Batterymarch puts its faith in us large-caps

Q: It was recently announced that you are to run an American large-cap fund for Legg Mason Investments’ offshore fund range. What can investors expect from this fund?

A: The fund will be run off Batterymarch’s computer-driven proprietary quantitative stock selection research process. What we are offering is a low-volatility fund that can add value in both rising and falling market conditions. In 1991 we launched a large-cap strategy in America and so far it has done exactly that.

Q: How would you describe your investment approach?

A: I arrived at Batterymarch in 1984 and prior to that the approach was deep-value, contrarian-orientated. We launched our US-based large-cap strategy in 1991 to be more core in its nature. As a result, the process is entirely based around bottom-up stock selection. We do not make any decisions based on our views of macroeconomics.

It is our belief that you need to have a disciplined investment process if you want to add value. To achieve this you need to adopt a rigorous stock selection process, efficient trading and keep a sharp eye on the risk control. To be successful in today’s market place you have to get these three areas right. However, some 80-90% of all the value added comes from stock selection.

Q: How does your stock selection process work?

A: We were one of the first managers to use computers as part of the investment process, starting in the mid 1970s. However, since 1990 a number of changes have been made to refine the stock selection process. It is now built on what we call “modelling smart investor behaviour”. All the stocks the model looks at are broken down into six major dimensions: cashflow, earnings growth, value, expectations, technical aspects and corporate signals. Within these various dimensions it then looks at a number of other factors. For example, when assessing a company’s cashflow the model uses different matrixes for different stocks. This is because there is not one single measure of cashflow that works for all the companies within the S&P 500.

On a daily basis the model analyses some 3,000 American companies, all of which are ranked. The analysis is conducted on a sector-neutral basis, so we are ranking like-for-like stocks.

Q: How do you then build the portfolio?

A: After we have ranked all the stocks we look to invest in some 180 to 200 names. However, for diversification purposes the fund will always be invested in the 20 economic sectors contained within the S&P 500. This means that initially the portfolio’s sector exposure must be equal to that of the S&P 500. As our ideas mature, the different sectors will become either bigger or smaller parts of the fund depending on how successful they are.

Q: How do you approach risk?

A: We follow a target tracking error of 2-4%. We will always hold the largest 100 compnaies in the S&P 500, which we then over and underweight based on thr quantitiative research. In addition, our exposure to the 20 different sectors in the S&P 500 generally fall within plus or minus 3% of their weights in the benchmark.

Q: In which sectors are you currently most overweight?

A: Our largest overweight sector relative to the benchmark is the energy sector. The current high price of oil means energy stocks have the ability to generate more cashflow in the future. The portfolio is also positioned to take advantage of the current high demand for materials, so we are also overweight in the materials, industrials and other cyclical sectors. While there is some concern about how much longer the strength of the actual sectors can last, we remain overweight in them because we favour the underlying stocks relative to their peers.

Q: Where are you underweight?

A: We are underweight in the two biggest sectors in the S&P 500, banks and healthcare, and the fund has a neutral exposure to the technology sector.

Q: How high is the turnover on the fund, and what is your typical investing time horizon?

A: We trade in the market on a daily basis. The time horizon for our investment model is six to nine months.

Q: Are you optimistic about the current outlook for American equities?

A: We are positive about the US market going forward. We think it could surprise on the upside in the second half of this year. The small-cap sector has outperformed large-caps for the past six years and we think the market will now rotate back to the larger companies. Not only are the valuations of the two now converging, but investors are increasingly looking for bigger, more stable stocks that have strong fundamentals behind them and can generate cashflow. Indeed, looking ahead we think the market will reward fundamentals more and more.

Q: Should investors be looking just at American large-caps then?

A: No. Investors should have exposure to all areas of the market. We manage assets across all market-cap ranges of the American equity market. However, as US large-caps are an important area, this fund should be used as part of a client’s overall asset allocation.

Q: How is Batterymarch related to Legg Mason?

A: Like Legg Mason Investments, we are a wholly owned subsidiary of Baltimore-based Legg Mason. The fund we are launching next month is similar to mandates we already run for our North American investors, and it will go into Legg Mason Investments’ proprietary offshore fund range.

Q: How sustainable is the US current account deficit?

A: We don’t spend any time debating this subject. Our process is all about stock selection and trying to offer a more attractive return than that available from our benchmark, so we tend to ignore market sentiment and cycles.

Q: What is the most important lesson you have learned in managing funds?

A: Despite short-term volatility, it is the underlying fundamentals that drive the market over time. I have learned it is important to have a portfolio that is based on the fundamentals, not just the themes of the day.

Bill Elcock is chief executive of Batterymarch Financial Management, a wholly owned subsidiary of Legg Mason in America. Before taking up the position in 2002 he was deputy chief executive. Elcock joined Batterymarch in 1984 as an assistant portfolio manager and later became a portfolio manager. He began his career at the Bank of New England. He has a degree from the University of New Hampshire and an MBA from Suffolk University in Boston, USA.