Scott Black: A No-Performance-Fee Hedge Fund Manager

Looking for good businesses at a discounted price

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Jan 22, 2018
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While almost all hedge fund managers give themselves access to every asset class in every corner of the world,

Scott Black (Trades, Portfolio) restricts himself to domestic, long-equity only.

The guru who founded Delphi Management in 1980 gives himself the task of finding underpriced companies using both quantitative and qualitative screens. But being value priced is the key.

He also does not charge a performance fee. Does that strategy still work for him?

Who is Black?

Black, the founder and president of Delphi Management, received a bachelor's degree from John Hopkins University and an MBA from the Harvard Business School.

His career began with corporate finance and international treasury positions at Xerox Corp. (

XSG, Financial) and Joseph E. Seagram. Black also worked at Merrill Lynch, where he became head of corporate development, and William O'Neil Company.

He started Delphi Management Inc. in 1980. His resume also includes guest lecturing on investments and corporate finance at several major universities, appearances in major business magazines and on business television. He was named a lifetime fellow of Harvard University in 2000.

What is Delphi?

Black’s firm is a Boston-based hedge fund, which describes itself as an equities specialist. He is the sole owner of the company.

Delphi offers three types of portfolio management:

  • All cap value.
  • Small and mid-cap value.
  • Concentrated mid-cap portfolio (reported on Delphi Value site).

Its clients are institutions, high-net-worth individuals and trusts on a discretionary basis.

Also noted in the Form ADV Part 2A: the firm charges between a half point and one-and-a-half points as a management fee, but generally does not accept performance-based fees.

Assets under management totalled $179 million on Nov. 20, 2017.

Strategy

On the firm’s website, Black and Delphi say they are disciples of the Graham-Dodd school of value investing. This, they say, means a potential investment should only be bought at a low absolute valuation.

Further, they only invest in targets that pass a proprietary set of rigorous quantitative criteria and have good management. They personally talk to management at every company in which they invest.

Unlike many hedge funds, which give their managers few boundaries (global macro), Black and Delphi invest only in U.S.-listed equity securities and only take long positions.

In its Form ADV Part 2A, the firm says it starts by asking two questions:

  1. Is this a good business?
  2. Can it be bought at a cheap price?

To address the first question, it starts with quantitative screening. This involves six criteria:

  • Should earn at least 15% after-tax return on equity.
  • Revenues and earnings should grow faster than inflation over the coming three to five years.
  • Free cash flow analysis for all non-financial companies to determine if the company can finance its growth with internally-generated operational cash flow.
  • Companies with low debt to equity ratios.
  • Price must offer a substantial discount to a "conservatively estimated liquidating valuation."
  • Conservative accounting practices.

A candidate company that passes the quantitative screening is then subject to a qualitative analysis. This means talking with management (it’s a Delphi rule), whether on the phone or in person. At this stage, Delphi is looking for:

  • A high degree of integrity.
  • Willingness to communicate about problem areas.
  • No promotional literature or slide shows.
  • A well-defined business strategy, and the ability to articulate their strengths and weaknesses versus their competitors.
  • A strategic plan and definable goals covering the next three to five years. This should include what Delphi calls the "four building blocks of any business": marketing, finance, production and manpower.

Then, Black and company deal with the second question: Can this business be bought at a good price? He says Delphi has "divided the world of Graham & Dodd into two subcategories: earnings-power plays and asset plays":

  • Earnings-power plays includes companies with consistently high returns on equity, with relatively few breaks. It also limits itself on price-earnings: no more than 13.9% of the coming year's conservatively estimated earnings. The price-earnings ratio of the S&P 500 is not a factor, meaning it deals only in absolute value, not relative value.
  • Asset plays include currently depressed companies that have generated a 15% return on equity in the past and have a strong probability of getting there again. After all that, it must still sell at a significant discount to its liquidating valuations.

Black pursues a variation on a value investing theme: buy cigar butts, but insist they have quality stock credentials. Consider that one of the criteria for company to get on the radar at all is to earn at least a 15% after-tax return on equity. That is just one of six criteria in the quantitative screen. All of this seems to cry out for a concentrated, high-conviction portfolio.

Holdings

Black has a reasonably diverse portfolio, but still two sectors comprise more than half the portfolio, as shown in this GuruFocus chart:

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These are the top 10 holdings as of Sept. 30, 2017:

With 85 stocks, Black hardly runs a concentrated portfolio. On the other side of the coin, though, his quarter-over-quarter turnover is just 9%.

Performance

Between 1980 (inception) and the end of 1998, Business Day reported his average annual return, net of fees, was 17.6% per year, compared with 14.4% for the Russell 2000 small-cap index. Beyond that, no performance data appears to be publicly available.

However, this chart showing Delphi’s equity holdings over the past three years suggests returns have not been so good:

1245927444.jpg

Seeing this drawdown by clients in an equities-only portfolio leads us to believe Black and Delphi have not done well recently. While other factors may be involved, and there is not much to contradict this assumption, it seems weak performance has drastically lightened his portfolio.

Conclusion

Many hedge funds have done poorly over the past five years, but Black’s fund differs from most other funds because his is long-equity only, and equities have had an outstanding run for nine years now.

Value investors could get some ideas from Black. There is the quantitative screening process, for example. It starts with 15% return on equity, which is a sign of future health; the same holds for revenue and earnings growing faster than inflation. Low debt to equity is a value standard, as is a deeply discounted price.

For value investors who feel the markets are passing them by because they cannot easily invest in other asset classes, Black is a reminder that a long-equities only portfolio can be powerful.

One final note of interest: This is a hedge fund manager who charges no performance fees and has stayed in business for nearly 40 years.

Disclosure: I do not own shares in any of the companies listed, and I do not expect to buy any in the next 72 hours.

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