With thousands of mutual funds, it's hard to keep track of more than a tiny fraction. So how do little-known funds distinguish themselves? Usually with impressive performance, especially during tough economic periods. DGHM AllCap Value is no different.
But the managers of the $125 million fund have been posting strong results for far longer than its four-year public record would suggest. Dalton Greiner Hartman Maher & Co., the fund's New York-based advisor, has managed separate accounts in a similar all-cap value strategy for nearly 30 years.
According to the company's audited performance record, the strategy has returned an annualized 13.6% a year since inception in 1983 through June 30 of this year, gross of fees. That's two percentage points a year better than the Russell 3000 Value Index, the benchmark.
In 2007, at the urging of one its large separate account clients, DGHM launched the open-end fund. It was lousy timing, coming just ahead of one of history's worst bear markets.
Nonetheless, the fund fared better than rivals. In 2008, it lost 22.4%, while similar offerings in the large-blend category plunged 37.8%. Over the last three years ending Aug. 4, the fund's 3.7% per year annualized return bests 95% of the funds in its category, according to Morningstar.
ANALYSTS AND STOCK-PICKERS
Identifying cheap stocks with a likelihood of growth is a big job. Out of 1,600 possible names in the fund's investable universe, the managers screen the top quarter of stocks with favorable valuations and profitability profiles. Then the analysts get to work, using fundamental research to try to find the best picks among the lot. Of the 400, just 30 to 40 make the final cut.
At DGHM, the 10 analysts are also stock- pickers. Many firms split the duties, believing that research and stock-picking are separate skill sets. But DGHM wants its analysts to have real conviction in their recommendations by putting money on the line.
"A portfolio manager knows a little bit about a lot of things, and an analyst knows a lot about a few things, so we're trying to blend that," says Jeffrey Baker, chief investment officer. He handles energy and health care, and is also the team leader for the all-cap strategy, Compensation is based on the five-year risk-adjusted performance of the picks.
Because the fund is fully invested - its cash position never dips below 3% - and is sector neutral, each of the Russell 3000 Value sectors is represented. "There are always good stocks in every sector," Baker says.
But if the team has an overwhelming like or dislike of a particular sector, they can apply over and underweights of up to 25% of the benchmark weighting. For example, a sector that has a 10% weighting in the Russell 3000 Value can go as high as 12.5% or as low as 7.25%.
That came into play in 2007 and 2008 when the financial services sector came crashing down and took many portfolios - especially value ones - with it. The managers took their financial weightings toward the low end, but didn't abandon the sector entirely.
Seeing too much risk in banking stocks before the crisis hit with full force in 2008, DGHM AllCap Value started moving into commercial banks, savings and loans, and insurance companies that didn't have exposure to the crippling subprime market. The fund shifted away from Fannie Mae and Ambac ahead of the worst damage. "We have sector bands because you could be way early on a sector or just plain wrong," Baker says.
As the fund's name suggests, companies range in size from obscure holdings like Mueller Industries to household names like JPMorgan Chase. Yet recently, the managers have found the most value in large-caps. "On a valuation basis, small-caps are at the higher end of their historical range vis-Ã vis large-caps," Baker says.
The typical stock in the Russell 2000, a benchmark of small companies, sports a P/E ratio of 22, while stocks in the S&P 500 have a P/E of just 13, according to estimates from Birinyi Associates. That's about as far as the macro calls go, Baker says. "We take what the market gives us, and the opportunities have recently been in large-caps."
One large-cap that makes the cut is AT&T. The telecom giant initially caught the managers' eye in the midst of speculation about how it would fare once competitor Verizon began offering Apple's iPhone to its customers, breaking AT&T's monopoly. "The market was too Draconian in its fears about the iPhone, and that it was already priced in," Baker says. "We felt that AT&T would be able to pick up growth in other areas."
In the first quarter, AT&T's iPhone activations rose 38% from the prior-year period, adding about 1 million accounts. AT&T trades at 11.3 times forward earnings and is up 17% over the last 12 months. However, the carrier's proposed $39 billion merger with T-Mobile may be imperiled as the FCC weighs whether to approve the deal.
Also finding a spot in the portfolio: 3M. The Scotch Tape maker weathered the 2008-09 crisis well, beating both its competitors in the industrials sector and the S&P 500 in general. Free cash flow is primarily the reason it sailed through the tough times, and the firm continues to be a cash generator, with almost $4 billion in free cash flow in 2010.
"It's one of those high-quality companies that you can feel comfortable owning," Baker says. "You're never going to get killed owning 3M."
Baker likes what 3M does with its cash. Over the last five years, the firm spent $8 billion buying back shares and paying out $7 billion in dividends. 3M is up 5.9% over the last five years, while maintaining a forward P/E ratio of 11.8. "As long as its valuations are reasonable and it generates free cash flow, we will continue to own it," Baker says.
Most investors may not know Mueller, but it has a prominent place in the DGHM portfolio. The firm is the leading maker of plumbing fittings and tubings. The stock was hit in the real estate downturn; fewer houses and office buildings meant less need for plumbing supplies.
But Mueller has a lot going, Baker believes. The most important, of course, is the $6 a share of net cash on its balance sheet. Mueller has used its cash to make wise acquisitions at favorable prices during the downturn, Baker says. Over the last 12 months, Mueller is up 49.4% and has a forward P/E of 12.1. For the first half of 2011, Mueller's net income more than doubled from the same period last year.
In health care, Baker says the firm is also finding opportunities, despite the uncertainties surrounding implementation of the federal health care overhaul. The managers look for names that won't come under pressure as the law works its way through the health care system.
One firm is Pharmaceutical Product Development, which helps drug companies conduct clinical trials. Because of the high cost of carrying out these trials, more pharmaceutical firms are outsourcing this function. Over the last 12 months, the stock is up about 10%, although it still trades at 43% below its five-year average. It has a P/E of 14.4 next year's earnings.
AVOIDING VALUE TRAPS
One of the big threats that value investors face is that cheap stocks will stay cheap for months or even years. Some stocks never move out of the gutter. If shares languish in the bottom quartile relative to their peers for six months, they are booted out of the fund and replaced with a stock with better prospects. That happens a couple of times a year.
The DGHM managers try to ensure they don't fall prey to the classic value trap by applying the momentum overlay to their valuation work. "This is one time where we take the decision away from the portfolio manager," Baker says.
Ilana Polyak, a New York financial writer, contributes regularly to Financial Planning.
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