Inflation solution by this fund that beats the market
The $7.3 billion Undiscovered Managers Behavioral Value Fund (UBVAX) is among the elite minority of diversified US equity funds that have outperformed the broader market so far this year. But chief executive David Potter says inflation is putting formidable obstacles in his way.
“Inflation is going to be more of an issue than the market anticipates,” Potter said.
At the very least, inflation will make it harder for him and his colleague Ryam Lee to find the kind of opportunities they’re looking for, Potter says.
Basically, these are companies that exhibit several traits. First, a lot of insider buying or buying. Second, the undervaluation of the share price. Third, fundamental reasons to expect the business to rebound.
Inflation makes targets rare
But inflation makes it difficult to achieve these goals. “We don’t see a lot of insider buying in the kinds of companies we would want to buy at current market levels given the macro risks,” Potter said.
And he doesn’t expect the challenges posed by inflation to subside for another year or two.
How this fund copes with inflation
Like most equity funds, Undiscover Managers Behavioral Value Fund seeks out stocks in companies ready to grow. But as noted above, this fund looks for different cues – insider buying, redemptions – of future growth than the vast majority of other funds.
“These signals come from inside the company, from the people who know it best,” Potter said. He and Lee are at Fuller & Thaler Asset Management, sub-advisor to JP Morgan Asset Management. “If you get several such insiders buying in large quantities at the same time, that’s usually a good sign. But this sign is often ignored or discounted by the market because insiders and board members tend to make (insider buys and buyouts) at a time when the market does not like the attributes of the company. Or at a time of major risk aversion like (the Covid-19 pandemic) at the start of this year.”
These insider actions are the “behavioral” indices on behalf of the fund. Focusing on equities when many other investors avoid them makes this portfolio strategy contrarian, Potter says.
After identifying potential candidates based on insider buys and buyouts, Potter and Lee perform a fundamental analysis of the stock and its valuation.
Potter and Lee are looking for stocks that are out of favor but with promising prospects. Now, however, inflation poses a hurdle for these undervalued stocks.
In response, Potter and Lee keep their powder dry. Expecting to find fewer names they like in the short term, they are hoarding cash instead.
They built their cash weight up to 7% or 8%, Potter says. Normally it is 2-4%.
Inflation isn’t Potter and Lee’s only concern. They’re also bothered by “signs of investor irrationality, such as interest in meme stocks,” Potter said. He quoted Bed bath and beyond (BBBY) for example. Recently, the stock price is up 265% from its close the previous week. The volume was greater than 800% of his average daily volume. “We’re seeing more foam in the market,” Potter said. “We may remove some riskier names.”
Favorite sectors of the fund
The fund’s top sector weightings as of June 30 were financials at 29%, materials at nearly 16% and industrials at nearly 13%.
Shareholders expect the fund’s financials weighting to remain close to that of its benchmark, Potter said. The Russell 2000 Value Index has a financials weighting of over 28%.
However, the fund has changed its composition within financials. “Our weighting has gone down in banking, which is the risky side of financials,” Potter said. “It has increased in insurance, the less risky side.” Inflation generally hurts banks more than insurers.
Assets in materials
The fund is almost 12 percentage points overweight in materials. The fund bets on defensive stocks, which should be less threatened by inflation than, say, high growth stocks.
Graphic Packaging manufactures cardboard packaging products. Berry Global (BERY) manufactures plastic consumer packaging. Silgan Holdings (SLGN) manufactures containers for the food industry. “Many companies in the packaging subsector are in slow-growing, but still growing, end markets,” Potter said. “They’re in very defensive end markets. Plus, they’re riding the tailwind of environmental sustainability. Whether it’s packaging cartons for grocery cartons or aluminum beverage cans, they’re highly recyclable. These have worked well for us. And in a potential downturn, they do well as defensive holdings, given their end markets.”
In line with his bogey
The fund’s industry weighting is roughly in line with its bogey weighting. “We’re maybe 1% to 2% underweight,” Potter said.
Another space the fund has increased its weighting in is “defensive, non-cyclical areas like healthcare REITs (and) medical office REITs,” Potter said. “We are also up in utilities. We have increased exposure to Steady Eddie insurers.”
The behavioral value of uncovered managers reduced exposure to hotel REITs, home builders and building products, Potter says.
Welcome mat for long-term investors
Who is this fund for? It’s “for long-term investors who can stick with us in a downturn,” Potter said. “A contrarian fund is not for everyone. It would not appeal to investors who want a momentum-oriented fund. If an investor is looking for a fund that goes up and up and is more of a secular growth type , like megacap (space) technology from 2012 to 2020, it’s not us.”
This year, from Thursday, the fund was down 0.35% against a 10.85% decline for the S&P 500, a 6.16% decline in the Russell 2000 Value Index and a 6. % on average by small cap value funds tracked by Morningstar Direct. .
Over the past 10 years, the fund’s average annual return was 12.18% compared to 13.79% for the S&P 500, 10.35% for the Russell 2000 Value and 9.9% for its peer group.
The “undiscovered managers” portion of the fund name reflects the name of the fund’s original parent company. This does not denote the fund’s current strategy or management, says Fuller & Thaler partner Ed Stubbins.
Follow Paul Katzeff on Twitter at @IBD_PKatzeff for advice on retirement planning and actively managing consistently outperforming portfolios.
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