Seeking out value from the bottom up

Richard Brody, manager of the M&G North American Value fund, answers questions from Adam Lewis.

Richard Brody joined Prudential Portfolio Management America in 1992 and has been the lead fund manager of the Prudential North American Trust since 1994. He is also lead manager of the new M&G North American Value fund. Prior to joining PPM America, Brody was a senior member of the investment team at the Chicago Group of Morgan Stanley Asset Management. Before this he spent seven years at Hewitt Associates, and also worked at the First National Bank of Chicago.

Q: What are the key differences between the new M&G North American Value fund and the Prudential North American fund you also manage?

A: The Prudential fund is a core value fund, whereas the fund we manage for M&G is more of a pure value portfolio. While the Prudential fund has distinct valuation characteristics it is structured to meet certain risk guidelines. These guidelines restrict me to not taking more than a five percentage point plus or minus position in any sector relative to the S&P 500 index. To ensure the Pru fund stays within its risk constraints it has 60% of its assets in a pure value component. The stocks held in the pure value component of the portfolio are all value-orientated companies selected on an active bottom-up basis, based on such things as fundamentals, valuations, management and balance sheet strength. However, to keep within the sector guidelines we have the completion component, which essentially fills in all the gaps.

The M&G fund, however, does not have any sector restrictions on where to invest. As a result it is 100% invested in pure value companies. So it is essentially a replica of the 60% pure value component of the Pru fund.

Q: What returns are you aiming for with the M&G fund?

A: We are looking for returns in excess of 1.5% over both the S&P Value and S&P 500 indices.

Q: How much value is there in the American market?

A: There will always be stocks that are cheaper than the overall market. Our job is to identify which of these are cheaper for valid reasons, versus those that are priced at discounts to the market for invalid reasons. We are most interested in those companies that are cheap for invalid reasons. This occurs when the market overreacts to short-term trends, and it is this which creates value opportunities for long-term investors.

Q: How would you describe your investment philosophy?

A: Our philosophy is based on a view that the price of a stock is determined longer-term by the value of the underlying business. To search out the cheap stocks we have a team of four manager/analysts, each of whom is responsible for covering several sectors of the market. Once they find a cheap company we start the research process. This process involves evaluating a company’s financial strength, competitive position and management team, and trying to identify why the market has placed a discount on it. If we think the reasons for this discount are not valid we become interested in owning it. At any point in time we will follow approximately 100 stocks closely, plus an additional group of companies that are in various stages of the research process. However, any stock we add to the portfolio has to be more attractive than any of the names we already hold.

Q: How many holdings do you have in the portfolio?

A: We hold between 50 and 55 companies in this fund. Having an internal discipline of not holding more than 55 stocks forces us to make decisions to get rid of stocks if we want to bring in new ones. Our aim is to remain fully invested at all times, keeping our cash position at a minimum.

Q: Why did you decide to launch the fund now?

A: The launch was demand-driven, not market timing-driven. At PPM we have been running pure value portfolios for 13 years. A number of clients in the Prudential North American fund said they liked the portfolio but told us they wanted access to just its pure value component.

Q: What is your view of the outlook for the American economy?

A: As we follow a bottom-up stockpicking approach to investing, we don’t base our decisions on macroeconomic forecasts. However, we do have to be aware of economic expectations and what is going on in the market in terms of valuations. As such it is our view that the overall market is reasonably valued. The 16-17x earnings estimate for this year is higher than historical averages but clearly more reasonable than it has been in recent years. As such the earnings and economic environment continues to be positive, and one in which the stockmarket is likely to move with earnings.

Q: How is the portfolio positioned?

A: At the end of May this year the largest two overweight sectors in the fund, compared with the S&P 500, were financials and consumer discretionaries. In financials we were most overweight in banks and insurance companies, while in the consumer discretionaries were mostly exposed to the retail & apparel and the autos sectors. While autos are in a difficult fundamental environment because of competitive pressures, we think the market is taking a too-negative long-term view of the sector. There are stocks that still have a lot of cash on their balance sheets, and if some companies are successful in negotiating their healthcare plans it would be positive for the overall sector.

While the sector overweights and underweights of the M&G fund are much less restricted than the Pru fund, the M&G fund is limited to not being more than 10 percentage points overweight of the S&P Value index. However, it does not have minimum weightings, so at the end of May the fund was 11 percentage points underweight in the technology sector. The second largest underweight of the portfolio is in healthcare. This is because we can’t find the names that meet the value or fundamental criteria we look for in this sector. Medical device companies are very expensive, and while the pharmaceuticals are more reasonably valued, they still aren’t cheap relative to the overall market.

Q: What market capitalisation do you mostly focus on?

A: This is a large-cap value fund. However, if we find value in medium to medium-large companies we will invest in them. The focus is on companies with market caps in excess of $1.5bn (840m), which results in a universe of approximately 1,000 stocks. However, at the end of May, one third of the portfolio was held in stocks with a market cap of above $50bn.

Q: What is the most important lesson you have learned in fund management?

A: That it is important to have a well-defined investment style and stick to it.