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Jay Sekelsky, Madison Investment Advisors

Jay Sekelsky took a calculated risk by quitting his job at a fund industry giant to work at a quaint shop in the Midwest.

Wenli Tan and Lawrence Jones, 11/03/2008

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Many stock-pickers who are steeled against the vicissitudes of the market might nonetheless shudder at the thought of venturing away from a financial capital on the East Coast. Madison Investment Advisors' Jay Sekelsky, though, jumped at the chance.

On the same day in January 1990 that he received word of a promotion at esteemed Boston-based asset manager Wellington Management Co., he announced that he would depart the firm to work at a 10-person, unproven operation in Madison, Wis., that ran less than $300 million. Moving from one of the epicenters of asset management to a heavily wooded, quiet college town might be difficult for some, but not Sekelsky, who hasn't looked back since.

Learn by Doing
Though not a native, Sekelsky called the Badger State home for much of his childhood. And it was there where the manager's passion for investing firmly took root. Armed with a degree in accounting from the University of Wisconsin-Madison, Sekelsky enrolled in Wisconsin's renowned Applied Security Analysis Program in 1986. ASAP has produced several high-caliber investment managers, including Bill Nygren of Oakmark, Stephen Petersen of Fidelity, John Smet of Capital Research and Management Co. (advisor to the American Funds), and Foster Friess of Friess Associates (advisor to Brandywine Funds), among others.

Sekelsky participated in ASAP's student-run portfolio-management program. He and a team of comanagers ran a $125,000 real-money portfolio. Their investment goal was to beat the market over a nine-month stretch, the duration of the program. That short time horizon was a struggle for Sekelsky, who had started studying the long-term processes of Warren Buffett, Benjamin Graham, and other investing legends. Nevertheless, he and his classmates had a keen eye for some long-term winners, including Microsoft MSFT.

Taking Calculated Risks and Avoiding What's Hot
His move from Wellington to Madison Investment Advisors was a risk, but much like the style of investing he had read about in the books of Buffett and Graham, it wasn't an erratic bet. He had the chance to comanage Madison Mosaic Investors MINVX alongside firm founder Frank Burgess. Sekelsky had high regard for Burgess, who started the firm in 1973 amid one of the worst bear markets in history, a trial by fire that helped shape the firm. "Starting a money management firm in a year when the market drops 40% leads you to build an extra layer of precaution into the investment process," Sekelsky says.

This cautious foundation is evident in Sekelsky's process. At the Investors fund, which he took over as lead manager in 1995, Sekelsky buys stocks with an upside/downside ratio of 3 to 1 or higher--which means that, based upon his estimates of their intrinsic worth, Sekelsky thinks that his stocks have a much greater potential for price appreciation than for price decline. In addition, the manager only invests in companies that can consistently generate returns on invested capital above their cost of capital and those that can build shareholder value. Sekelsky also requires consistency and predictability of free cash flow, a trait that can be extremely valuable in turbulent times.PAGEBREAK

These strict criteria weed out many stocks in the large-cap stock universe, which until recently, included all companies in the energy sector. Sekelsky had shunned the sector because he didn't like that most energy companies' business models rely heavily on commodity prices, which tend to be volatile. He also didn't like their rich valuation levels and argued that they possessed too much downside risk. As the energy sector tumbled on lower crude-oil prices, however, some stocks have become attractive value plays, Sekelsky says. He scooped up the fund's sole energy pick, Schlumberger SLB, in September. He likes the fact that Schlumberger is run by great capital allocators and has a durable balance sheet.

Sekelksy is dipping his toes in the energy sector, but he is still focused on well-established companies with predictable cash-flow streams in other areas of the market. Moreover, when he buys, he does so for the long haul. Take some of the portfolio's current picks. Target TGT has had a place in Sekelsky's portfolio since 1998 when the company was still known as Dayton Hudson. Johnson & Johnson JNJ has been a Sekelsky standby since 1992, when its shares traded at less than $15 per share.

A pick Sekelsky recently sold--and one that he has been particularly proud of--is McDonald's MCD. Most investors doubted McDonald's could pull off a turnaround at the turn of the millennium. The fast-food giant was facing serious head winds on several fronts--a depressed economy, consumer interest in healthier options, and growing competition from the likes of Burger King, Wendy's, and a variety of more-upscale chains. As the company posted quarter after quarter of disappointing earnings and its shares lost more than half their value, Sekelsky and his team bought more, arguing that the company had one of the world's most recognizable brands, a vast portfolio of prime real estate assets, and had done a good job of returning cash to shareholders. McDonald's traded at a mere $12 per share in early 2003; it traded at above $60 in August when Sekelsky took the fund's winnings off the table.

Providing Shelter from Storms
While Sekelsky's unwavering focus on valuation and predictable cash flow has helped the fund sidestep trouble, this single-mindedness has not been rewarded at times (and sometimes for long periods). The fund's returns land in the bottom half of the large-blend category over the trailing three- and five-year periods. The dearth of energy companies in the portfolio over the past several years goes a long way to explain the fund's relative performance.

That said, Sekelsky's caution has provided good downside protection. For example, the team's avoidance of richly valued tech companies with hard-to-predict cash flows held back returns in 1998 and 1999, but it helped bolster the fund during the 2000 to 2002 ensuing bear market, when the fund landed in the top third of its large-blend category each year. More recently, the fund has lost less than the typical large-blend fund in the past year, in part because of his long-term picks Johnson & Johnson, Target, and McDonald's.PAGEBREAK

Sekelsky and his team also avoided some of the financial sector woes that have plagued others by making an early exit out of troubled mortgage insurer MGIC MTG in August 2007 and betting on financially sound insurance giants, such as Aflac AFL and Berkshire Hathaway BRK.B, which have held up well the past 12 months.

The close attention that Sekelsky pays to firms' balance sheet health and the desire for good downside protection may stem from his early days at Madison Investment Advisors (and time at Wellington), when he worked on fixed-income portfolios in addition to the equity side. A mind-set that considers the full range of a firm's capital structure seems particularly important to navigating today's marketplace.

Finding Tomorrow's Winning Stocks
Beyond providing a measure of protection here, of course, Sekelsky is always on the lookout for the next McDonald's. He thinks that Walgreen WAG has that potential. The drugstore giant has consistently generated high returns on invested capital, but its shares took a beating for disappointing sales in the latter half of 2007, Sekelsky says. Like McDonald's, Walgreen has excellent balance sheets and a portfolio of valuable real-estate assets.

In the end, while other managers will often look at many of the same factors that Sekelsky and his team do, the group here has shown good discipline in its approach. And that's why Richard Thompson, a financial advisor at Morgan Stanley, recommends the fund to his clients, saying that "it is Sekelsky's discipline and consistency" that keeps him coming back.

Another important factor is the fund's downside protection. "In a client portfolio of seven or eight funds, you don't need every fund to be batting .300," says Thompson. While the fund has shown periods of significant relative underperformance, the absolute losses have been modest, underscoring the team's caution and desire to protect shareholder capital.

Wenli Tan is a mutual fund analyst with Morningstar.
Contributing editor Lawrence Jones is an associate director of fund analysis with Morningstar. 

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