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PrinciplesofPortfolioConstruction:LordAbbettSmid-Cap
Strategy
January5,2017
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ManagersJustinMaurerandThomasMaherdiscusstheadvantagesofa
flexibleactiveapproachinselectingsmall-andmid-capequities.
InBrief:
Thestrategyseekssmall-andmid-capcompaniesthathaveattractivevaluations,butthere
needstobeacatalystandacompellingbusinessrationale.Bothvaluationandf undamentals
areimportant,butwearewillingtopayupslightlyf orverystrongf undamentalsthatareat
inf lectionpoints.
Theprocessstartswithdeep,experiencedinvestmentresources.Leadportfoliomanagers
JustinMaurerandTomMaherarebothPartnersofthefirmandhaveco-managedthe
strategysinceearly2007;theyareactivelyinvolvedintheresearchprocessaswell.They
aresupportedbyanassociateportfoliomanagerandfourdedicatedanalystsorganized
asgeneralists.
Thisactivelymanagedteamapproachhelpsusexploitthelargernumberof companiesand
greaterlevelof marketinef f iciencieswithinthesmall-andmid-cap(“smid”)universethanthose
withinthelarge-capuniverse.Ourf ocusisonstockpicking,andourobjectiveisthe
achievementof competitivereturns.
Supportingthededicatedteamisateamof morethan30globalindustryanalysts,whoprovide
rigorousanalysisintoidentif yingnon-consensusviews;achief riskof f icer,whoprovides
enhancedanalyticstohelpidentif yandmanageriskintheportf olio;and10experienced
traders,whoareinconstantcommunicationwithportf oliomanagersonmarketconditionsand
opportunities,especiallyimportantinthesmall-capspace.
Q.Whatisthestrategy'sphilosophy?
A.Webelievethatmarketsareinef f icient,especiallyasyoumovedownthemarket-cap
spectrum.Activemanagementallowsskilledmanagerstoexploittheseopportunities.Ourrelative
value,bottom-upapproachiswell-inf ormedbyspecializedandf ocusedresourcesandprovides
thef lexibilitytoinvestinbothsmall-andmid-capstocksacrossthestylespectrum.An
experiencedteamandin-depthf undamentalresearchthatf ocusesonf indingstocksthataremost
mispricedbythemarketisessentialtooutperf orming.Managingriskalsoisessentialtosuccess,
and,assuch,webelieveitiscriticaltounderstandandquantif ymacroandf actorexposuresand
theirpotentialimpactstotheportf olio.Insum,ourinvestmentphilosophyandprocessismanaged
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withaf ocuson1)identif yingvaluethroughrigorousresearch,2)expressingourconvictionas
activestockpickers,and3)maintainingabalancedanddiversif iedportf olioconstructiondiscipline
withsensitivitytorewardperunitof riskateachstepof theprocess.
Q.Pleasedescribetheprocess.
A.Theinvestmentprocessisongoinganditerative.Thestepsincludeideagenerationand
validation,researchconsistingof f undamentalcompanyresearchandvaluationanalysis,andrisk
managementf ocusingonrisksatthecompanylevelandattheportf oliolevel.Of course,valuation
andf undamentalriskassessmenthavealwaysbeenpartof theprocess;overthepastf ewyears,
wehaveimplementedanotherlayerof riskmanagementattheportf oliolevel,helpingtoenhance
monitoringandexpandourunderstandingof market-levelexposureswithintheportf olio.
Q.Howdoyougoaboutscreeninginvestmentcandidates?
A.Theopportunitysetisthemarket-caprangeof theRussell2500Index,1roughly$500millionto
$10billion.Mostopportunitiesf allwithinarangeof $1-8billion.Weusevaluationmodelstoscreen
f orcompaniesthathaveundergoneameaningf uldeclineinprice.Traditionalvaluationcriteria,
suchasprice/earnings,price/book,price/cashf low,andprice/salesratios,2areusedtoidentif y
stocksthatdisplayextremevaluationrelativetotheirhistoricallevels.
Q.Pleaseelaborate.
A.Throughsubsequentscreeningtechniques,weidentif ywhichof thesecompaniesmaybe
undergoingsomef ormof positivef undamentalchange.Ourqualitativescreenswillidentif y
companiesthatareexhibitingimprovementsinsales,operatingmargins,andearningsona
sequentialbasis.Inaddition,wescreenf ormeaningf ulinsider-buyingactivityasapotential
determinationof positivef undamentalchangef oragivencompany.
Q.Howdoyounarrowdownthatfield?
A.Af terthoroughf undamentalresearch,wedelveintopotentialcatalyststhathaveyettobe
ref lectedinthecompany’sstockprice.Thesedriversmayincludenewproductintroductions,
divestitures,acquisitions,sensitivitytogeneraleconomictrends,andthelike.Ouranalysisis
conductedthroughon-sitevisitstothecompanyanditscompetitors,customers,andsuppliers,as
wellasmanagementmeetingsthatoccuratourof f ices,andrelevantindustryconf erences.We
alsoselectivelyutilizetheresourcesof regionalbrokeragef irms.
Q.Howmanystocksdoesthestrategytypicallyhold?
A. Whiletherangeof holdingsis70–100,wegenerallyown75–90names—aslightreductionf rom
previousyearsgivenourdesiretoexpresshigherconvictioninstock-selectiondecisions.The
weightsaredeterminedbyreward-to-riskratioandconvictionlevel.Wegenerallyenterpositionsat
50basispoints,andaf ullpositionmayrangef rom1–3%.
Q.Howdoyouapproachvaluationanalysis?
A.Ourvaluationanalysisaidsusinachievingourhighlevelof “rewardperunitof risk”objective.
So,thef inalstepistovaluethecompanyanddevelopariskprice(downside)andrewardprice
(upside)usingprojectedearningsandmultiplepotentialbasedonhistory.Weaimtohavea
reward-to-riskratioof atleast3:1,dependingonmarketconditions.Pricetargetsarereviewedon
acontinualbasis,andadjustedbasedonf undamentalf actorsandmarketaction.
Q.Whatifyou’renotcomfortablewiththedownside?
A.Weof tenpassonbuyingahighreward-to-riskratiostockif theabsolutedownsidepriceriskis
toolarge.
Q.LordAbbettexpandeditsrisk-managementcapabilitieswiththeintroductionofa
newriskmanagementteamin2012.Howsignificantwasthat?
A.Webelieveourtwo-prongedapproachtoriskmanagementiscriticaltoachievinglong-term
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successinourinvestmentprocess.Intermsof companies,weseektominimizevaluationrisk
throughinitialvaluationscreens—thatis,buyingcompaniesatthelowendof theirvaluation
history.Wealsoseektominimizef undamentalriskbyhavingadeepunderstandingof the
companiesweown.Inotherwords,wewanttolimitnegativesurprises.Intermsof portf oliorisk,
inf ormationaltoolshaveevolvedtobettersupportachievementof ourgoal—tothoroughly
understandportf oliopositioningandthepotentialimpactof macrof orces.
Q.Whataboutyourselldiscipline?
A.Theselldisciplinef ocusesonacontinuousmonitoringof eachholding’sf undamentalprogress
andstockpriceperf ormancerelativetoouroriginalinvestmentthesis.Thesaleof aholdingmay
betriggeredbypriceappreciationthatchangestherisk/returnprof ile,aprospectivef undamental
changeinthecompany’soutlook,orif researchdiscoversamoreattractiveopportunity.
Q.Howhasallthisactivemanagementtranslatedtostockselection?
A.SinceinceptiononDecember30,2005,mostof thestrategy’slong-termoutperf ormance
versusourRussell2500benchmarkhascomef romstockselection,asopposedtorelativesector
weightings.
Q.Eventhebestportfolioswillthriveincertainenvironmentsandstruggleinothers
whentheirstyleisoutoffavor.Whattypesofenvironmentsaremostandleast
favorableforyourprocess?
A.Whilewelooktominimizetheef f ectof macroshocksinourrisk-managementapproach,the
portf oliogenerallyhasbenef itedmostwhenthemarketisrecognizingf undamentalsandrelative
valueinarationalmanner.Thisassessmentisnottobeconf usedwithperf ormanceduringbull
marketsversusbearmarkets—inf act,wemeaningf ullyoutperf ormedourbenchmarkin2007and
2008,whichwerecompletelydif f erentmarketenvironments;however,theywereenvironmentsin
whichthemarketsref lectedtherealityof corporateearnings,f inancialmarkets,andpublicpolicy
responses.Bycontrast,2011and2012wereyearswhenf earandgreedinsteaddrovemarket
directionratherthanearningsandf undamentals.Ourperf ormancewasparticularlychallenged
duringthesecondquarterof 2012,whenthemarketwasreactingnegativelytomoremacro
issues,includingconcernsaboutglobaleconomicgrowth.Duringthisquarter,stockstendedto
reactverynegativelytomodestearningsmisses.Atthattime,ourportf oliowasoverweightnames
thatweresensitivetoglobalgrowth.Ourf ocussincethatexperiencehasbeentof urther
emphasizestock-specif icrisktolimittheef f ectof macroshocks.
Q.So,ifyouhadtocondensethekeypointsofthisstrategyinashortelevator
conversation,whatwouldyousay?
A.Insummary,weprovideinvestorsasmid-capequitystrategywiththef ollowingdef ining
f eatures:
Time-testedrelativevalueprocessimplementedbyaproven,experiencedteam;
Fundamentally-drivenstockselectionf ocusedoncatalystidentif ication;and
Thoroughanalysisof valuation,f inancial,andbusinessrisks.
Theresulthistoricallyhasbeenahigher-returning,lower-volatilityapproachdesignedtocapture
marketinef f iciencies.[However,pastperformanceisnotareliableindicatororaguaranteeof
futureresults.]
1TheRussell2500™Indexisamarketcap-weightedindexthatincludesthesmallest2,500companiescoveredinthe
Russell3000universeof U.S.-basedlistedequities.
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2 Price/earningsratioistheweightedaverageof eachholding’sP/Eratio(priceof astockdividedbyitsearningsper
share).Price/bookratioisaratiothathelpsdeterminewhetherastockisundervaluedorovervalued.Itiscalculated
bydividingastock’spricepersharebyitsbookvaluepershare.Price/cashf lowratioisanindicationof relativevalue,
calculatedbydividingastock’ssharepricebyitscashf lowpershare.Price/salesratioisaratiof orvaluingastock
relativetoitssales.Itiscalculatedbydividingastock’scurrentpricebyitsrevenuepersharef orthetrailing12
months.
ANoteaboutRisk:Thevalueof investmentsinequitysecuritieswillf luctuateinresponsetogeneraleconomic
conditionsandtochangesintheprospectsof particularcompanies,includingmarket,liquidity,currency,andpolitical
risks.Midandsmallcapcompanystockstendtobemorevolatileandmaybelessliquidthanlargecapcompany
stocks.Midandsmallcapcompaniestypicallyexperiencehigherriskof f ailurethanlargecapcompanies.Investments
invaluecompaniescancontinuetobeundervaluedf orlongperiodsof timeandbemorevolatilethanthestockmarket
ingeneral.Thesef actorscanadverselyaf f ectportf olioperf ormance.Noinvestingstrategycanovercomeallmarket
volatilityorguaranteef utureresults.
Indexesareunmanaged,donotref lectthedeductionof f eesorexpenses,andarenotavailablef ordirectinvestment.
Abasispoint(bps)isoneone-hundredthof apercentagepoint.
Theportf olioisactivelymanagedandmaychangesignif icantlyovertime.
Diversif icationdoesnotguaranteeaprof itorprotectagainstlossindecliningmarkets.
Theopinionsintheprecedingcommentaryareasofthedateofpublicationandsubjecttochangebasedonsubsequent
developmentsandmaynotreflecttheviewsofthefirmasawhole.Thismaterialisnotintendedtobelegalortaxadviceand
isnottoberelieduponasaforecast,orresearchorinvestmentadviceregardingaparticularinvestmentorthemarketsin
general,norisitintendedtopredictordepictperformanceofanyinvestment.Investorsshouldnotassumethatinvestments
inthesecuritiesand/orsectorsdescribedwereorwillbeprofitable.ThisdocumentispreparedbasedoninformationLord
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