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Despite Experience, Solid Process, a Downgrade for This Large-Growth Fund

Succession questions have led us to downgrade LKCM Equity's rating to Neutral.

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Despite LKCM Equity’s experienced manager and proven process, succession questions warrant a downgrade of its Morningstar Analyst Rating to Neutral from Bronze.

Firm namesake Luther King, 79, has led this fund since its inception in 1996, but the absence of an announced succession plan becomes a bigger concern each passing year. A well-resourced team of sector-specific all-cap analysts supports King; its members average an impressive 19 years with the firm. King is also joined by two comanagers, his son Mason King and Scot Hollman, but they focus on other strategies and have little influence in this one. While Hollman and Mason King have management experience and a decent record, Luther King’s departure would be a loss, as he’s proved to be a dependable steward of investors’ capital and a savvy stock-picker.

King looks to buy strong businesses at what he considers good valuations, looking for companies with strong histories of capital allocation and stable balance sheets regardless of market cap. This leads to a defensively tilted all-cap strategy that has landed in the large-growth Morningstar Category since 2012, although King views the strategy as a core offering. He doesn’t mind a portfolio that stands out compared with the strategy’s S&P 500 benchmark, building his 60-stock portfolio from the bottom up and trading very little compared with peers.

The defensive tilt of the strategy helps it hold up in drawdowns and provides lower volatility than its peers, but sector weightings have damaged the strategy’s performance over the past 10 years as it lagged its peers and benchmark. Relative to its category, this strategy allocates more assets into industrials and materials, while keeping a large technology underweighting. Stock selection has remained impressive, but it’s unclear how much longer King will be the chief stock-picker here. Middling fees don’t help this strategy’s appeal.

We expect to rerate this strategy in November 2019 under our new ratings methodology.

Performance | Neutral | by Nicholas Goralka Oct. 27, 2019
Middling performance leads to this strategy’s Neutral Performance rating.

From its early-1996 inception through September 2019, this strategy’s annualized gain of 8.7% trails its S&P 500 benchmark by 20 basis points. The strategy fared better against its peers, however, ranking in the upper half of all large-growth and large-blend funds that have been around as long (it has been in both categories). Risk-adjusted performance measurements have been better over that time, aided by lower volatility resulting from manager Luther King’s moderately defensive portfolios which tend to overweight low-beta sectors like materials and industrials.

However, in the trailing 10-year period through September 2019, returns have lagged the benchmark on both an absolute and risk-adjusted basis. The volatility protection the fund provided in the past has eroded as manager Luther King’s preferred sectors have lagged; his tech underweighting has also weighed on returns over that time frame. (Avoiding overvalued tech firms caused the strategy to lag the index by a wide margin in the late 1990s, but that same posture helped it hold up much better than the benchmark in the ensuing early-2000s’ bear market.) King’s stock selection has remained strong, so performance could rebound in the future amidst a more accommodating secular backdrop, but this strategy’s performance edge has waned.

Price | Neutral | by Nicholas Goralka Oct. 27, 2019
The fund levies average fees, resulting in a Neutral Price rating. While its lone share class is categorized as institutional in Morningstar's database, the fund's minimum investment level of only $2,000 makes the retail peer group more relevant for price comparisons. The fund's 0.81% expense ratio is reasonable compared with the no-load large-cap peer group, which has a median fee of 0.87%, but ranks in that group's middle quintile.

Fees slightly ticked up in 2018, but it is impressive that LKCM has kept costs down despite the fund's tiny asset base of less than $350 million.

Process | Positive | by Nicholas Goralka Oct. 27, 2019
Lead manager Luther King looks to invest in financially stable and sustainable business models. He focuses on several fundamentals, such as returns on equity, assets, and cash flow, as well as financial leverage, when forming his opinion of a company. Mindful of valuation, he prefers companies with strong histories of capital allocation to provide management with the flexibility to continue growing business values. King also prioritizes management team quality, and the firm’s investment team does on-site research and meets with company leadership to get a better sense of a company’s path before investing. This robust approach earns a Positive Process rating.

While this strategy has drifted into the large-growth category in recent years, King hasn’t changed his core-oriented approach. The strategy’s typical holding has a higher historical growth rate and price/earnings ratio than the S&P 500, but lower debt levels. King tends to keep 60-90 stocks in the portfolio, keeping individual positions less than 4% of assets. King and his team automatically review stocks that fall below their 200-day moving average or show a high amount of insider selling. While they don’t always sell such stocks, the goal is to trim riskier positions to aid downside protection. They’ve largely been successful, as the fund’s long-term risk profile has been attractive.

This strategy provides core equity exposure, but it won’t always fit neatly into the Morningstar Style Box. It moved from large-blend to large-growth in 2012, but that doesn’t reflect any change in Luther King’s process. He continues to look for stable businesses with good growth prospects and attractive valuations, regardless of whether they’re classified as value or growth stocks.

King invests across the market-cap spectrum in this pursuit, which makes the strategy more of an all-cap offering than its S&P 500 benchmark. Its $58 billion average market cap as of June 2019 was considerably lower than the benchmark’s $110 billion, and the gap between those two metrics has been widening since the 2008-09 drawdown. The portfolio still invests in mega-caps such as Microsoft (MSFT) and Apple (AAPL), as well as small- to mid-cap names like Franklin Electric (FELE). Bottom-up, company-specific analysis dictates sector positioning, and King’s areas of expertise mean the portfolio tends to lean heavily in favor of industrials and materials at the expense of tech and financials.

Turnover is low, often below 20% per year, reflecting the long-term nature of King and his team’s research process. King’s activity levels in 2019 have been typically subdued; he has added consumer stocks Mondelez International (MDLZ) and Keurig Dr. Pepper (KDP) while cutting jeweler Tiffany & Co (TIF).

People | Neutral | by Nicholas Goralka Oct. 27, 2019
Questions about succession warrant a downgrade to a Neutral People rating.

Lead manager Luther King founded his eponymous firm in 1979 and has steadily built up a capable research staff. As of August 2019, the firm oversaw about $18 billion of assets with most of its 80-person staff involved in public or private asset management.

King is aided by two comanagers. Scot Hollman, who joined the firm in 1983, and son Mason King, a team member since 2004, have been named managers since 2010, though they both focus their efforts elsewhere and Luther King remains sole lead. Steve Purvis, who heads Neutral-rated LKCM Small Cap Equity (LKSCX), was also a listed manager until May 2017, when he was removed to focus on his primary charge. Luther King, Hollman, and Mason King are among the 14 firm owners. While either comanager, or both, could succeed Luther King in managing this fund, his departure would be a loss.

Unlike some fund shops, where the analyst role is used as a stepping-stone to a portfolio manager job, the analyst track at LKCM is a career path. Accordingly, the team’s members average an impressive 19 years with the firm, providing solid support for King, 79. However, his age raises questions of how much longer he will continue to serve as manager of this strategy, and the firm has not publicly announced a succession plan.

Parent | Positive | by Christopher Franz, CFA Jan. 9, 2019
A strong, investors-first culture earns Luther King Capital Management a Positive Parent rating. Established in 1979, the employee-owned, Fort Worth, Texas-based boutique, with smaller branches in Austin, San Antonio, and Dallas, oversees $16 billion in assets spread across institutional and separate accounts, as well as open-end mutual funds. Its six-fund lineup includes fixed-income and balanced options but is centered on domestic equities, applying a quality-oriented, growth-at-a-reasonable-price strategy across the market-cap spectrum. Long-term performance is sound, but flagship offerings LKCM Equity and LKCM Small Cap Equity have struggled to keep pace with growth peers in the nearly 10-year bull market following the financial crisis. Still, credit goes to firm founder and portfolio manager Luther King, who has cultivated a patient, long-term-oriented culture.

The firm is not without its challenges. Succession is a concern, as founder King is 78. Comanagers are listed on each fund, including King’s son, Mason, who has been with the firm since 2004 and aids on its flagship equity offerings. LKCM Small Cap Equity has seen significant redemptions over the past five years, depleting its asset base. Still, the firm has remained committed to its quality-oriented investment style over its 39-year history, ignoring market fads, and has delivered a clear and consistent experience for shareholders.

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Nicholas Goralka does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.