-market risk, (b) has a distinctive, understandable approach, and (c) it provides exposure to the large cap value segment of the market with no style drift, and doesn’t replicate the core, broad equity funds investors generally own.

Q: Why don’t all investment professionals create concentrated portfolios with a limited number of stocks?

A: We believe one reason may be that concentrated portfolios tend to have a lower R-squared to the market indexes than more diversified portfolios (i.e. there is a higher probability concentrated portfolios’ returns will deviate from the benchmark’s return). The tradeoff between long-term out performance and a lower correlation with the market’s short-term performance is not a bet most investment managers or consultants want to make. However, by avoiding concentration, the chances of significantly beating those benchmarks are also substantially lowered.

Q: Are concentrated portfolios appropriate for all investors?

A: Diversifying across style categories (e.g. value and growth) with widely diversified portfolios within each style segment will result in an investor owning several hundred stocks, thus essentially becoming an index-like portfolio. Most likely, such an approach will also result in below average performance, especially after fees. It would seem more sensible to have style-specific, concentrated portfolios while still diversifying across styles. This would likely increase the correlation between an investor’s overall portfolio and the market while achieving higher overall returns. Clearly, such an approach assumes the manager of each concentrated portfolio has a demonstrated skill in stock selection. If not, the highly diversified portfolio would indeed act as insurance against relatively poor results, but perhaps could best be achieved with low cost index funds.

Q: Why isn’t LCV offered as a mutual fund?

A: Certain regulatory and tax considerations make creating a mutual fund structure with only 10 stocks highly disadvantageous from an investor’s viewpoint. In any case, having LCV in a separate account format allows us to consider the tax situation of individuals, which would not be the case in a mutual fund.

Q: What is the minimum investment in LCV and what are the fees?

A: The minimum investment is $500,000. Fees are based on a sliding scale depending on asset size.

Q: How does somebody get more information on the portfolio and working with Logan Capital Management?

A: Call us at 215-851-1100, visit our web site at www.logancapital.com, or drop by our offices in Philadelphia.

 
 
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