As interest rates rise and the investment climate radically changes, many active funds whose investment objectives are managing risk over the long term may begin to look appealing to investors, particularly if the roaring market starts to lose steam. These funds, because of their long-term approach to investing, in part, follow the strategy for defensive investors enumerated by Benjamin Graham in his book "The Intelligent Investor."
These defensive-oriented funds are exceptionally adroit at managing risk and finding cheap stocks overlooked or disfavored by the market in downturns or periods of momentary market turbulence. The reason the 15-year period is a more meaningful measure of performance, particularly for the defensive investor, is best explained by paraphrasing Graham himself.Ă‚
The fact that a stock may decline in price, as Graham noted, doesn’t necessarily make it a “risky” investment, as it is bound to increase again under more favorable conditions. A stock shouldn’t be characterized as “risky merely because of the element of price fluctuation. But such risk is present if there is danger that the price may prove to have been clearly too high by intrinsic value standards — even if any subsequent severe market decline may be recouped may years later.” [1]
Each of the following actively managed risk funds, to some degree, subscribe to Graham’s prudent and timeless investment principles.
These active funds have been able to navigate through market downturns as well as the recent bull market. The defensive posture of these funds stems from the belief that in adverse market conditions, the objective should be losing less than other investors, particularly passive funds. For the reasons noted above, value investing has, to some extent, been out of favor during the long-running bull market.
The AMG Yacktman Fund (Trades, Portfolio) avoids picking stocks, despite their popularity, that have inordinately high valuations. This guiding parameter has helped the large-cap active fund generate an overall 9.2% return over the past 15 years. Because of market volatility that was rampant since last October, the fund held 28% in cash.
Now that many stocks have been battered, the fund is looking at some companies, such as Samsung Electronics (XKRX:005930, Financial), which lost its once prominent position as the Chinese consumer’s handset of choice. The market has punished the stock and it now looks attractive given its current valuation in light of its existing diverse array of businesses as well as its established large-cap status.
The remaining part of the portfolio is comprised of stable companies, including select consumer staple companies that have products with a dominant market presence and a business strategy to restructure their offerings to adopt to changing consumer preferences. Stocks that fit the bill for the fund include PepsiCo (PEP, Financial) as well as Procter & Gamble (PG, Financial), which sold its battery business as part of its restructuring strategy to ensure continued earnings growth.
Another active fund that has weathered difficult market cycles is Parnassus Core Equity. The investment objectives of the fund are based on environmental, sustainable and corporate governance criteria. Parnassus has beaten 98% of its peers for the past 15 years, with an enviable average return of 9.2%, and tops the large-blend active category for the past year. The fund avoids high valuations, which is why it cut back on its tech sector holdings last year.
Fund manager Todd Ahlsten prefers strong, stable companies that have demonstrated product innovation as well as recurring sources of revenue that can weather economic downturns while allowing the company to continue to grow. He favors 3M (MMM) for its strong balance sheet, which will not diminish in light of potential imminent risks that could threaten the overall large-cap market.
The fund recently acquired a position in Nvidia (NVDA, Financial), the video card and chip manufacturer. Nvidia’s earnings have dropped significantly recently due to a slowdown in its chip sales to cloud computing services companies. The stock has been unmercifully pummeled on the bad news, dropping 50% last year. At its current bargain price, Nvidia is a company that meets Ahlsten’s fundamental criteria as it has a strong balance sheet and still has great long-term growth potential in the gaming and data center markets. At its current depressed price, the stock is selling well below its intrinsic value. The fund’s purchase of a severely depressed Nvidia was made with the view that it will amply pay off in 15 years.
Neuberger Berman Genesis is another active fund whose objectives of value investing for the long-haul mirror those of Parnassus. Fund manager Judith Vale looks for small-cap companies that have shown consistent free cash flow and have steady revenue sources and robust balance sheets. The fund has logged a 9.5% average annual return over the past 15 years, besting 85% of its small-cap growth peers.
The fund achieved its enviable returns by losing less than other active funds in downturns and maintaining positions is strong companies that have weathered adverse market conditions. Neuberger’s top holding is Aspen Technology (AZPN, Financial), a software company that provides systems for chemical companies and refineries to run their plants more efficiently and effectively.
Aspen’s contracts are usually for a five to six-year period, with built-in price increases. The long-term prospects for software companies are excellent as more large companies begin to shift their in-house legacy systems to the cloud. Even non-cloud provider software companies are poised well, as software is the necessary grease that runs all hardware systems and enables the creation and modification of databases to meet the specific needs of corporations.
Vale is also is also taking advantage of the long period of zero-interest rates that have helped prop up weak companies with excessive debt. She is looking to add to the portfolio strong small-cap companies with clean balance sheets and sufficient free cash flow to purchase their own shares at depressed prices as well as acquire other companies.
Should an economic downturn occur, and interest rates rise, companies with strong financials will be well poised to purchase other companies who have floating rate debt or unfavorable debt to equity ratios.
[1]Benjamin Graham, "The Intelligent Investor." Revised Edition, pp, 121-122.
Disclosure: I have no positions in any of the securities referenced in this article.
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