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Clients Have a Friend in Luther King

Texan has built a $9.6 billion under-the-radar firm by delivering strong results and building relationships, instead of marketing and gathering assets.

Katie Rushkewicz Reichart, CFA, 10/03/2012

Luther King Capital Management is one of the biggest asset managers most mutual fund aficionados have never heard of. The employeeowned firm doesn’t have a distribution arm and lacks a presence with advisors yet still has $9.6 billion of assets under management. Its eight mutual funds have just $1.5 billion in assets, more than half of which are in a small-cap strategy.

“The firm was not built to be product-driven because of its history. We were investors before we were a firm,” founder and president J. Luther King Jr. says.

After nearly 50 years in the industry, King knows gathering assets isn’t a formula for success, or at least the way he wants to do things. He’s more interested in delivering strong investment results for the firm’s client base, which includes high-net-worth individuals, endowments, foundations, pensions, trusts, and estates. Beyond that, King takes pride in developing relationships with the firm’s clients on both a professional and personal level.

“I can’t tell you how many funerals and weddings you go to in the investment business,” he says in his slight Texas drawl. With a charming and approachable personality, it’s easy to envision King offering advice to a client who was having trouble with one of her children. “That’s the key in the investment counseling world; you have to have empathy with people,” he says.

Humble Origins
Based in Fort Worth, Texas, LKCM’s office is a mix of antique and modern. Glass offices form the perimeter, cubicles the middle. A large table in the conference room is made of carved wood, surrounded by ornate chairs. Native American art scenes dot the walls, with relics of Western art history and other emblems, such as a stuffed fox, placed here and there.

King, a sixth-generation Texan, started his career at the First National Bank of Fort Worth in 1963 and later went on to manage mutual fund assets for Shareholders Management Co., which became a part of American General Insurance Co. After a stint with a New York-based investment firm, which was sold, King ventured out on his own. He knew he wanted to be independent and stay in Texas but wasn’t sure whether to start a trust, a hedge fund, or a registered investment advisor. He chose the last and hung up his shingle in 1979. King always figured he was destined to become a regional bank president, so the move did involve some career risk. “I paid off the house, escrowed the kids’ college tuition, and went for it,” he says.

King’s first client was a wealthy family that had tried to recruit him to manage its investments. In a symbolic start that would continue to define the firm for decades to come, the family stipulated that he stay independent and not turn into a massive marketing and distribution outfit. For the first several years, King didn’t have business cards and kept his name off the door, only taking clients by referral. In the 1980s, the firm started managing money for foundations and universities and received some institutional business. On the institutional side, some people thought hiring managers from a small firm in Texas counted as portfolio diversification. Eventually some of those institutional clients dropped off as they demanded a more style-pure or passive investment strategy. Today, King says that about half of the firm’s clients are high-net-worth individuals, with the other half institutional.

Don’t Fence Me In
Its client base has evolved through the years, but the firm’s investment philosophy has remained unchanged. A credit analyst by training, King has always focused on such fundamental metrics as return on equity, return on assets, return on cash flow, and financial leverage, looking for solidity and sustainability. King employs what he considers a core strategy, avoiding deep-value turnaround plays while remaining sensitive to valuations. LKCM Equity LKEQX, the firm’s large-cap mutual fund, typically has a higher historical growth rate and price/earnings ratio than the S&P 500 Index but lower debt levels. It also has below-average turnover. “We let the management of the business build out the business value of the enterprise,” King says.

The firm is research-intensive, meeting with roughly 1,500 companies in 2011. “We probably do more primary research than anyone in this part of the United States,” King says. He gets excited relaying how an analyst walked a firefighter-equipment plant in Michigan as part of the research process, saying that’s one of the “cool parts” of the job.

One thing he’s not concerned about is neatly fitting into the Morningstar Style Box. “We don’t pigeonhole very well,” he says. The large-cap fund invests across the market-cap spectrum, considering both growth and value companies. King points out some might consider Coca-Cola KO (one of Equity’s holdings) a value stock at $30 and a growth stock at prices above that, but he says that it’s still the same company fundamentally. After many years in the large-blend category, Equity recently moved to large growth, although that’s unlikely to bother King. “In my view, it’s hard to outperform the market if you don’t have tracking error, but it makes consultants nervous,” he says.

Still, King’s philosophy is disciplined. One risk-control method involves an exceptions report that flags stocks in the portfolio that dip below their 200-day moving average, show an unusually high amount of insider selling, or have other alarming trends. “If a stock has a certain number of exceptions, you don’t ignore it,” King says. The report triggers an automatic review by the analyst and others on the research team. The goal is to eliminate the most dangerous tail of the portfolio. “It’s not rocket science, but it’s terribly effective,” King says.

Indeed, nearly all of the firm’s funds have below-average Morningstar Risk ratings, which measure a fund’s downside volatility. In 2008, the Equity fund shed just 31.8% to the S&P 500’s 37% decline. Losing less than its rivals has bolstered Equity’s long-term record. Its 7% annualized gain for the trailing 10 years through July bests more than 70% of its peers. It’s also edged the S&P 500 and has been less volatile.

From One to Many
In the early days, King focused on all of the company-specific research himself. However, he’s no longer going it alone, having steadily built up a research staff during the past three decades. The firm now has 33 investment professionals, the majority holding CFA or CPA designations. It’s a robust outfit for a firm of its size and touts many experienced members. Paul Greenwell, Scot Hollmann, David Dowler, and Joan Maynard, all hires in the 1980s, remain key associates, and team members average 20 years of industry experience.

Analysts cover different sectors and are compensated on one-year performance, the quality of their research, their impact on the portfolios, special projects, and other criteria. Unlike some fund shops, where the analyst role is used as a steppingstone to a portfolio manager job, the analyst track at LKCM is a career path, and analysts’ pay can be above that of managers if they’re doing good work. “It’s in our clients’ and the firm’s best interests for the analysts to be happy,” King says.

Even so, King recognizes that the analysts want to feel that they’re having a direct impact on the portfolio. For that reason, 20 top analyst picks, known as “foundation stocks,” are included in the portfolios regardless of the manager’s view on them. The number of foundation stocks from each sector depends on how much of the benchmark it consumes. For example, if the health-care sector is 20% of the Equity fund’s S&P 500 benchmark, King will include four health-care stocks chosen by the analyst, with each consuming at least 0.8% of the fund’s assets. (It could be higher if the manager has more conviction in the pick.) The analysts’ compensation is directly tied to these picks, and King says that the analysts like having a voice.

Keeping It Local
Building up the analyst staff allowed portfolio managers to step away from stock-specific research, a decision that King lauds. With analysts handling much of the grunt work, managers were freed up to visit clients, a part of the job he considers key. The November/ December 2006 issue of CFA Magazine quoted him as saying, “I don’t work for anybody I don’t consider a friend.” The magazine recognized him as “most inspiring” in the investment industry.

While all of the firm’s mutual funds have multiple managers listed in the prospectus, “it’s not a committee approach,” King says. The lead takes responsibility for all decisions, with comanagers able to step in if necessary. When it comes to deciding who has potential to become a manager, King says that it’s not always the best analysts, whose analytical drive might cause them to keep asking questions and be a bit risk averse. Instead, a manager is someone who “can make decisions on imperfect information over a short period of time.”

It appears this structure has worked well for morale. Five-year manager retention across the firm is a strong 94%, and King says that analyst retention has also been good. But King is always looking for up-and-coming talent and is especially proud of the firm’s internship program that’s evolved through the years. “Young people bring young energy to the firm,” he says. The firm has about 10 interns, including several from King’s alma mater, Texas Christian University, who work year round. The group participates in a financial modeling class, visits the trading floor on Wall Street, does projects with analysts and traders, and sits in on investment calls. “Twenty years ago, not many kids from TCU ended up on Wall Street, but now they do,” he says proudly. LKCM has hired some former interns full time, many of whom have ties to the Texas area. That geographical link, whether via the employee or a spouse, is something King especially likes to see during the hiring process, as it can help with retention.

A Strong Stable
While LKCM’s investment staff and firmwide assets have grown during the past 33 years, the firm still hasn’t gained much traction in the mutual fund world. Small Cap Equity LKSCX, launched in 1994, has received the most attention, particularly during periods when many well-known small-cap funds were closed to new investors. It has $825 million in assets and is the only fund to have a separate Advisor share class that’s funded. Each of the remaining funds, which include Equity, Fixed-Income LKFIX, Small-Mid Cap LKSMX, Balanced LKBAX, and three Catholic-based Aquinas funds (which the firm bought from the Catholic Foundation), has less than $220 million in assets. All but Small-Mid Cap, launched in 2011, have been around since the mid-1990s. Small Cap, Equity, and Balanced have especially strong long-term records relative to peers, but lack of distribution has limited their reach. The funds are offered on the ETrade, Fidelity, JPMorgan, and Schwab platforms but don’t have No Transaction Fee arrangements.

However, LKCM remains friendly toward mutual fund investors. Small Cap Equity, Balanced, and Fixed-Income are all priced below-average relative to peers. Equity receives a Neutral Morningstar Price score, but its 0.8% expense ratio is reasonable considering its tiny $128 million asset base. When asked why the funds aren’t priced higher, King says, “because maybe I thought it was fair.”

The funds are also now more accessible to regular investors, with the minimum initial investment dropping to $2,000 from $10,000 in 2011. Meanwhile, managers have aligned their interests with fund investors’: Two thirds of the firm’s mutual fund assets have at least one manager with more than $1 million invested in the fund. King says that LKCM’s employees and affiliates collectively are the firm’s biggest client.

Still Going Strong
Doing right by investors seems to be in King’s bones. He won the Daniel J. Forrestal III Leadership Award for Professional Ethics and Standards of Investment Practice from the CFA Institute in 2008, an especially emotional honor because Forrestal was a friend of his. His level of integrity extends across the firm. A former SEC lawyer even works in the LKCM’s compliance department. “The firm is so compliant, it’s annoying,” King quips.

While King has molded LKCM into a topnotch organization, he thinks that it’s in clients’ best interests to keep it private. “Everybody in the world has tried to buy this firm,” he says. But he has no interest in selling the firm that’s never had an unprofitable year. “If someone bought us they would have a right to ask for a return on their invested capital; we would run it differently,” he says. “We could not do what we do in this firm if we had an outside owner.”

Much like Berkshire Hathaway’s Warren Buffett, King has kept his succession plan under wraps. For now, though, the 72-year old shows few signs of slowing down. In addition to his role at LKCM, he serves on four publicly traded boards, three of which are listed on the New York Stock Exchange. While he’d never buy shares of those firms for the funds, his experience as a board member has given him insight into different business practices. King is a trustee and former chairman of the board at TCU, where he received his bachelor’s and master’s in business administration degrees and earned the Distinguished Alumnus Award in 1992. A bevy of other leadership roles throughout his career, both professionally and philanthropically, keep him busy. In fact, King comes into the office on Saturdays and Sundays, when he says he gets his best work done.

One thing that’s not in the cards right now is retirement. “I’m going to work until I can’t work any more because it is an avocation.”

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