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Equity Perspectives

Blending astute stock selection, research, and risk management to deliver alpha 

Put Lord Abbett portfolio managers Jeff Diamond and Noah Petrucci in the same room, and the first thing you might notice is the personal chemistry they bring to running a mid cap value equity strategy; they also have more than 50 years of collective experience in the financial industry. As Petrucci describes their collaborative approach to active management and beating their benchmark (the Russell Midcap® Value Index), Diamond is likely to interject a complementary perspective—and vice versa.

“It’s a strong balance,” says Diamond, who joined Lord Abbett in 2007 as a senior research analyst on the Mid Cap Value team, and began managing the mid cap strategy in 2008. “We want the benefit of some specialization and the efficiency of dividing up responsibilities, but we savor having a teammate who can debate ideas with you and offer a different perspective. We don’t want to have silos.”

“We’re both generalists by training,” adds Petrucci, who teamed up with Diamond in 2012. “And that background facilitates sure-footed evaluation of companies and investment ideas.”

How does that work when their benchmark comprises 585 companies? They segment responsibility for the various sectors in that index. Petrucci is the point man for energy, industrials, technology, consumer staples, utilities, and telecommunications. Diamond follows consumer discretionary, health care, financials, materials, and real estate. Couple all that with centralized equity research led by David Linsen, and risk management led by Alec Crawford, Lord Abbett partner and chief risk officer, and the result is a three-pronged approach to active share,1 the widely cited measure of active management introduced in 2009 by former Yale professors Martijn Cremers and Antti Petajisto.

Concentration and Conviction
Active share may have garnered considerable attention some years ago as an easy-to-compute measure of portfolio “activeness,” which also is predictive of future excess returns, but Diamond and Petrucci are quick to emphasize the importance of choosing stocks with greater conviction. While some managers have built portfolios with 120 or more positions that largely track the indexes, Diamond and Petrucci prefer to concentrate on 70–90 stocks to improve their chances of outperformance.

“We strive for high active share by overweighting our best ideas so we’re not distracted by small positions that have been shown to detract from performance over time,” said Diamond. “If we focus on fewer stocks, we’re going to know them better." Put another way, an active weight in the Lord Abbett Mid Cap Value Strategy might be a minimum of 50 basis points (bps) over the benchmark and the average active weight would be about 110 bps; but if there is strong conviction in the underlying investment thesis, Diamond and Petrucci generally prefer to go 135-225 bps points over the benchmark weight.

Stock Selection and Inflection Points
In building an investment thesis that sometimes counters overly bullish (or bearish) Wall Street forecasts, the potential to add value may be considerable, notwithstanding the risk of negative surprises dampening performance. So it goes at Lord Abbett, where analysts, portfolio managers, and risk management and quantitative research experts confer regularly to weigh in on the strengths, weaknesses, opportunities, and threats facing companies and sectors.  

Against that backdrop, Diamond and Petrucci pursue a “traditional value” strategy, with rigorous, bottom-up fundamental research that seeks to identify attractive companies whose stocks are undervalued on both an absolute basis and relative to history. They screen for stocks whose multiples (either on sales, book value, cash flow, or earnings) are at historically attractive levels, and they look for indicators of positive fundamental change, including revenue re-acceleration, margin expansion, de-levering, positive earnings surprises, and insider executive buying.

“We’re trying to find a point where a company’s returns or profitability are about to inflect upward—before the market has realized such potential,” says Petrucci. “At the same time, we seek to limit our downside risk.” That means establishing and monitoring reward-to-risk ratios, ever mindful of the portfolio’s exposure to overarching factors such as interest rates or oil prices, for example.

What kind of reward-to-risk ratios? Generally it’s at least two to one, but it’s not a hard and fast rule and the level of downside risk also plays a role. For example, suppose one stock has 100% upside potential and 50% downside risk, while another has 40% upside and 20% downside. The ratio for both would be two to one, but Diamond and Petrucci typically would lean toward the stock with less downside risk. 

“As value investors, we are sensitive to capital preservation, given the potential to outperform over time by compounding capital and limiting losses,” says Diamond.

Petrucci put that in baseball terms: “We’re trying to hit singles and doubles, as opposed to swinging for the fences, which increases your risk of striking out more often. We think we’re more likely to succeed with a gradual accumulation of runs.”  

Patience and Discipline
Google the words “value investing” and you’ll invariably find a plethora of quotes on the importance of patience dating back to Benjamin Graham and David Dodd’s seminal book Security Analysis, first published in 1934. After all, history shows that years of patience may be rewarded in a much shorter time frame, and ill-timed impatience can lead to underperformance.

To understand how such patience works in practice, consider the contrarian view Diamond and Petrucci took when a consumer goods company in their portfolio was taken over by another, despite questions of whether that combination would make sense. Regardless of such skepticism, Diamond and Petrucci focused instead on the acquiring company’s CEO and prior record as a turnaround expert. So Diamond and Petrucci kept their shares of the combined company and bought more on weakness, convinced that the CEO could extract more synergies, divest certain assets, buy some others, and revive underperforming brands.

Diamond and Petrucci showed similar patience with a global insurance and reinsurance company that took several years to regain traction after the global financial crisis of 2008-09. This wasn’t a “deep value” play in a secularly challenged industry, where the chances of turning around a company and boosting its stock price were slim. Confident in management and their overall investment thesis, Diamond and Petrucci saw a path for significant improvement in margins, earnings power, and multiple expansion in a consolidating market.

With stock multiples reaching new highs of late, one might wonder whether mergers and acquisitions (M&A) might play a bigger role in a value strategy. But Diamond is quick to point out that M&A typically is not the core element of an investment thesis, although a consolidating industry does make for “a good fishing pond.”

Themes in Perspective
While themes play a role in their portfolio, Diamond and Petrucci are not thematic investors, per se. Bottom-up, fundamental analysis comes first; secular themes such as “Web 3.0” (next generation technology) and experiences over things (shifting millennial preferences) may act as tailwinds.

One example is the way Diamond and Petrucci played exploration and production (E&P) sector during the down cycle last year. They focused on E&P companies in high-quality, low-cost shale regions—that is, those producers with good underlying assets that can survive even if the slump were to drag on. Purely picking the statistically cheapest companies was not a viable strategy, because there were substantial differences in asset quality. But companies with good asset positions generally continued to do well. So the focus was on identifying companies with good, underappreciated, assets that were not richly priced and had the potential to improve over time.

Asset quality, in this case, is defined as the economics of wells that companies are drilling. Wells could be in the same general shale formation, but returns on investment in core areas may eclipse those in peripheral areas with lower yields.

Now that oil supply and demand has come back into balance, the team is willing to take a little more risk on E&P companies, but that decision is not so much a call on oil prices as it is on underlying fundamentals and less downside risk than was the case during the slump.

One investment theme that bucked consensus was in the consumer sector. After the election, consumer stocks rallied on the idea that lower income tax rates would provide a windfall that could be spent on consumer goods such as clothing. But disappointing holiday sales at traditional retailers painted a more bearish picture, lending credence to the team’s belief that consumers will spend more on experiences than actual goods.

“A lot of that is driven by millennial preferences,” said Diamond. “They’re more interested in taking a picture of themselves standing on top of Machu Picchu and putting it on their Facebook page than buying a piece of clothing that has a logo on it.”

As a result, the Mid Cap Value Strategy has leaned more toward resort and cruise line companies, and avoided department stores and specialty retailers, which also have been adversely affected by the rise of e-commerce.

The Bottom Line
Lord Abbett’s Mid Cap Value Strategy hinges on a deliberate and repeatable process designed to mitigate valuation risk and identify key business and financial drivers to achieve a competitive return per unit of risk. After screening for stocks with historically attractive valuations (e.g., price/sales, book value, cash flow, earnings) and indicators of positive change, the team focuses on the stocks of companies with financial drivers, such as revenue acceleration opportunities, margin expansion/leverage, and skilled allocation of capital.

Team members and research analysts host or attend hundreds of company meetings a year, meeting directly with companies, as well as their suppliers, customers, and competitors to complete a mosaic view of each company from a global, sector, and individual security perspective. The team focuses in on the factors of success that are identified for that industry. In addition, their process facilitates the free flow of information between specialty analysts. This dynamic underscores the importance of cross-pollinating sector investment ideas, as it helps to develop a coherent investment strategy across sectors.

More important, the strategy is scalable. While Lord Abbett has not set a limit on the level of assets under management, the firm continually assesses its level of resources and is prepared to add resources as client and asset growth dictate.

 

The Russell Midcap® Value Index measures the performance of those Russell Midcap companies with lower price-to-book ratios and lower forecasted growth values. The stocks are also members of the Russell 1000 Value Index.

Alpha is the difference between a fund's expected returns based on its beta and its actual returns. Some investors interpret that as the value that a portfolio manager adds, above and beyond a relevant index's risk/reward profile.

Active share is computed by summing the absolute values of differences between a portfolio’s holdings and those of its benchmark and dividing this by two. The result can be interpreted as the percentage of the fund that differs from the benchmark.

A Note about Risk: The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies, including market, liquidity, currency, and political risks. Mid and small cap company stocks tend to be more volatile and may be less liquid than large cap company stocks. Mid and small cap companies typically experience higher risk of failure than large cap companies. Investments in value companies can continue to be undervalued for long periods of time and be more volatile than the stock market in general. These factors can adversely affect Fund performance. No investing strategy can overcome all market volatility or guarantee future results.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

A basis point (bps) is one one-hundredth of a percentage point.

Diversification does not guarantee a profit or protect against loss in declining markets.

The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to ma king an investment decision.

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