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Undiscovered Managers: Balancing Act

There's no actual pot of gold at the end of James Balanced: Golden Rainbow, but long-term investors aren't seeing their money disappear, either.

Rob Wherry, 04/18/2011

This article first appeared in the February/March 2011 issue of Morningstar Advisor magazine. Get your free subscription here.

There is good reason why James Balanced: Golden Rainbow GLRBX isn't on most investors' radar screens. To meet the managers, investors would have to travel on rural roads that cut though cornfields about 45 minutes outside of Dayton, Ohio. Eventually, they would come upon the rustic timber headquarters of James Advantage Funds, the parent of Golden Rainbow, tucked into the tree line outside the community of Alpha, Ohio.

It's worth the trek. The fund is in the top decile of the conservative-allocation category over the trailing five-, 10-, and 15-year time periods. And although it has performed well in down markets--typical of balanced funds--it has also done a solid job of keeping up with the market during rallies. The fund captured just 48% of the market's losses the past decade, while capturing 73% of its upside. By comparison, the fund's peer group captured 67% of the downside and 68% of the market's gains during that time period.

Over the past decade, "you saw funds that hit their peaks, and then they got crushed," says Bob Feighan, an advisor with Ameriprise, based in Westchester County, N.Y. "I am not looking to outperform the market with this fund, but I am also not looking to lose my clients' principal."

Small-Cap Momentum Tilt
A look under the hood of the fund explains that track record. It typically keeps 50% of its assets in high-quality bonds--nothing surprising there. But on the equity side, the fund invests almost 60% of its assets in small- and mid-cap stocks; the category average for those types of securities is 25%. (It's had a similar stance for most of its 20-year history.) The average holding's market cap is $7.3 billion, one fourth the category average. That has put this fund in two of the sweet spots of the past decade--bonds and small-cap stocks.

The roots of that positioning can be traced back to a 40-year-old Ph.D. dissertation thaat Frank James, the patriarch of this family-run fund shop, wrote while at Rensselaer Polytechnic Institute in Troy, N.Y. Boiled down, his paper surmised that stocks that were hitting their highs, especially small caps, had a good chance of heading higher--what investors now call a momentum strategy or relative strength. That thinking was contrary to a book that was getting buzz in 1973, Burton Malkiel's A Random Walk Down Wall Street. Malkiel argued that trying to outperform the market over the long haul was futile because asset prices behaved in random, unpredictable patterns. The book helped kick-start the index investment movement. PAGEBREAK

Undaunted, James moved his family to Ohio to take a teaching job and on the side ran money for a few local doctors out of his house. But the mid-1970s' bear market gave him a rude awakening, so he tweaked his strategy to include risk and valuation measures. That helped him land a trust account run by a local savings and loan firm, whose logo was a golden rainbow. When the S&L went public in the 1980s, it sold off the product to James, who kept the Golden Rainbow moniker. James launched the retail version of the fund in 1991 and later offered market- neutral and small-, mid-, and micro-cap offerings. James Advantage Funds now manages just more than $1 billion in retail assets, and Golden Rainbow remains the flagship fund.

Almost 20 years after its launch, the fund has returned an average annual 8.5%, 2 points ahead of the category average.

Building on an Idea
Tell Frank James and his sons, Barry and David, that they live in the sticks, and they take no insult. They think investing from the Midwest gives them an edge. They may be right. Researchers at Princeton, Harvard, and Syracuse found that a manager is more likely to hold (or buy, or sell) a particular stock if other managers in the same city are holding (or buying, or selling) that same stock. One interpretation of this research is this: Fund Manager A talks about a stock over lunch with Fund Manager B. Then, Fund Manager B may head back to his office and trade the stock. The correlation was strongest in cities like New York and Boston that are home to large financial institutions.

"I have a skeptical view of people in that neck of the woods," say John Brotherton, owner of Brotherton Investment Consultants in Scottsdale, Ariz., about Wall Street. "I have had money with [firms like James] for years. There is none of the bologna."

The Jameses have never run with the herd. David James, the database expert in the family, uses technology to download and crunch all the equity data he needs independent of Wall Street. This work has been crucial to the firm's success. The James Advantage Funds use a two-pronged strategy--a top-down, annual economic forecast and a computer stock-picking model--that has been continuously fine-tuned since Frank James finished his dissertation. The strategy thrives on sifting through information to find the market's sweet spots ahead of competitors.

The management team starts each year with an economic forecast that provides them a road map for where they think stocks, bonds, and the U.S. and global economies are headed. That forecast, which is updated weekly, looks at unemployment, GDP growth, currencies, and the environment on Capitol Hill, among other things. Ultimately, it leads them to industries and sectors that look attractive.

Then comes the stock-picking model. The model churns through 200 data points. Although the firm doesn't reveal all of the data points--or their importance in the algorithm--the model does look at momentum statistics like trading volume, historical stock performance and 52-week highs and lows, and valuation metrics like price/earnings and price/book. The model also looks at the number of analysts that cover a given stock. Ultimately, the algorithm ranks stocks, and the highest-scoring ones are eventually placed into the portfolio.

"We want to buy things that are cheap with good earnings as an insurance policy against things going bad," Frank James says. "These stocks are genuinely neglected. Wall Street hasn't noticed them."

Looking in the Rearview Mirror
That two-step process has helped Golden Rainbow navigate all kinds of markets. The fund lost just 0.8% and 5.5% in the bear markets of 2002 and 2008, respectively, compared with 3.1% and 18.6% drops for the conservative-allocation category. In recovery years like 2003, the fund did lag the broad market, but its 18.2% return was decent on an absolute basis and far out in front of competitors. Its 7.1% 2009 gain trailed the category and the S&P 500. But the rally that year buoyed lesser-quality stocks that this fund doesn't typically own. The fund also does well stacked up against other conservative-allocation funds that own a lot of small caps, a signal of good stock-picking.

The fund also has an above-average track record over long time periods. During the trailing decade, the fund has gained an average annual 7.1%. That outpaces the category by 4.1 percentage points and the S&P 500 by 2.3 points. Owning a lot of Treasuries and small caps during a period when those assets did well explains a lot of the performance, but again, the fund also outperformed rivals with similar leanings.

Still, with valuations high and yields low, small caps and Treasuries are unlikely to provide the same kind of returns they have over the past decade. Furthermore, the fund is managing more money now. It has seen net inflows of $423 million since the 2008 downturn, the strongest flows it has ever garnered. And the fund's expense ratio remains much higher than the median for no-load conservative-allocation funds. These factors could make posting the kind of returns this fund has in the past a challenge.

The Jameses are well aware of those potential headwinds. They don't expect sizable returns from bonds for the foreseeable future and have been decreasing the fund's duration--a measure of interest-rate risk--from 7.0 years to 4.0 years.

On the equity side, the portfolio continues to look reasonably cheap. The average holding has a long-term growth rate comparable with the category average but trades at 11.6 times forward earnings versus 13.7 for the peer group. Barry James admits that large-cap stocks are trading at bargain prices, and he says that the fund could shift some assets that way in the future. Small caps will still have a presence, but the fund can be more flexible than history suggests.

"They could increase their weighting to large caps. I am comfortable with that," Brotherton says. But he adds, "I don't own them for bull markets. I own them because they are consistent" over the long term.

One noticeable underweighting in the portfolio is financials. "We are anticipating a volatile year," Barry James says. "We are still concerned some of the big [financial firms] still have not washed out the housing sector. Operating earnings look good, but then there is all that toxic stuff."

He's also keeping an eye on expenses given the amount of inflows. During the past five years, the fund's annual expenses have slightly decreased, but that's attributable to costs staying flat while assets grew. To date, there is no language in the prospectus outlining breakpoints for fee reductions as assets rise above certain dollar levels. This is one of the fund's drawbacks.

Overall, though, the fund's solid management team and proven process make it a good candidate for a long-term core holding. A $10,000 investment made after the tech bubble burst would have doubled, while a similar stake in the S&P 500 would have gained just $2,200. That's not an actual pot of gold at the end of the rainbow, but it's pretty good. "I've monitored this fund on good days and bad days," Feighan says. "These guys know what they are doing."

Rob Wherry is a mutual fund analyst with Morningstar. 

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Rob Wherry is a mutual fund analyst with Morningstar.

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