Q: What is the history of the company and the fund?

Logan Capital was established in 1993 and currently manages approximately $1.6 billion in assets for predominantly institutional investors. In 2011, Logan and Waterloo International began pairing their respective long and short expertise in order to offer long/short strategies to Logan’s clients. As part of our long/short strategy offerings, we manage a long/short mutual fund called Logan Capital Long/Short Fund (LGNMX), which was launched in September 2012. 

Logan’s most popular strategies have historically been growth-oriented, but we introduced value strategies in 2000 in order to mitigate some of the volatility associated with a long-only growth strategy. So that is what the value component does in the fund: it helps reduce volatility while also potentially enhancing return. We felt that we could further lower volatility and possibly improve returns even more by adding a short component. So we took the Waterloo track record, and layered it on top of the Logan core strategy, and we came to the conclusion by looking at 10 years of data that we could accomplish this goal. 

In 2011, we started a hedge fund based on the strategy, which we ran for 18 months. In 2012, we began offering the strategy using a mutual fund format. As such, the fund offers a solid way for both institutional and individual investors to participate in the market while dampening negative performance in a down market.

Q: How does the fund benefit from its long/short approach to investing?

Maintaining a short allocation is comparable to holding an insurance policy: just because your home hasn’t burned down doesn’t mean you forego insurance. A short portfolio ensures that if the markets turn, we will be able to lower volatility and reduce our drawdown. Hopefully, if we achieve these goals, our investors will be better positioned to weather market turbulence. 

On the long side, the fund has two components: a growth strategy and a value strategy. Growth and value stocks tend to outperform one another at different points in the economic cycle. Therefore, exposure to both can smooth out performance over time.

The growth strategy, or “the offense,” seeks long-term capital appreciation. We use the value strategy to balance the growth; it also provides current income by focusing on high-quality names with solid dividend yields and significant balance sheets to make sure dividends are secure. 

On the short side, being successful requires more than just flipping a long process. The fund uses a specific methodology developed by Waterloo, which previously managed short-biased hedge funds. 

Q: What is your investment philosophy?

The idea behind our fund is that, given that markets historically move higher, we believe the fund should be more long than short. Our fund has the flexibility to increase or decrease equity-market exposure by adjusting its mix of long, short and cash positions. However, unlike some of the other long/short strategies out there, the fund will tend to lean more long, given that the market historically rises 71% of the time.

Shorts can make money even during rising markets, as long as the market is not up too much. We think if an investor wants exposure to the market, but they want to do it in a way that’s a little less aggressive, they can do that by allocating to a long/short strategy where you will participate in the upside of the market because the fund leans long, but because there are short positions and because we do modulate the exposure levels, there is a little more “defense” than a traditional long-only fund.

Q: How do you transform your philosophy into an investment strategy?

On the long side, our process takes advantage of the emotional swings that investors have that can allow either growth or value to dominate returns. To counter this, we maintain a consistent allocation over time of 60% growth /40% value, and we rebalance every six months. 

Within growth, we invest in companies with strong management teams and unique products that clients value and will pay a premium for. These types of companies do well in growing economies, and when times become more challenging, they do not have to excessively discount their prices.

Having differentiated products remains critical today, given the economy’s relatively lethargic pace, coupled with the fact that businesses are frequently subject to significant changes, many of which are technology-driven. 

For the value strategy, we seek to buy companies that produce secure income. A lot of the value team’s effort goes toward making sure companies are earning more in cash than they are paying out in dividends, and evaluating whether their balance sheets and fundamentals are secure. 

Our short selling investment approach involves a disciplined, methodical search for “flawed” companies with timely catalysts. Such flaws may be evidenced by high inventories or accounts receivable, decelerating sales growth, heavy insider selling or deteriorating technical factors. We then carefully scrutinize the quality of earnings of such companies. 

We believe that a key to successful short investing involves not only the successful identification of critical “flaws”, but careful consideration of the time horizon that we think is likely to be required for positions to become profitable. By emphasizing catalysts, we seek to avoid potential short situations that would require extensive holding periods and their attendant increased costs and risks.

Q: What is your research process and how do you look for opportunities?

The foundation of research into value companies we own is a thorough examination of the balance sheet and cash flow. Making sure the income is secure gives us downside protection. 

For a growth name to be added into the portfolio, a company must meet three criteria: it has to be in the right area of the economy, have good quantitative and qualitative fundamental characteristics, and trade strongly on a technical basis. 

Considering what is going on in the world and in the economy is important when looking at growth names. We try to get a sense of where we are in the economic cycle, and then go back and see what types of businesses did well in similar prior periods. 

Over the last several years, the economic recovery has been rather lethargic. Early in the cycle of similar previous economic recoveries, consumer stocks tended to do well. So early on in this cycle, we were predisposed to own solid, well-run consumer discretionary names. 

When companies fitting within our macro-economic predispositions move up in our rankings, we dive deeper into why earnings are growing, to identify those that are increasing earnings through top-line growth, by growing sales and growing their businesses, not just through cost cutting, thus making them sustainable for years to come.

One example is Home Depot Inc. Our work in 2009 showed that the economy was recovering, so from a top-down perspective we were seeing more consumer-oriented names, and Home Depot ranked highly.

The company didn’t have some of the fundamental challenges that others in housing and construction faced. Management had reacted to the difficulties in the industry in a positive way, and saw an opportunity to expand its business to service commercial contractors and builders. We thought this would benefit the company going forward.

When shorting, the research is quite different from buying long stocks—it is almost like game theory. We try to get into the minds of long owners to find near-term catalysts that would make them sell their stock in a time period that is acceptable from a risk-reward perspective. 

Disappointing sales and downward revisions are good indicators of future problems, particularly when a company is also overproducing inventory or allowing accounts receivable to grow disproportionately to sales growth.

On the short side, we prefer simple-to-understand businesses. An example would be Gap Inc. For several quarters, Gap had been reporting decelerating sales and rising inventory. Comparable same stores revenue growth was also consistently trailing analysts’ estimates, yet many Wall Street analysts remained bullish due to the company’s ability to hit earnings targets. 

However our view was that making earnings numbers through perpetual cost cutting and stock buybacks was unsustainable. We also felt that the rising inventory was a potential source of future gross margin disappointment. We further noted that other similar mall-based retailers were also struggling. 

We shorted Gap in the high $20s and covered in the low $20s after investors finally reacted to an announced shortfall in sales and earnings The company later released additional bad news and the stock price declined further, but once we felt that the negatives had become well known, we were less comfortable being short the stock in the low 20s.

Q: How do you construct the portfolio? Does diversification play a role in the process?

On the long side, the portfolio is always 60% growth and 40% value and stays relatively fully invested. We own approximately 40 growth stocks and 12 value stocks. Our systematic, semiannual rebalancing is key to taking advantage of market volatility. 

The benchmark we compare to most regularly is the Morningstar Long/Short, which is a category rather than a benchmark per se. We also look at the Hedge Fund Research Index.

On the growth side, the fund is not benchmark-centric. Our minimum sector allocation is zero, but we are comfortable being up to double the sector weight of the Russell 1000 Growth index (or 20% for smaller sectors). These parameters are wide enough, so we can focus on true growth opportunities, and are not forced to just own something even though it will not give us sufficient earnings growth. 

For value names, our investible universe starts with the 100 largest publicly traded companies. These are narrowed down to companies without too much debt, with relatively low volatility, and with cash flow exceeding what is paid out in a dividend. 

Exposure management is a function of the short positions moving up or down based primarily on our idea generation. Generally, the portfolio has between 10 and 30 short positions, each dollar-weighted in the 1% to 3% range. 

Within the shorts, we diversify primarily within four broad sectors—consumer, healthcare, technology, and retail—and in 20 to 25 subsectors. 

Q: How do you define and manage risk?

We focus on our system and methodology, including a strong appreciation for the necessity of risk controls. That the fund balances growth with value is itself a risk control. Because growth and value stocks tend to outperform one another at different points in the economic cycle, exposure to both can smooth out performance over time. We also believe that a regular program of rebalancing is a an important way to manage risk 

We further believe that by having a short portfolio, we are managing overall portfolio risk. 

We also have risk controls specific to short selling. The portfolio is diversified across 25 industries, which comprise 4 main sectors: Healthcare, Technology, Consumer Products, and Retail. Risk is analyzed from a sector as well as individual stock risk standpoint with developments in the sector monitored and analyzed. Position sizes generally range from 1% to 3% and sector allocations generally do not exceed 35% of the portfolio. 

We define liquidity in an individual position as average daily trading dollar volume of at least $1.0 million, and more typically $2.5 million. In terms of the entire portfolio, we view liquidity as the ability to liquidate with minimal price effect. On average, our losses in an individual short position are limited to approximately 15% maximum. Importantly, we are willing to reduce exposure in companies that we still believe are fundamentally flawed if the alternative would mean greater volatility and/or drawdowns in the portfolio. 

In sum, we are not trying to shoot for the stars, because sometimes when you fly too close to the sun, you can get burned badly. We believe that if you are pretty good most of the time, that will certainly be reflected in your long-term performance. That’s what we try and do.