John Minahan, PhD, CFA, is a Senior Investment Strategist at NEPC, a Boston-based investment consulting firm. This article is adapted from the forthcoming book Investment Management: The Noble Challenges of Global Stewardship. This book will be available in September, 2008. For more information, inquire at farjones@q.net.
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Many times I have evaluated value managers whose strategy might be summarized as follows: purchase stocks of companies which are fundamentally troubled, but where the manager believes a catalyst is present which will turn the situation around and that catalyst is not yet priced into the stock. Then hold such stocks until either the thesis has played itself out, or it becomes apparent the thesis is unlikely to play out.
I was new to the industry the first time I encountered such a manager. The manager came to my attention because she showed up in a holdings-based style analysis, having migrated from value to growth, and this set off alarms regarding “style discipline”. The manager had very good performance, and this happened during a period of time when growth was outperforming value, so on the surface it looked like the manager had broken her value discipline because growth was where the returns were.
A closer examination of the portfolio revealed the manager had very little turnover during this period, and the stocks which were now plotting as growth had plotted as value when the manager bought them. All that had really happened was that the manager was correct with many of these stocks: earnings were up and their prices were up even more, and the stocks were now plotting as growth stocks. She was able to explain the investment thesis for any stock I asked about and for those she still held, justifying that the thesis was still intact. This led me to suspect the style-box program I was using just wasn’t subtle enough to accurately capture the manager’s style, and the style was in fact consistent through this period.
When I discussed my concerns with the more senior consultant with whom I worked on this account, he dismissed my interpretation. He claimed the style analyzer was "objective" whereas the manager's explanation was "spin". He told me that when I get a little more experience I will learn to be more skeptical of charming managers who will “say whatever it takes” to win or keep the business.
I have seen variants of this scenario play out many times, from both sides of the consultant-manager divide. The situation looks somewhat different from the manager's perspective. Not only are these situations very frustrating, but ironically, they can lead managers to make difficult decisions between staying true to their investment style or changing their style to conform to a consultant's notion of style discipline. I know of several cases where managers' product development efforts reverse-engineered consultants’ evaluation criteria, and effectively said "Who are we to question what the market wants? If the market wants style boxes instead of superior returns, we can do that."
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