Valuation's Role in Risk Control

Courtney Dobrow: Hi, my name is Courtney Dobrow. I'm a mutual fund analyst here at Morningstar.

With me here today is Stan Majcher of Hotchkis and Wiley. He has run their Mid-Cap Value Fund since its inception in 1997.

Thank you for being with us here today.

Stan Majcher: It's great to be here.

Dobrow: Let's turn off and just talk about the Hotchkis and Wiley deep-value approach, how it's implemented in this fund?

Majcher: Sure. So, when you think about Hotchkis and Wiley, what we try to do is gain a competitive advantage. We think we can do that in the market a couple of ways. One is our philosophy, and then the people, and then the asset size. So what we do is, philosophically we believe there is a couple of ways to beat the market, by looking at out-of-favor, undiscovered securities, things with temporary issues, you can generally get a very good price.

Another way to outperform the market would be through momentum strategies. We don't implement those. It will be very difficult for us to do it culturally. So we focus, really, on out-of-favor, undiscovered securities. We don't value things on the boom or the bust. We look at "what should it earn in a normal environment?"

So, that's our philosophy. How we do that is through the people. So, it doesn't matter what your philosophy is, if you don't have the people to implement it, it's very difficult to outperform the market. So, we focus on retaining personnel. So, hire high-quality people. They go through a rigorous vetting process before they are hired. We have equity ownership with the firm. Our investment staff tends to own significant amounts personally of the funds that we operate in. So, we really retain people that are high quality, that believe in the philosophy.

And then the other way we gain a competitive advantage is through our asset size. So, typically what happens in the asset management industry is high-quality offerings or offerings that have high returns become bloated with assets. There is an inability to reinvest in the areas that they have invested in the past. What we do is we limit our asset size.

So in the case of Mid-Cap Value, we keep our assets at a reasonable level, significantly lower than our peer group of managers, and it allows us to invest in the full spectrum of mid-cap value.

Dobrow: How do you – as a manager looking at the portfolio, how are you thinking about risk and volatility in the portfolio, especially over the past challenging few years?

Majcher: In terms of volatility and risk, they are very unpredictable. Not necessarily risk, but volatility is very unpredictable. You never know when you are going to enter a high-volatility period or a low-volatility period. So, what we really focus on is, one, valuation. That's one of the risks that we really feel we can control is not overpaying for securities.

So, that when bad news happens as it inevitably will, or when our research is off the mark, we're not heard as significantly as we normally would be, but there are periods of time when the volatility, when the market doesn't really focus on what a company is worth. It's really just price momentum. What we try to do in those periods of time is really take advantage of it. We're going to underperform in certain periods--we know that--but if we focus the research on what a company is worth over time, we can outperform.

Dobrow: I think when I spoke with you before, you mentioned that the ideal scenario is buying a security, it drops, you add a little more. Can you talk a little bit about that?

Majcher: Sure. I think a lot of people think that as a portfolio manager, specifically a value manager, you want all of your stocks right after you buy them to go up in price. For us, actually, if a stock underperformed, as long as we didn't have our full position, we would want it to underperform as long as we had something else to sell at a relatively higher valuation, and then we can reinvest those proceeds into the lower-valued securities.

So, historically, we've shown some charts of stocks that never went up in price, but it's as if the stock more than doubled. The reason is because the stock, when it dramatically underperformed, we took significant positions; since it has outperformed, we dramatically reduced those positions.

So, it's really making sure you understand what the valuations are of each security in the portfolio. When they are outperforming or becoming more expensive than everything else, you are re-wading back into the securities that have the best valuations.