Lasting value

From a small base in 2001, value managers at Hotchkis & Wiley have delivered top-tier returns and grown assets beyond their wildest expectations. Can they keep it up?

Soft-spoken and self-effacing, George Davis Jr., CEO of Los Angelesbased Hotchkis & Wiley Capital Management, doesn’t exude the brash confidence that usually comes from trouncing the competition. Rather than loudly proclaiming his recent run of success, the Little Rock, Arkansas, native has been calmly cautioning clients that his firm’s hot streak is bound to end.

“Clients need to understand what they have hired us to do,” says Davis, 45. “We’re not a company that’s always going to shoot the lights out.”

True, but the value equity manager has done a pretty fair imitation of a Wild West gunslinger. Over the past five years, Hotchkis & Wiley has grown at a blistering pace, thanks to its outstanding performance as a stock picker. Assets under management, all invested in U.S. value equities, have soared from $4.2 billion in mid-2001 to more than $32 billion. In its five strategies -- core, large-cap, midcap, small-cap and all-cap value -- the firm has ranked at or near the top of its peer group for the past five years.

It’s an extraordinary performance for a firm that was badly bruised and splintered after a 2001 management buyout from Merrill Lynch & Co. But Davis is wise to be restrained. Stock market investors cycle back and forth between a fondness for value and for growth; Davis knows only too well that the recent stretch during which value stocks have outperformed growth must eventually come to an end.

“We’ve had the wind at our back for the past four years from a market that favored value investing,” Davis says. “But now we’re creating expectations that that wind is no longer there.”

Davis is also grappling with thorny strategic issues. Early in his tenure as CEO, he decided to expand H&W’s minuscule retail presence. He succeeded -- mutual funds account for 39 percent of total assets, up from just 4 percent in 2001 -- but at a price: Retail flows are more volatile than their institutional counterparts, and distribution is considerably more expensive. To prepare for the inevitable fade of value stocks, Davis has closed nine of H&W’s ten funds to new investors, leaving only one institutional portfolio open. The idea is to restrain asset growth and protect the firm’s track record. Davis and his colleagues are debating whether to diversify into international equity and fixed income, businesses they ran under Merrill. Whether H&W moves into new asset classes or stays put, Davis is determined to keep his firm petite in a world increasingly dominated by fund management giants.

“We’re definitely still a boutique, and we don’t want that to change,” he says. “We feel it’s the right thing to put the brakes on and make sure we can continue to perform. We don’t want to dramatically change the way we invest.”

Why would he? By any measure, his firm’s investment performance has been exceptional. “Since the bubble burst and value stocks took off, H&W has been almost untouchable,” says Andrew Gogerty, an analyst at Morningstar Associates. Remarkably, despite its dramatic growth in assets, the firm employs the same number of investment professionals that it had in 2001 when Davis took charge: 14.

H&W follows a relative-value strategy, focusing on projections of a company’s long-term earnings. Its portfolio managers tend to make concentrated bets in their top ten holdings. Over the three years ended March 13, the firm’s flagship $5.8 billion Large Cap Fundamental Value fund returned an average annual 27.64 percent, compared with 22.23 percent for the Russell 1000 value index; it ranked in the second percentile among large-cap value funds, according to Morningstar. In the 12 months ended March 13, however, limited exposure to energy stocks caused the fund to underperform the Russell 1000, returning 10.05 percent, versus 10.63 percent for the benchmark, putting the fund in the 32nd percentile.

When they bought the firm in 2001, reportedly paying about $42 million, Davis and his eight partners reckoned that assets under management might grow from $4.2 billion to perhaps $15 billion in five years. No one imagined amassing more than $30 billion. Davis won’t reveal H&W’s profit margin, but Rachel Bernard, who covers asset manager stocks for Morningstar, figures that the firm’s operating margin is somewhere between 35 and 40 percent. Boston Consulting Group, tracking large global money managers with assets of more than $120 billion, estimates average operating margins at 39 percent. If H&W were sold today, it might fetch $800 million.

“We’ve grown much faster than we anticipated,” Davis says. “But this is a marathon, and we aim to go the distance.”

HOTCHKIS & WILEY TRACES ITS LINEAGE TO OLD money. Co-founder John Hotchkis is a descendant of California’s Bixby clan, whose fortune dates to the latter half of the 19th century, when the family purchased sprawling ranches near what is now Long Beach, California.

Hotchkis was schooled in value investing in the late 1950s, when he studied under the renowned Benjamin Graham at the University of California, Los Angeles. In 1980, while working as a high-net-worth money manager at Everett Harris & Co., a Los Angeles investment firm, he got to know George Wiley, a pension consultant at Callan Associates who had served as a fighter pilot in World War II. Both were eager to set out on their own.

The two men launched their business with $8 million in capital, a respectable but hardly magnificent sum at the time. Within a few years Hotchkis & Wiley, which managed fixed income and equities, had reeled in several big pension accounts. Performance was strong, and the firm steadily grew, building assets to about $1.5 billion by the end of 1987.

Davis arrived in the summer of 1988. After graduating from Stanford University in 1983 with a BA in history and economics, he worked for two years as an assistant to well-regarded money manager Claude Rosenberg at RCM Capital Management, a San Francisco growth-stock firm. “Claude was a great manager, a mentor and a friend,” says Davis, who had returned to Stanford and gotten his MBA shortly before he came to H&W.

In the fall of 1987, Stanford professor John McDonald had introduced Davis to Hotchkis, who coaxed the young man into moving to Los Angeles to work at his firm as a portfolio manager focused on paper and forest product companies. In mid-1995, Hotchkis, then 64, and Wiley, then 72, turned over a minority equity stake to four new partners: Davis and three of his fellow value portfolio managers.

Then the roof caved in. In 1996 the founding partners agreed to sell to Merrill Lynch, over the bitter opposition of many of their colleagues. Merrill agreed to pay $80 million up front and an additional $120 million over the next five to seven years if assets and revenues hit certain targets.

But a few months later, H&W’s four-person fixed-income team bolted to set up Metropolitan West Asset Management, taking two thirds of the firm’s $2 billion in bond assets with them. (Total assets in 1996: $10.1 billion.) Then, as the stock market bubble inflated, value stocks were pummeled, and H&W’s performance began to flail.

By this time, Merrill executives had become distracted by their grand ambition to make their firm a leading global asset manager. In 1997, Merrill paid an extravagant $5.3 billion for Mercury Asset Management Group, a U.K. fund manager with $180 billion in assets. Within months Mercury lost a string of clients, causing Merrill executives to focus even more on their ailing U.K. operation.

Left adrift, H&W endured several years of subpar performance and client losses. In 2001, Merrill agreed to sell the business to Stilwell Financial, the parent of Janus Capital Corp. (No longer known as Hotchkis & Wiley, the firm had become a division of Merrill Lynch Investment Managers.) But on June 8, just two days before the deal was to close, portfolio managers Harry Hartford and Sarah Ketterer, a daughter of John Hotchkis, left to set up their own firm, Causeway Capital Management. The Stilwell deal blew up. By the end of 2001, Hartford and Ketterer would snare roughly $1.2 billion in international equity accounts from their former colleagues -- roughly 16 percent of the firm’s total assets.

As the once-glittering money management boutique lay in tatters, Davis moved fast.

First, he resolved to make a break from Merrill. Although Merrill wanted out, it didn’t want to simply walk away. “It became apparent that the best solution was for us to separate from Merrill,” says Davis. “Then the challenge became to make sure that if we were going to finance this transaction, that we had a strong partner and that all the people in the firm were willing to make a commitment.”

A determined Davis retreated to his family’s cabin, 30 miles west of Bozeman, Montana. One by one, he phoned the other eight principals in the firm. He wanted his colleagues to commit to stay for at least five years; he needed them to borrow money -- in some cases, multiples of their net worth -- so they could together purchase a majority stake in the firm. “I got a resounding and positive response from each and every person,” he says. “I felt invigorated.”

Davis spoke with many private equity firms, but he had a personal connection to one: Stephens, a Little Rock asset manager and investment bank owned by the Stephens clan. Davis’s father worked at Stephens as an investment banker; his brother is an executive vice president in charge of institutional equity sales. “People at the Stephens Group have known me all my life,” says Davis. When the deal closed in October 2001, Stephens took a 41 percent stake (which it still owns) and loaned the nine principals millions of dollars to give them control of H&W. (Stephens executives declined to comment for this article.)

In its separation agreement with H&W, Merrill is believed to have received $42 million -- 1 percent of total assets of $4.2 billion, far less than the $80 million it had paid for the firm.

Davis signed on as CEO in October 2001, and his timing couldn’t have been better. He and his colleagues were just breaking out their new business cards when the U.S. stock market entered an unusual period in which value would dramatically outperform growth. Between 2000 and 2005 the Russell 1000 value index returned an annualized 5.57 percent, compared with a negative 7.02 percent for the Russell 1000 growth index. Value had an extended advantage over growth in the 1980s, but relative outperformance was only about half as much.

Playing in the market’s sweet spot, Davis decided to ramp up his firm’s retail presence. H&W had sold mutual fund versions of a few of its institutional portfolios as far back as 1985; now Davis expanded the retail lineup. In 2001 the new CEO hired Bob Dochterman, a former regional sales manager for Mercury Funds, a division of Merrill Lynch Investment Managers, to lead a sales and marketing team. Pushing retail was a reasonable strategy, and a risky one, as retail assets are typically more volatile than their institutional counterparts.

But it worked. In 2002 the firm rolled out retail and institutional versions of a new portfolio, the All Cap Value Fund; at the end of February 2006, its retail assets totaled $255 million. In 2004, Davis launched a retail-only portfolio, the Core Value Fund, which had assets of $1.3 billion at the end of February. H&W retail funds, which offer class-A shares with front-end loads to compensate brokers, have been sold on all the major wire house platforms.

In the mutual fund business, financial advisers and individual investors famously rush into top-performing funds. Once H&W funds appeared at the top of Morningstar rankings, they became hot properties. Mutual fund assets swelled from just 4 percent of the total in 2001 to 16 percent at the end of 2003 and 39 percent at the end of 2005.

Davis was also determined to grow H&W’s subadvising business. The firm had only a modest presence there, dating back to 1982, when it won a mandate from American Beacon Advisors, the manager of American Airlines’ pension fund. Davis’s biggest coup: In December 2003 he won H&W a place on the roster as one of the five money managers of Vanguard Group’s Windsor II Fund. The firm now manages about $2.2 billion, or 5 percent of the assets in the Vanguard fund.

H&W’s investment professionals -- 11 portfolio managers, two equity analysts and a head of research -- focus on companies’ long-term earnings power. “Our basic conceit is that the market takes a short-term view and often undervalues companies,” says David Green, an H&W portfolio manager since 1997. “By taking a long-term, five-year view, we can take advantage of this.”

“All value managers are looking at the same universe of stocks,” says Michael Rosen, CIO of Angeles Investment Advisors, an investment consulting firm based in Santa Monica, California. “Hotchkis & Wiley has almost a religious commitment to the process, and that’s been more important than the process itself.”

The firm’s research-intensive investment approach centers on the concept of normalized earnings -- in essence, a company’s ability to generate an average long-term return on its equity based on the cost of capital. H&W typically invests in companies that are currently underearning -- earning less than their cost of capital suggests they should be -- but have promising prospects.

“It’s not a sustainable situation for a company to be generating below-market returns on equity,” says Sheldon Lieberman, the portfolio manager in charge of the firm’s large-cap funds. “Either management will take corrective action, such as taking free cash flow and investing in higher-return-on-equity businesses, or they’ll get replaced. Over time, return on equity will revert upward, and the market will recognize that fact and bid up the stock.”

Although the number of companies in H&W’s portfolios -- generally between 40 to 60 -- is typical for value investors, the firm keeps an especially large share of its total assets in its top ten holdings. Typically, they represent 35 to 40 percent of fund assets. “When a money manager concentrates his bets, it increases risk but shows conviction,” says David Bauer, an asset management industry consultant with Casey, Quirk & Associates in Darien, Connecticut.

“Making concentrated bets is important because it proves they really believe what they say,” says Bill Puckett, CIO of the Teachers’ Retirement System of Oklahoma, which has invested with H&W since 1990. Puckett’s fund currently has about $660 million in H&W’s Large Cap Value Fund and about $330 million in its Mid Cap Value Fund.

As a relative-value manager, H&W looks for growing companies whose stocks are less risky than the overall market. The firm’s large-cap fund has a 2.05 Sharpe ratio, a measure of risk-adjusted performance in which risk decreases as the ratio rises. The Sharpe ratio of the Vanguard large-cap value index is lower, at 1.86.

The fast-growing company at the top of H&W’s stock roster is Electronic Data Systems Corp., an information technology service provider that has pulled off a successful turnaround. H&W’s single-biggest holding, 5.2 percent of total fund family assets, EDS stock gained 34 percent in the 12 months through mid-March. The Standard & Poor’s 500 index rose 9 percent during the same period.

H&W is also making a big bet on homebuilders, even though many investors have recently dumped the stocks. The firm believes the industry is slowing down, but at a manageable pace. At the end of February, H&W had concentrated its investments in two of the industry’s biggest players, Lennar Corp. and Centex Corp. Though Lennar traded in late March at $59, down from its 52-week high of $68, and Centex traded at $62, down from its 52-week high of $79.66, H&W fund managers are still well ahead on the stocks. They initially bought the two stocks in the first half of 2002, paying prices in the low $20s; in mid-2004 they added to their positions, paying in the low $40s for Lennar and in the mid-$40s for Centex. They remain bullish, arguing that as interest rates rise, bigger homebuilders will enjoy huge advantages in the cost of capital and purchasing power.

Still, bargains in value equities are increasingly scarce as the gap between value and growth multiples has compressed. At the end of February, the average projected price-earnings ratio of H&W’s Large Cap Value Fund portfolio was 12.7, not much below the 13.7 ratio of the S&P 500. At the end of 2001, the fund’s P/E ratio was 15.2, versus 20.2 for the S&P 500.

Might Davis diversify his asset base beyond value equity? If he does, he risks losing the edge -- the focus -- that many think is essential for a small or midsize firm to prevail. But he’s thinking about shifting into fixed income or international equities and hopes to reach a consensus on this critical subject with his partners by the end of the year.

“Any major strategic moves will be well out in the future,” Davis emphasizes. “We’re not going to do anything that distracts us from our core strengths and managing $32 billion of equity assets.”

Related