It is several decades since the ‘lords of creation’, in the words of author Frederick Lewis Allen, presided at the corner of Broad and Wall. Today’s House of Morgan, which left that venerable HQ in 1989 for a modern skyscraper further down Wall Street, bears little resemblance to the institution that hosted the likes of Astor, Guggenheim and du Pont; stopped stock exchange panics; and saved the gold standard.
These days, Morgan is a dynamic, modern institution with teams of specialists stationed around the world. But at JP Morgan Investment, which manages $197 bn of funds, managing director and chief investment officer Thomas Luddy is keenly aware of the firm’s heritage as trusted advisor and keeper of capital. Luddy’s analysts and portfolio managers tackle their job as stakeholders in companies with all the assiduity of Pierpont Morgan delving into US Steel, General Motors and AT&T.
‘Size gives Morgan the advantage of being able to afford the investor insight, technology and communications infrastructure that go along with being a global investor,’ Luddy comments. ‘These are all critical elements in maximising information and, ultimately, increasing performance. With our global reach and deep commitment of resources, we have significantly better information than the competition,’ he claims.
Steering this information superstructure is no mean feat. With some $151 bn under management for employee benefit funds, corporations, insurance companies, mutual funds, government agencies and non-profit institutions, along with private client assets worth over $46 bn, Morgan is one of only two firms to have been ranked among America’s ten largest money managers for 21 years straight. Currently, a family of 161 mutual funds totalling $27 bn is the fastest growing segment of JP Morgan’s fund management business.
Managing this sprawling breadth of capital are over 400 analysts, researchers, portfolio managers and traders stationed in New York, London, Tokyo, Melbourne, Frankfurt and Singapore. Around 40 per cent of the firm’s assets are from non-US sources; a third are invested outside America’s borders.
Luddy emphasises that Morgan has no ‘star system’; the firm’s specialists work together as a team. ‘Teamwork is critical,’ he affirms. ‘As the firm gets larger, each individual has to contribute to the common objective. If we’re not working as a team, we’re not taking advantage of our size and the capabilities it gives us.’ Morgan’s 85 equity analysts worldwide form one of the largest research staffs in the industry and one of the most experienced, with an average of eleven years in the role. Research is not just a training ground, but a career track in itself.
Luddy himself is a 20-year Morgan veteran who first entered the ranks as equity research analyst. He next became an equity portfolio manager, then head of the US equity research group in 1984. He was named CIO in 1994, when the post was first made a distinct role at Morgan. At the same time, a Global Investment Committee (GIC) was formed to oversee the overall strategy.
‘We want our local investment operations around the world to have the same organisational imprint,’ Luddy explains. ‘If a client in London or Tokyo walks into our office, he should feel the same underlying Morgan philosophies. Still, we are very much a decentralised decision-making organisation, and the GIC is not making investment decisions. Its purpose is to set our strategic direction for investing in our own capabilities, as well as to oversee the decision processes being used around our network of funds.’
The GIC is made up of six functional heads of different businesses along with Luddy, acting as ‘keepers of the philosophy’ on a global basis. For instance, Gerd Woort-Menker, London-based global functional head of research, works with other research heads around the world to make sure disciplines are the same across the board.
Luddy says the GIC is ‘living, breathing and focusing on the success of the investment process and all the aspects that go with that.’ He describes the framework that encompasses Morgan’s worldwide investment decision-making in terms of three elements: establishing a proprietary information advantage, capturing the information in valuation models, and finally, constructing disciplined portfolios according to client needs.
The first step of culling information is accomplished by over 110 company and economic analysts worldwide. Each of Morgan’s six regional offices houses sector specific analysts, a system which Luddy says combines local insight with a global perspective. For example, six copper analysts visit companies in their regions, but work together to construct a global supply-and-demand model which is critical to forecasting a copper company’s earnings, wherever it is.
Another important link is the macro-research effort, which Luddy heads up. This group concentrates on country and asset-class allocation, looking at central banks, government policy, socio-economic issues and corporate profitability. It forecasts variables that determine the valuation of asset classes and countries.
‘Once we have that information, we need a language to capture it,’ Luddy says. ‘We spend a lot of time developing fundamental valuation formats to be used by analysts and portfolio managers alike. All the decentralised information generated from researchers worldwide is put through a valuation framework, which then serves as the backbone of investment decision-making.’
For equity valuation, the Morgan team uses a ‘dividend discount-based’ methodology. This forward-looking model adjusts for business cycle, business risk and cashflow considerations, and contrasts with conventional approaches using only historical data. Once companies’ internal rates of return have been calculated, they are sorted by rank and sector: ‘The top half of this universe is where history has shown the most attractive stocks,’ says Luddy. ‘That’s the pond we want our portfolio managers fishing in.’
Which fish wind up in the Morgan net depends on the portfolio managers’ judgement. In fact, managers are also allowed a very small margin of flexibility to choose stocks in the less desirable half of the stock universe. Only rarely will a manager keep a cash position, and in general a portfolio is fully invested in its target instrument.
Guidelines and benchmarks for portfolios are set at the local level to meet specific client needs, and a peer review process monitors portfolios to make sure they meet the goals. The Morgan network encompasses a wide range of such parameters and constraints, catering to individual clients whether they be pension funds or billionaires.
Besides equities, some $71 bn in fixed income funds ranges across such niche products as mortgage funds and private placements. Morgan became one of the first international bond managers for US pension funds in 1977, beginning to manage currencies at the same time.
Luddy explains the Morgan system as a centralised research capability, rather than a product specific process. ‘The top down ranking process does not make us top down managers,’ he says. ‘It is merely a vehicle for capturing insights and marrying them with the factors that drive valuation. The ranking mechanism takes all the analysts’ information and puts it into a common language to give portfolio managers a picture of relative value in each market and sector.’
One area that occupies Luddy’s macro-research group is comparing valuation across borders and around the world. Equities are generally compared within their geographic region and industry sector, but as investment increasingly becomes a global proposition, the research group is considering moving towards a way to adjust accounting and earnings numbers in a uniform way.
The same basic research focusing on cash flow is done by Morgan’s equities analysts everywhere. ‘Cash is cash no matter where you are,’ he says. ‘We look at profitability and cash flow of a company over the business cycle, rather than over the next quarter or next year. This means our analysts can arrive at a common valuation denominator around the world, despite different accounting standards.’
An IRO meeting Morgan analysts for the first time should think about their company from the point of view of someone acquiring it. ‘What determines the company’s fundamental value?’ Luddy wants to know. ‘What are the long-term strategic issues? And most critically, what is the cash flow picture? We focus on management’s decision-making process over how they invest their free cash flow or use it for dividends, and how they determine capital spending objectives.’
Much of this information is gathered by analysts during company visits. Portfolio managers spend more time back at headquarters meeting management. The research ranking may identify the top half of the stock universe, but the portfolio managers have to delve further into the variables that determine companies’ success. ‘Why is the business a good one?’ Luddy queries further. ‘What are its competitive advantages? The better we understand these issues, the more conviction we have about sustainable profits and growth trends, or the ability to correct temporary problems.’
It is clear from Morgan’s rigorous investment process that its portfolio managers are long-term investors. ‘We believe that an asset’s value will be determined by fundamentals, and that fundamental research can establish relative value among all financial assets,’ the firm’s prospectus states. ‘The markets, however, are often driven by waves of emotion and short-term views; fundamental factors are often misperceived, and the result is significant mispricing. We believe such mispricings correct themselves over a reasonable period of time, and that capturing those corrections can yield superior long-term results at acceptable levels of risk.’
Big Fish in a Small Cap Pond
Going head-to-head with institutional investors can be daunting for young companies. Imagine facing off with James ‘Chip’ Otness, JP Morgan Investment managing director and small company fund manager. After 26 years at Morgan, this Harvard University graduate and ex-US Marine reservist has a longer track record than virtually every company in his portfolio.
Morgan’s approach to its $2.7 bn in co-mingled US small cap portfolios is to outperform the Russell 2000 index by 2 per cent annually while minimising the volatility of excess return. ‘We find return through fundamental research and systematic stock valuation,’ Otness notes, ‘while disciplined portfolio construction minimises volatility.’
That translates into a sector neutral approach to investing in Russell 2000 stocks, capitalised at $100 mn-$1 bn, so the fund is invested in every sector regardless of macro trends. ‘Interest rates might be rising, but we will remain invested in utilities and banks,’ says Otness. ‘It is just that we will invest in banks that have more demand deposits and less sensitivity to rising rates.’
Otness has some leeway in terms of sector weighting, making corrections whenever a sector gets 1.5-2 per cent away from the index. ‘Sometimes there are opportunities, and sometimes there are not,’ he muses. ‘So I don’t want to be tied to the index. It’s the law of large numbers – I just have to be right 70 per cent of the time.’
Otness works in tandem with Candace Eggerss, who concentrates solely on technology stocks, along with Morgan’s 26 US-based equity analysts. Like the other Morgan portfolios, this one relies on a continuous screen of the universe to identify stocks with superior financial strength and operating returns. If an interview with management confirms a commitment to professional management and attractive cashflow, a valuation study computes an internal rate of return for each stock. ‘We get to know management over many meetings,’ Otness says.
‘We want to make long-term investments, which means developing long-term relationships with those companies,’ he says adding that small cap companies are usually run by entrepreneurs, not professional managers. ‘They are people who have succeeded despite the best advice from their friends. For all their strengths, they tend to make decisions alone, with few strong managers surrounding them. This means responsibility is not pushed down the management chain, and the risk profile is raised.’
So management may try to wow the Morgan manager with cashflow projections but, to Otness, an IRO or CFO who always looks to the chairman for approval when answering questions signals that middle management are not decision-makers.
Once a position is taken in a company, regular formal and informal reviews focus on forecasted growth and profitability inputs to the valuation model. Otness wants to see a monthly profit & loss statement, with an eye to how many profit centres there are. ‘Successful small cap companies grow into large ones,’ he points out. ‘I look for management that knows how to grow, and that understands there is still a lot to be done. Smug managers mean a higher risk profile for the company.’
Morgan’s small cap strategy is value-oriented, although its sector neutral portfolios contain bio-tech and high-tech stocks which most value players would ignore. ‘We are core managers with a value tilt which comes out of our dividend-discount valuation process,’ Otness says. ‘But few would call us a value manager since we invest in bio-tech stocks which might not have a pay-off for five years.’
Once Otness has met the management and taken a position, the more that company gets out to see investors the greater the comfort level. ‘Many companies miss the opportunity to build investor conviction when things are going well,’ he points out, referring to companies for whom investor relations is only used for crisis management. ‘Almost every company goes through difficult times, and most could dampen downside volatility if they would spend more time with investors to begin with.’
And he adds a warning for them all: ‘Don’t ever try to mislead investors, because we will never look at you again.’
