An investment manager analyst by definition meets with investment man- agers throughout the year. This means dozens and even hundreds of phone conferences, face-to-face meetings, and on-site visits. In order to keep all of the data gleaned from these meetings organized and consistent, I make a point to write a memo that contains the relevant details from any such meeting. These memos address the following subject matter:
■Background
■Firm Information
■Investment Professional Information
■Support Staff Information
■Performance/Risk Discussion
■Portfolio Discussion
■Issues/Concerns/Questions
■Follow-up Required
■Conclusion
Most of the information contained in the memo comes from the con- versations that we have had with the investment professionals at CAM.
The rest comes directly from the analytical work that we have performed ourselves during the initial phases of the due diligence process. In addition to making the due diligence process more organized, the memo forces us to
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put the meeting in perspective because a conclusion (or decision) is re- quired at the end of every memo.
I have included a sample memo based on the phone interview with CAM.
To: Investment Committee From: Frank J. Travers, CFA
Re: CAM Asset Management Small-Cap Value Product BACKGROUND
The Market Leaders Fund is currently searching for a small-cap value manager as a replacement for XYZ Asset Management. XYZ was ter- minated following the departure of several key investment personnel (see XYZ memo dated September 15, 2003). Frank J. Travers, CFA, is in charge of this search, and the deadline for final review is in three weeks.
FIRM INFORMATION
CAM Asset Management was formed in 1997 and is owned by Mark Innes (40%), Andrew Wares (30%), and Jim Bradshaw (30%). The firm specializes in small cap investing and currently has two product offerings: a small-cap value (which we have determined is really more indicative of GARP) product and a small-cap long/short hedge fund.
The hedge fund’s long exposure closely mirrors the holdings in the small-cap value portfolio. The three partners are supported by Tara Fitzpatrick, who migrated from being a general assistant to her current position as a junior analyst. In addition, CAM has a receptionist who doubles as an executive assistant to the group. The firm’s Form ADV is included in the attachments for a more detailed review.
INVESTMENT PROFESSIONAL INFORMATION Mark Innes
1982 to 1985 Analyst, Mackey Capital Partners 1986 to 1991 Co–portfolio manager, Atlantis Capital’s
small-cap mutual fund
1991 to 1997 Lead portfolio manager of Atlantis Capital’s small-cap fund
1997 to Present Partner, co–portfolio manager of CAM’s small-cap product, lead manager of firm’s hedge fund
Andrew Wares
1983 to 1997 Director of client service at Victory Asset Management
1997 to Present Partner, CEO/CFO/COO at CAM
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James Bradshaw
1983 to 1997 Portfolio manager, balanced accounts (high net worth) at Victory Asset Management
1983 to 1997 Director of research/portfolio manager at Victory Asset Management
1997 to Present Partner, co–portfolio manager of CAM’s small-cap product
SUPPORT STAFF INFORMATION Tara Fitzpatrick
1994 to 1995 Video store clerk
1995 to 1996 Administrative assistant at the Carlyle Company, a real estate management firm
1996 to 1997 Office manager at Hendricks Consulting, a management consulting firm
1997 to 1999 Portfolio assistant at CAM 1999 to Present Junior portfolio analyst at CAM PERFORMANCE/RISK DISCUSSION
The small-cap value portfolio has experienced very good performance relative to the small-cap value peer group; however, portfolio data pro- vided by the manager seems to indicate that CAM is not a “pure”
value shop (see Exhibit 8.2). The table illustrates the small-cap value product’s performance relative to the small-cap benchmarks as well as the peer group of small-cap value managers.
While the overall track record is strong, the portfolio has experi- enced some choppy returns. In particular, the portfolio experienced very strong performance in the 1998 to 1999 period, which has been established as a growth-oriented market. In our conversation with Mark Innes, the portfolio manager, we confirmed that the portfolio was weighted in sectors not typically favored by value managers, such as technology and health care (at their peak in the 1998–1999 period, these two sectors held a combined weight of more than 60% in the portfolio). The CAM portfolio also exhibited good performance rela- tive to its peer group (refer to the peer group chart in the attachments).
Over the past five years, the CAM portfolio achieved returns that placed it in the first quartile of products with similar investment objec- tives. In more recent periods, the portfolio’s performance placed it in the second quartile. This is based on the poor relative performance in the 2000–2001 period.
Up/down market analysis (Exhibit 8.2) versus the small-cap value index clearly indicates that CAM had significantly outperformed the
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index during months in which the index return was positive, while only moderately underperforming the index during months in which the index return was negative. However, when we excluded the strong 1999 performance period (which was based largely on the portfolio’s extreme weighting on growth-oriented stocks), the portfolio’s relative performance in up markets goes from a large value added to a large value subtracted.
CAM’s small-cap portfolio exhibited slightly more variation in re- turns than did the small-cap value index, with an annualized standard deviation since inception of 22.7% versus 21.0% for the index. How- ever, the CAM portfolio did experience slightly lower standard devia- tion than the median small-cap value fund over the same period. The CAM portfolio’s Sharpe ratio since its inception, at 0.34, is nearly three times that of the small-cap value index and the median small-cap value mutual fund. Likewise, the CAM portfolio exhibited better Sortino, Treynor, and Jensen ratios than did the small-cap indexes and the median small-cap value mutual fund. As a result, we can conclude that, based on absolute and risk-adjusted historical performance, the CAM portfolio looks attractive.
Initial Interview 175
EXHIBIT 8.2 CAM versus Benchmarks—Annualized and Calendar Year Performance
Annualized Performance (Periods Ended June 2003)
YTD 1 Year 3 Years 5 Years Inception
CAM 15.9% –2.7% 7.9% 8.6% 9.7%
S&P SmallCap Value Index 13.0% –8.4% 8.0% 3.8% 4.8%
Value added 2.9% 5.7% –0.1% 4.7% 5.0%
S&P SmallCap Index 12.9% –3.6% 2.4% 3.7% 4.5%
Value added 3.0% 0.8% 5.5% 4.8% 5.2%
Calendar Year Performance
2003 1998 1999 2000 2001 2002 (YTD)
CAM 0.9% 24.1% 14.8% 10.7% –9.6% 15.9%
S&P SmallCap Value Index –5.1% 3.0% 20.9% 13.1% –14.5% 13.0%
Value added 5.9% 21.0% –6.1% –2.4% 4.9% 2.9%
S&P SmallCap Index –1.3% 12.4% 11.8% 6.5% –14.6% 12.9%
Value added 2.2% 11.7% 3.0% 4.2% 5.0% 3.0%
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PORTFOLIO DISCUSSION
CAM employs a bottom-up, fundamental approach toward individ- ual stock selection as well as portfolio construction. Mark Innes in- formed me during the call that they are driven almost exclusively by bottom-up stock selection. When asked about risk controls, Mark indicated that they place some restrictions on maximum individual stock weights (5%) and broad sector weightings (maximum of one-third of the total portfolio). Based on the current portfolio pro- vided to us and the discussion that I had with Mark, it is clear that CAM takes a fair amount of sector concentration risk. Of particular interest are the actual sectors in which they have historically held high weights: technology and health care—both of which are widely considered to be more growth oriented than value oriented. Cur- rently, the CAM portfolio has roughly 70% of its holdings concen- trated in just three broad sectors (consumer cyclicals, health care, and financials).
Back in the 1999–2000 period, the portfolio had more than 60% concentrated in technology and health care stocks. The portfo- lio is highly concentrated based on industry weights as well, with nearly 50% of the portfolio concentrated in the top five industries.
An analysis of the current portfolio indicates that the weighted av- erage market capitalization is $777 million versus $684 million for the small-cap value index. In addition, roughly half of the portfolio (31 stocks) fall into the micro-cap range (stocks with market caps under
$500 million).
Individual portfolio positions seem to be concentrated in the 1%
to 3% range (based on the current portfolio), but we need to check on this historically, as Mark indicated in our conversation that some stock weightings had gotten out of hand during the run-up in the market in 1999–2000.
Fundamentally, the portfolio does not look like either value or growth; rather it exhibits characteristics of each. The portfolio’s price- earnings ratio is in line with the small-cap value index, but is substan- tially higher in other price-based areas (price/sales, price/book, price/cash flow). However, the portfolio is definitely geared more to- ward the growth style when looking at the earnings and revenue growth figures. Lastly, the portfolio’s individual holdings also seem to have strong cash positions (liquidity) and, thus, the ability to pay off debts and fund internal growth.
Based on the fundamental portfolio analysis, I would initially conclude that the current portfolio is more indicative of the GARP (growth at a reasonable price) style than either value or growth. How-
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ever, the portfolio does offer an attractive P/E as well as strong growth rates.
ISSUES/CONCERNS/QUESTIONS
1. I am concerned with the portfolio’s sector bets, despite the fact that they are coming from the bottom up.
2. The portfolio has a tendency toward investing in sectors that are traditionally more growth oriented. In isolation, this is not an issue;
however, if we were to include this manager in our Market Leaders Fund, I would be concerned that its weighting in technology and health care might rise to uncomfortable levels based on the CAM portfolio in combination with our other growth-oriented managers.
3. Another issue involves the current level of product assets in relation to the capacity limit that CAM has set. Currently, the CAM small- cap portfolio has roughly $450 million in assets. Mark stated that they would close the product to new assets at $500 million (leaving room for an additional $100 million in contributions from existing clients). In addition, CAM manages about $100 million in its hedge fund product. I do not know what portion is long, but will assume for now that the fund has another $50 to $60 million in long assets.
This would bring the firm’s level of small-cap assets over the $500 million mark. It seems that CAM is in the process of receiving some pretty large contributions. I have to wonder if that is due to the very good track record. If so, I would be concerned that these new assets might be the first ones to leave should the portfolio experience any performance hiccups (i.e.: relative underperformance in a widely value-driven market).
4. I am also concerned that the firm is actively managing a small-cap long/short hedge fund. Mark seems to be in complete control of this product. Based on the differing fee structures, it is likely more prof- itable at this stage to focus just on the hedge fund. I need to get a better sense that Mark has strong ties to the firm and that he won’t branch off to start his own firm to focus on the hedge fund product.
FOLLOW-UP REQUIRED
1. Need to contact list of references.
2. Need to conduct background check on all three partners (pending positive on-site visit).
3. Once Mark sends the additional information regarding positions in 1999–2000, need to analyze the holdings in relation to concentra- tion risk.
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4. Need to conduct a historical portfolio analysis.
5. Need to analyze CAM’s portfolio relative to our other small-cap manager to determine if CAM’s growth element is repetitive and/or to highly correlated to the growth manager.
CONCLUSION
CAM’s small-cap value product is stylistically somewhere between growth and value product. I feel that is safe to consider it GARP or value with a growth bias. I am concerned by the portfolio’s historical tendency toward taking certain concentration risks (e.g., individual stock weights ran up in the growth market of 1999/early 2000, and both sector and industry weights have been and still are pretty concen- trated) and need to probe a bit deeper into the hedge fund product.
However, the firm has achieved solid results without taking risks that are too far removed from the small-cap value universe. The on-site visit will help to determine if this firm/product should be considered for inclusion in the Market Leaders Fund.
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CHAPTER 9
Attribution Analysis
P
ortfolio attribution allows the analyst to slice and dice a portfolio in a variety of different ways, providing a means of numerically assessing what a portfolio manager has done well and not so well—in effect, creating a quantitative, results-oriented assessment of a manager’s skill set. It is the only truly quantitative means we have of making a determination of skill.Attribution can be done in isolation, which is often referred to as absolute attribution or contribution to total return, or it can be done relative to some benchmark. In either case, the methodology is pretty straightforward, but requires a fair amount of underlying portfolio data, particularly when performing the analysis over multiple periods. Attribution results can often shed light on an investment manager’s perceived skills and aid the due dili- gence analyst in making a more informed decision when it comes to hiring or firing an investment manager.
Attribution analysis can be simplified and calculated based on static portfolios or it can include transactional data for the period in question.
■Static portfolios.This method does not take into account any transactions that may have occurred between the start and end dates of the analysis. It can be considered to be an estimate as opposed to true attribution analy- sis. Two factors play a critical role in the analysis when using static port- folios: (1) time period under evaluation and (2) portfolio turnover. I have found monthly and even quarterly time periods to be acceptable when portfolio turnover (amount and number of transactions) is low. However, when evaluating a portfolio in which the manager trades frequently, it is more efficient to perform attribution based on static portfolios for shorter time periods. For example, if using a static portfolio for a three-month time frame, the analysis would not take into account any stocks that were bought and sold during the period. The more transactions that were made during the period, the less accurate the results may be.
■Complete portfolios including all transactions. This method takes into account each and every transaction that is made by the portfolio
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manager for a specific portfolio over a defined time period. As a re- sult, it yields the most accurate results, but is obviously more data (and labor) intensive.
Lastly, the decision to hold cash and cash equivalents is every bit as much an investment decision as sector allocations and individual purchases and sales. A portfolio manager’s decision to hold cash in lieu of stocks (or bonds or whatever financial instruments are outlined in the portfolio’s in- vestment objectives) will have one of three potential effects on the underly- ing portfolio: positive, negative, or neutral (none). I typically treat cash as a separate asset class, separate and distinct from any sector or industry classifications. To keep things simple, the examples outlined in this chapter do not include cash or cash equivalents.