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Finding New Footing

His previous firm Van Kampen now merged away, Alexander Yaggy is racking up strong returns at a new fund.

Rob Wherry, 04/21/2015

In every issue, Undiscovered Manager profiles a manager on the Morningstar Manager Prospects list, which is compiled by Morningstar’s manager research group.

The situation isn’t exactly good news for investors. A well-regarded manager steps down from the fund where he built a strong record, leaving investors to contemplate whether to stay put or follow him to his next job. The decision isn’t a simple one. There is no guarantee the successor will stick to the same strategy that attracted investors to the fund in the first place or if he will reinvent it in his own image. Investors who sell could trigger a tax bill, depending on what kind of an account they own. In addition, if the manager is starting from scratch at another firm, expenses at the new fund could be high and he may not enjoy the same breadth of resources he did at his old charge.

“It is difficult to find a manager that can produce alpha, so if you find one you should stick to them,” says Raymond Benton, a financial advisor with Lincoln Financial Advisors/Sagemark Consulting in Denver, explaining the difficulty in assessing a manager departure. “On the other hand, if a team has been trained in the application of a process you may want to stay.”

Unfortunately for investors, manager departures aren’t a rarity. Granted, there will always be the occasional retirement. But these exits can also occur because a manager has been wooed away by a competitor, he’s moving to a smaller fund company where he will have the freedom to invest the way he wants, or, in the case of Alexander Yaggy, the firm is being sold and the inevitable fund mergers are not far behind.

In the 2000s, Yaggy helped run the small cap-value strategy under the Morgan Stanley and Van Kampen banners. For example, between 2006 and early 2010, his Morgan Stanley/Van Kampen Small Cap Value fund gained an annualized 3.3% versus a 2% and a 2.7% loss for the Morningstar small-value category and the Russell 2000 Value Index, respectively. However, in late 2009, Morgan Stanley decided to sell Van Kampen to Invesco for $1.5 billion, touching off months of fund mergers as Invesco tried to remove redundancies between the two lineups. In the end, roughly five dozen funds were affected, including Yaggy’s charges. The Van Kampen fund was renamed Invesco SmallCap Value VSCAX. In this case, investors who stayed put did fine. The fund carries a Bronze Morningstar Analyst Rating.

Those who followed also did well. Yaggy’s departure worked in his favor. Cortina Asset Management is a small, Milwaukee-based fund company with $2.3 billion under management. At the time, all of its assets were held in separate accounts that were primarily focused on growth and core strategies. The firm, though, was interested in growing its business by launching a mutual fund lineup that retail investors could access that would include value strategies, too. In September 2011, the firm launched Cortina Small Cap Growth CRSGX and Cortina Small Cap Value CRSVX. Yaggy took the reins at the value offering.

Yaggy’s transition has been a smooth one. Cortina Small Cap Value has returned an annualized 18.2% the past three years through February, outpacing the Russell 2000 Value and the small-value category by 2.9 and 3.6 percentage points, respectively. During its short life, the fund has performed better than peers in down markets. And fees, which are usually an issue for new (and small) funds, are rated Below Average for the institutional share class. (That share class contains most of the assets.)

“Our objective is to be good, not big,” says Yaggy. “There is no bureaucracy [at Cortina]. There is an investment culture here that is based on all the lessons we have learned over our careers.”

Change for the Better
Yaggy doesn’t mind change. In fact, he prefers it. One of the cornerstones of his strategy is finding companies with market capitalizations between $400 million and $2 billion that are potentially changing for the better, although the market has failed to recognize those budding transformations. Change can take the form of a new CEO at the helm, a turnaround that is finally taking hold, leading to improving fundamentals, or an undervalued part of the business that is finally getting attention. Yaggy and his team–portfolio managers John Clausen, Andrew Storm (who worked with him at Van Kampen), and senior equity analyst Gregory Waterman— aim to find those companies before their peers by conducting face-to-face meetings with management, picking the brains of industry experts, and rigorously studying a given sector’s competitive landscape. The team wants to ultimately understand the drivers of each portfolio candidate’s bottom line.

“We don’t want to get lulled into investing in a company simply because it has a cheap valuation,” says Yaggy. “We look for positive change. Everything must be changing for the better.”

The team gauges a company’s worth using various financial ratios and valuation methods. They will use price/book for financials, price/earnings for retail companies and EV/EBITDA for industrials, for example. In some cases, they will apply a sum-of-the-parts calculation. Balance sheet strength is also important. They prefer companies with appropriate or low debt levels, high return on capital and return of assets ratios, and accelerating annual free cash flow growth.

They will also derive both a best- and worstcase price target to get a sense of any downside risk with a potential holding.

They aim to build a portfolio of roughly 60 to 80 holdings. While they are conscious of the fund’s benchmark—the Russell 2000 Value Index— the fund’s sector weightings can be out of step with the index and peers depending on where the team is finding value. As of Dec. 31, the portfolio had overweights to technology, consumer discretionary and health care stocks and underweights to financials and industrials.

The fund’s value tilt is apparent from the portfolio’s metrics. The average holding trades at a 16.9 forward price/earnings ratio versus 19.2 for the Russell benchmark, despite the holdings having a long-term earnings growth rate that easily outpaces the index.

Off to a Good Start
It’s hard to have a better start than the one this fund had. In 2012, the fund’s first full calendar year, it returned 27.4%, catapulting it to near the top of the category rankings and outpacing the Russell index by 9 percentage points as an overweight to small-cap financial services stocks provided a strong tailwind.

Morningstar attribution data shows the fund had an average 27% exposure to financial services that year, or about 3 percentage points more than the benchmark. While that sector performed well for the benchmark, too, Yaggy’s stock-picking gave him an edge. Ocwen Financial OCN, the mortgage-servicing firm that soaked up about 2% of assets versus a 0.36% weighting for the index, more than doubled that year. (That position has been sold.) Other financial-services firms such as CNO Financial CNO and PHH Corp. PHH were strong contributors. Stock-picking in the basic materials, health-care, and industrials sectors also helped overshadow poor performance from energy holdings and companies such as ACCO Brands ACCO, the office supply company whose shares dropped roughly 33% that year.

Last year, though, Yaggy and his team did hit some obstacles as the fund eked out a small 1.4% gain, almost 3 percentage points behind the Russell index. As valuations escalated in the first half of 2014, Yaggy sold off most of the fund’s energy holdings, a prescient move given the collapse of oil prices that happened later in the year. While decent stock selection in that sector meant the fund generated a positive return from its energy holdings, other energy-related industrials such as McDermott International MDR weighed on performance. A bigger headwind, though, was positioning the fund for rising interest rates, which hurt as rates actually decreased and REITs and utilities stocks did well as investor, flocked to those stocks in search of yield.

Technology stocks helped keep the fund in positive territory in 2014. The fund saw positive results from semiconductor firms such as Integrated Device Technology IDTI that Yaggy was attracted to due to their new management, large cash positions, and improving fundamentals.

Consumer goods company Helen of Troy HELE, which owns or licenses brands such as Braun, Dr. Scholl’s, Pert, and Vicks, also contributed to performance. Yaggy says he had watched this company for a decade, almost investing several times only to back off over concerns about executive compensation and long-term strategy. As calls for change at of the company mounted, Helen of Troy hired a new CEO and then promptly announced a share repurchase program and cost-cutting measures. Yaggy bought in during the second quarter and has since watched the stock jump 20%. It is now the fund’s largest holding.

Building a Foundation
Cortina was founded in 2004 by portfolio managers Brian Bies, Tom Eck, and John Potter, and the firm’s chief operating officer, Lori Hoch. The growth and value investment teams number seven portfolio managers and four analysts who are divided by sector specialization, but who have frequent communication between each other. The firm does a good job of relaying its thoughts to shareholders through clear and concise fund letters.

Fees are decent for a fund this size. The fund’s institutional shares charge a 1.1% annual fee, which is rated Below Average and is 16 basis points cheaper than the category average and 10 basis points below the comparison group median. Those shares have the longest track record and hold most of the fund’s assets, but they also require a $25,000 minimum investment. A retail share class was launched in April 2014. Those shares require just a $2,500 minimum investment, but their 1.35% annual expense ratio is rated Above Average. That said, the fund’s prospectus lists fee breakpoints that are triggered when it surpasses certain asset levels.

Yaggy and the firm’s other portfolio managers receive a bonus based on both short- and long-term performance of their respective funds. But more emphasis is placed on long-term performance, which Yaggy says is three years or more. Such a long time horizon for a bonus more directly aligns management’s goals with those of long-time fundholders. Yaggy and his co-workers are putting that money to work in the funds they run. They all have decent ownership levels in the Cortina funds.

Rob Wherry is a mutual fund analyst with Morningstar.

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