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Equity Perspectives

The Lord Abbett Value Opportunities Fund is a double play on flexibility, in that it can tap a much broader universe than single-focus strategies. Here's how.

 

In Brief:

  • The Fund seeks companies that have attractive valuations, but there needs to be a catalyst and a compelling story. Both valuation and fundamentals are important, but we are willing to pay up slightly for very strong fundamentals that are at inflection points. 
  • The process starts with deep, experienced investment resources. Lead portfolio managers Justin Maurer and Tom Maher are both partners of the firm and have co-managed the strategy since early 2007; they are actively involved in the research process as well. They are supported by four dedicated small/smid analysts organized as generalists.
  • This team approach helps us exploit the greater level of market inefficiencies within the small/smid cap universe more than those within the large/mid universe.
  • Supporting the dedicated team is a team of over 20 global sector analysts who provide rigorous analysis into identifying non-consensus views, a chief risk officer who provides enhanced analytics to help identify and manage risk in the portfolio, and 10 experienced traders who are in constant communication with portfolio managers on market conditions and opportunities, especially important in the small cap space.

 

Q. What is the Fund’s philosophy?
A. 
We believe that markets are inefficient, especially as you move down the market cap spectrum. Active management allows skilled managers to exploit these opportunities. Our relative value, bottom-up approach is well-informed by specialized and focused resources and provides the flexibility that many value managers do not have. An experienced team and in-depth fundamental research that focuses on finding stocks that are most mispriced by the market consensus is essential to outperforming. Managing risk is also essential to success and we believe it is critical to understand and quantify exposures and potential impacts to the portfolio. In sum, our investment philosophy and process is predicated on (1) identifying value through rigorous research, (2) expressing our conviction with active market positions, and (3) effectively managing opportunity with risk management at each step of the process..

Q. Please describe the process.
A.
The investment process is ongoing and iterative. The steps include: idea generation and validation, research consisting of fundamental company research and valuation analysis, and risk management focusing on risks at the company level and at the portfolio level. Of course, valuation and fundamental risk assessment have always been part of the process; over the past few years, we have implemented another layer of risk management at the portfolio level, helping to enhance monitoring and expand our understanding of market-level exposures within the portfolio.  

Q. How do you go about screening investment candidates?
A. 
The opportunity set is the market cap range of the Russell 2500 Index,1 roughly $500 million to $10 billion. Most opportunities fall within a range of $1-$8 billion. We use valuation models to screen for companies that have undergone a meaningful decline in price. Traditional valuation criteria, such as price/earnings, price/book, price/cash flow, and price/sales ratios,2 are used to identify stocks that display extreme valuation relative to their historical levels.

Q. Please elaborate.
A.
Through subsequent screening techniques we identify which of these companies may be undergoing some form of positive fundamental change. Our qualitative screens will identify companies that are exhibiting improvements in sales, operating margins, and earnings on a sequential basis. In addition, we screen for meaningful insider-buying activity as a potential determination of positive fundamental change for a given company. Using this process, we identify a group of approximately 250 stocks that may have significant potential.

Q. How do you narrow down that field?
A.
After thorough fundamental research, we delve into potential catalysts that have yet to be reflected in the company’s stock price. These drivers may include: new product introductions, divestitures, acquisitions, sensitivity to general economic trends, and the like. Our analysis is conducted through on-site visits to the company and its competitors, customers, and suppliers, as well as management meetings that occur at our offices, and relevant industry conferences. We also selectively utilize the resources of regional brokerage firms.

Q. How many stocks does the fund typically hold?
A. While the range of holdings is 80-110, we generally own 90-100 names. The weights are determined by reward-to-risk ratio and conviction level. We generally enter positions at 50 basis points, and a full position may range from 1% to 3%.

Q. How do you approach valuation analysis?
A.
Our valuation analysis aids us in achieving “reward per unit of risk” objectives. So the final step is to value the company and develop a risk price (downside) and reward price (upside) using projected earnings and multiple potential based on history. We aim to have a reward to risk ratio of at least 3:1, depending on market conditions. Price targets are reviewed on a continual basis and adjusted based on fundamental factors and market action.

Q. What if you’re not comfortable with the downside?
A.
We often pass on buying a high reward-to-risk ratio stock if the absolute downside price risk is too large. 

Q. Lord Abbett expanded its risk management capabilities with the introduction of a new risk management team in 2012. How significant was that?
A
. We believe our two-pronged approach to risk management is critical to achieving long-term success in our investment process. In terms of companies, we seek to minimize valuation risk through initial valuation screens—buying companies at the low end of their valuation history. We also seek to minimize fundamental risk by having a deep understanding of the companies we own. In other words, we want to limit negative surprises. In terms of portfolio risk, our goal is to thoroughly understand portfolio positioning and the potential impact of macro drivers.

Q. What about your sell discipline?
A.
The sell discipline focuses on a continuous monitoring of each holding’s fundamental progress and stock price performance relative to our original investment thesis. The sale of a holding may be triggered by price appreciation that changes the risk/return profile, a prospective fundamental change in the company’s outlook, or if research discovers a more attractive opportunity.

Q. How has all this active management translated to stock selection?
A. 
Since inception on December 30, 2005, most of the long-term outperformance of the fund has come from stock selection as opposed to relative sector weightings versus our Russell 2500 benchmark. In fact, there has only been one calendar year, 2012, where stock selection was negative. 

Q. Even the best portfolios will thrive in certain environments and struggle in others when their style is out of favor. What types of environments are most and least favorable for your process?
A.
While we look to minimize the effect of macro shocks in our risk management approach, the portfolio has generally benefitted most when the market is recognizing fundamentals and relative value in a rational manner. This assessment is not to be confused with performance during bull markets vs. bear markets—in fact, we meaningfully outperformed our benchmark in 2007, 2008, and 2009, which were three completely different market environments; however, they were environments where the markets reflected the reality of corporate earnings, financial markets, and public policy responses. By contrast, 2011 and 2012 were years where fear and greed instead drove market direction rather than earnings and fundamentals. Our performance was particularly challenged during the second quarter of 2012 when the market was reacting negatively to more macro issues, including concerns about global economic growth. During this quarter, stocks tended to react very negatively to modest earnings misses. At that time, our portfolio was overweight names that were sensitive to global growth. Our focus since that experience has been to further emphasize stock-specific risk to limit the effect of macro shocks.   

Q. So if you had to condense the key points of this fund in a short elevator conversation, what would you say?
A.
In summary, this strategy is managed by an experienced team focusing on comprehensive, bottom-up research with a focus on attractive valuation, risk management and a disciplined portfolio construction process. The result historically has been higher returns and lower risk than the benchmark since inception. However, past performance is not a reliable indicator or a guarantee of future results.

 

1 The Russell 2500™ Index is a market cap weighted index that includes the smallest 2,500 companies covered in the Russell 3000 universe of United States-based listed equities.
2 Price/earnings ratio is the weighted average of each holding’s P/E ratio (price of a stock divided by its earnings per share). Price/book ratio is a ratio that helps determine whether a stock is undervalued or overvalued. It is calculated by dividing a stock’s price per share by its book value per share. Price/cash flow ratio is an indication of relative value, calculated by dividing a stock’s share price by its cash flow per share. Price/sales ratio is a ratio for valuing a stock relative to its sales. It is calculated by dividing a stock’s current price by its revenue per share for the trailing 12 months.

 

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