Big-Game Value Hunters


Team-managed Northern Large-Cap Value Fund (NOLVX) is run with a conservative investment philosophy and a relatively long-term horizon. It seeks undervalued stocks of mid- to large-cap companies that pay a minimum dividend yield of 2%.

The fund's $1.04 billion in assets are distributed among 49 holdings -- none higher than 2.5% of total assets at present -- in nine sectors. Financials and industrials make up the largest weightings -- 21.9% and 17.7%, respectively.

For the three years ended Nov. 30, the fund returned 6.8% on an annualized basis, vs. a 4.9% gain for its large-cap value peers, and 5.8% for its benchmark, the BARRA Value Index. The results were achieved with slightly less volatility, earning the portfolio a 4-Star fund ranking from Standard & Poor's. The fund's average price-to-earnings ratio as of Nov. 30 slightly exceeded its peers (17.2 vs. 16.9). Expenses on the portfolio are moderate at 1.10%, vs. 1.33% for its peers.

In the past year, the fund has seen a change in personnel, with the departure of three of its nine team members, including its two lead co-managers and a third manager. It's now run by three new co-managers: Stephen Kent and Betsy Turner, since February, 2004, and Stephen Atkins, as of Oct. 1. Five additional portfolio managers have input, completing the team.

The fund was established in August, 2000, by Chicago-based Northern Trust, shortly after it purchased Carl Domino Associates, the fund's predecessor firm based in West Palm Beach. Kent joined Domino in 1992, Turner in 1993, and Atkins in 1998.

Carol Wood of Standard & Poor's Fund Advisor spoke recently with Atkins about the fund's investing strategy and top holdings. Bill Belden, product manager at Northern Funds, also participated in this interview. Here are edited excerpts of their conversation:

Q: How would you describe your investment philosophy?

Atkins: We're a traditional large-cap value fund. We look for high-quality, mature, blue-chip companies trading below their intrinsic value that pay at least a 2% dividend.

Our traditional large-cap value philosophy differentiates us from deep-value funds, which might buy distressed names hoping they'll turn around, and relative-value funds, which I see as value funds that don't want to be contrarian. But I think any value manager has to be somewhat contrarian.

Q: What kinds of stocks do you hold?

Atkins: Our portfolio holds recognizable names that have been around for years. We hold onto stocks for three to five years, because we think you've got to wait for the story to turn around. The portfolio tends to underperform in fast-rising bull markets, but to outperform in down and flat markets.

Q: What's your investment strategy on the fund?

Atkins: Eight portfolio managers sit on our investment strategy committee, which meets every Friday. Any portfolio manager can present new ideas and have input into the product.

Each stock in the portfolio is covered by one of our managers, who communicates information to the rest of us. We're generalists. We want to understand a variety of industries. For instance, I cover names in health care, energy, and financial services.

Our industry analysis is completely bottom up. We talk to the Street to get analysts' opinions, but because we're contrarian, we often want to go against what the Street thinks.

Q: What is your benchmark?

Atkins: The BARRA Value [index] is our primary benchmark, and our main objective is to outperform it. We're starting to integrate the Russell 1000 Value index into our framework, and we strive to outperform the S&P 500 over a full market cycle.

We don't mind being 50% underweighted, or 200% overweighted in a sector relative to the BARRA, if that's where the value is.

Q: Will the fund's recent management changes affect its operations?

Atkins: I expect things to remain the same, because we manage accounts on a team basis. We have a fairly simple process and defined rules that make the process repeatable and predictable over time.

Q: What are your buy criteria for stocks?

Atkins: Most importantly, a stock must have at least a 2% dividend yield. Liquidity is the second criterion -- it must have 500,000 [traded shares] minimum daily volume.

A stock must also be in the mid-cap space or larger. Generally our stocks are large-cap -- $12 billion and up -- or high mid-cap. We're more flexible regarding market cap than liquidity. But for us to buy something with a $2 billion market cap, it would have to be a very compelling story.

Our three screens reduce our universe to about 150 to 250 names, from which we select 45 to 50 stocks for our portfolio. We buy only stocks traded in the U.S. We'll look at ADRs [American depositary receipts], but won't buy anything traded exclusively on a foreign exchange.

Belden: We want to own 75% large-cap stocks weighted over time, relative to Lipper's definition.

Atkins: Our qualitative criteria include catalysts for value or appreciation -- a story that will eventually be recognized by the market and drive stock-price appreciation.

Q: What are your sell criteria?

Atkins: If a stock yields less than a 1% dividend, with no prospect for an increase, or if it declines 30% from our average cost, we will exit by end of quarter. That protects our downside. One reason we say we'll exit by the end of the quarter is to let the selling pressure abate.

Fundamental deterioration in a company's financial strength would precipitate a sale. We call this qualitative because there's no rule associated with it. But simply finding better names makes up the bulk of our sell decisions.

Q: Are there any areas or sectors that you avoid?

Atkins: We've typically stayed away from utilities because they're highly regulated, offering limited return on capital and more difficult to value.

Q: How do you manage risk in the portfolio?

Belden: Risk management is inherent in the portfolio construction and stock selection process.

Atkins: We set stock weightings at 5% maximum, although we start trimming anything over 3.5%. Most individual stock weightings are anywhere between 1% and 3.5%.

We won't have more than a 20% weighting in any particular industry, but don't have a sector constraint.

Q: Could you mention one or two holdings and tell me how they reflect your investment style?

Atkins: We recently added Bristol-Myers Squibb (BMY). It's a very liquid large-cap stock in a sector that's out of favor, trading at about 13 times earnings. They've got some new drugs that should be coming to market within two to three years, when we think it will be well positioned. With a 4% dividend yield, you're getting paid to wait.

Another recent addition is SBC Communications (SBC). It's got a 5% dividend yield, trades at only about 17 times earnings, and is pretty cheap on the book value as well. We expect telephone companies to come out ahead in the long-term battle between telephone and cable, because they are financially much stronger.

Q: Year-to-date as of Oct. 29, the fund's return, 3.84%, was slightly below its peers' 4.30%, after outperforming them on both the one- and three-year periods. What accounts for this downturn, and what are the chances that it will turn around?

Atkins: The bulk of that underperformance was because of Merck (MRK) and Marsh & McLennan (MMC), both of which declined substantially at the same time. We've sold those stocks and added Bristol Meyers and SBC. I think we've already started to turn around.

Q: Do you have an outlook for the market and for your asset class?

Atkins: We're predicting average market returns in the high single digits over two to three years, as higher interest rates and inflation, the budget deficit, and a lower dollar, provide a headwind for the U.S. economy and stocks in general. In that environment, our style, which emphasizes dividend yield as a component of total returns, will be attractive. From Standard & Poor's Fund Advisor


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