Going After Opportunity

Our interview with Jay Sekelsky, lead equity manager for Mosaic's stock funds since 1995, was originally scheduled for Tuesday, September 11, at 9:00 am. For reasons that are painfully clear, we all decided that morning was a poor time for our conversation about mutual funds, financial markets, and investing. Like the rest of the United States — if not the rest of the world — we reserved that day for news-watching, reflection, and not a few hopes and prayers for those in New York and Washington, DC, and Pennsylvania.

But in the same way that our nation's leaders have called for a return to normalcy, we wanted to return to our planned conversation with Sekelsky. Drawn to the Mosaic Funds because of their "slow but steady" approach to achieving solid returns for investors, we thought now might be an especially good time to talk about prudence, patience, and value in mutual fund investing. Commented Sekelsky: "We don't really position ourselves as market strategists as much as stockpickers. So we tend not to get too concerned about the day-to-day moves of the market, but rather the opportunities that the market creates."

Jay Sekelsky joined Madison Investment Advisors, the managing group for the Mosaic Funds, in 1990 as an assistant portfolio manager. Previous to Madison, Sekelsky was an investment officer with Wellington Management Co. He earned both a BBA and an MBA from the University of Wisconsin, and is also a Certified Public Accountant (CPA) and Chartered Financial Analyst (CFA). Working Money Staff Writer David Penn spoke with Jay Sekelsky on Wednesday, September 19, 2001.

One of the things I look out for is the return vs. risk, and that's an area where the Mosaic Investors' Fund really seems to rank highly. Could you give us an overview of the fund, and talk about how you've been able to achieve these above-average returns with what seems to be below-average risk? For a long time, we have focused on both managing the upside as well as the downside, looking at the risk­reward factors, if you will, whenever we buy a security.

Like what? As an example, one of the rules we follow when we buy a security is to establish what we believe to be the target valuation of the stock, as well as the downside potential for the stock. And to buy a stock, it needs to have a 3­1 ratio of upside to downside. So we prefer to buy a stock with, let's say, 30% upside to 10% downside potential versus a stock that might have 90% upside but 60% downside potential. I think there are too many investors who look at just the 90% and say, "Hey, this is great," and they forget about the downside risk. So we've always focused on the valuation and the risk­reward, trying to be opportunistic and a little contrarian as well.

You used a couple of terms that intrigued me — opportunism and valuation. Is it accurate to refer to the Mosaic Investors' Fund as a value fund? We prefer to think of it as a "blend" fund, because it does have some of the characteristics of growth, and in fact we look for growth first, but we don't want to pay too much. You've probably heard the term "GARP," haven't you? "Growth at a reasonable price"? That would really encompass what we do, but we take it a step further and call it "growth at a reasonable risk" [GARR]. We want to buy growth, but we don't want to pay too much for it. We want to take a reasonable amount of risk for the growth we're buying. So the typical company for us, or the ideal company, is going to be a very consistent 12­15% grower. Not a 20%, or 25%, or 30% grower, but just one with a growth rate in the mid-teens. We do this in a consistent fashion, like a Freddie Mac (Federal Home Loan Mortgage Corp.: FRE), or a Johnson & Johnson (JNJ). Those are the types of stocks we're interested in, and we feel like our downside is somewhat protected by buying stocks with that type of profile.

Would you also be betting on the notion that a 12­15% growth rate is more sustainable than the 20%, 30%, 40% growth rates? Yes. They are much more sustainable, much more achievable, and less prone to disappointment.

You referred to your fund as one of stockpicking. How do you do your stock selection? Well, like everybody else, we have certain screens for certain characteristics that we think are important, certain desirable characteristics, such as return on equity about 15% on average for the last five years, or double-digit growth rates, which might mean only 10% or 11%. Typically, we are only going to buy companies with a market cap above $1 billion. The companies we buy can only have one sequentially down year in the last five, or two in the last 10, so there's a consistency of earnings. And there are many other factors too. When we put those all together, we end up with a hunting ground of only about 400 stocks.

Then what happens? Then I and my two other portfolio managers here — Rich Eisinger and Dave Halford — each follow different areas of the market. We're continually looking at what we view as the risk­reward on every stock individually and then comparing them against each other and trying to formulate a portfolio, based on the best return relative to the risk we're taking. Really, our ultimate goal is to fully participate in the up markets, but try to protect the principal in the down markets as best we can. Obviously, even in days like this — that is, we're going down — we just try to go down less than the market. And so over a long period, we think that's a good recipe for success.

In terms of cash-to-equity ratio — and things might have changed dramatically of late — I learned through Morningstar that you have around 30% in cash. Is that accurate? No, that's high, and we've really had a higher allocation this year than we normally do. We prefer to run the fund at about 5% cash, all other things being equal. To be honest, this year we've been having trouble finding ideas that meet our criteria and offer the risk­reward we're talking about. We've been carrying, probably on average, 15% cash for the past six to nine months. This is not a reflection of our desire to avoid the market, but rather a reflection of our lack of ideas that meet our criteria.

Growth at a reasonable risk (GARR), for example. Exactly.

I did want to ask you one question about sectors, for lack of a better term, though I understand that's not really how you look at the market per se. Some of the stocks you were able to find that worked well for you were in financials, retail, and health. Do these sectors have anything in common, other than the fact that they seem to be doing relatively well, compared to other areas? You could categorize the financials and health care as both being somewhat defensive. And they also tend to do well during a weaker economic environment as well as a declining interest-rate environment, especially the financials. Health care is a bit of a safe haven, because you know that Johnson & Johnson (JNJ) is going to make their numbers while all the tech companies aren't. This is just a broad statement of this type of market.

In looking to find companies that are just showing earnings progression, investors are going to gravitate toward some of those sectors. We actually moved into them from a valuation perspective months ago because the stocks looked inexpensive to us relative to some of the growth-oriented stocks. This got us into the defensive stocks a little early, but it's been helping quite a bit lately. And I would categorize the retail to be more opportunistic from the standpoint of a year ago, when everyone was giving away the retailers because they viewed the holiday season as being a poor environment. The retailers weren't going to make money, and consumers weren't going to spend. So the valuations became very cheap. So rather than trying to make a top-down call, we bought some of the stocks because they looked inexpensive and the risk­reward was in our favor, as opposed to many other sectors of the market that weren't. That's worked out well for us. We have since reduced our exposure, and I think going forward, retail's probably going to be tougher.

Why is that? Valuation has become a little fuller and fundamentals have deteriorated since last fall.

What are some of the stocks that have worked for you?In that retail area, Lowe's Home Improvement Co. (LOW), Ross Stores (ROST), which we still own — we don't own Lowe's any longer; we sold that earlier, in the middle of the year, when we thought it had reached a pretty full valuation. We still own Ross Stores primarily because they are moving away from the more traditional department stores and getting more into discount goods and apparel, which is more of a winning recipe going forward. Target Corp. (TGT), also in the discount area, has been a good stock.

What else? In the financial area — and this is one of the things we like to point out — is Markel Corp. (MKL), an insurance company with a fantastic track record, fairly illiquid, and in the mid-cap category. Many mutual funds are just too big or not nimble enough to be able to invest in companies like that. Being the size we are, we're able to take advantage of opportunities like Markel. That's one of the real advantages of having funds the size we do, relative to some of the behemoths out there.

Does that also give you access to some of the smaller caps, should you find stocks there you like? It would, except we have defined ourselves as being a large-cap fund, and we have about 75% or more of the companies in large-caps and only 25% in mid-caps. Even if we found some smaller-cap names, the only place they'd really fit would be in our mid-cap fund, and even there it'd be somewhat limited. Honestly, the small-caps require a different level of research and time commitment, relative to some of the other companies.

You mentioned the mid-cap fund, and that's another fund that, if I recall, has also been doing fairly well for Mosaic. In terms of types of companies, again, understanding your bottom-up approach, what are you finding in the mid-caps that seems to be working well? We've found a number of stocks in the health-care area, and we've found a few names in the more service-oriented portion of technology, such as Equifax Inc. (EFX), although the Standard & Poor's 500 index has changed the categorization of the company from technology to a service-oriented company. It's a stock that exhibits consistent earnings and renewable revenue streams relative to some of the more cyclical companies. Some others are MBIA Inc. (MBI) in the financial area, and SouthTrust Corp. (SOTR), a high-quality regional bank that has benefited from the steeper yield curve we've seen.

Anything else? More than anything, the two things that have helped the mid-cap fund are avoiding technology for the most part and being overweight in retail, consumer, and cyclical stocks with stocks such as Ross Stores, Office Depot Inc. (ODP), and Tricon Global Restaurants (YUM). We're avoiding technology not because we want to make a top-down bet against it, but because the opportunity didn't exist in our opinion. We purchased Ross Stores around the low teens, and now it's trading around $27. In this environment, to find a stock like that says a lot about the analysis that's done here, and Rich Eisinger is really the portfolio manager who should be credited for that pick.

Ross Stores really has been one stock that you look at every day, and it's still up, and you wish you'd caught it before! It really is a great stock.

We talked a little about the general state of the market. I wanted to ask you about the notion there's a bull market out there somewhere and it's just a matter of trying to find it. Do you subscribe to that idea at all? That's more of a top-down approach. I think there are always opportunities in the market, and I agree that in some markets it's more difficult to find them than in others. What we're trying to do is just participate to the extent we can in up markets, and protect the money on the downside. One thing I did today — because the S&P is down a lot this quarter; in fact, at one point today, we were down close to 20% for the quarter alone — was look as far back as 1940 to find out how many quarters the market was down in double digits. There were only a dozen such instances.

Is that all? Eleven out of the 12 times, the following quarter was up. This goes to show we can have these big down quarters, but they are usually followed by an up quarter. When you only have 12 down quarters over a 60-year period, or 12 big down quarters in a 60-year period, people think the sky is falling. But the truth is, we've weathered all these events in the past, and stocks have proved to be a good place to be; we'll weather this downturn as well. It'll become an opportunity, and for those who stay invested I think it's going to pay off. You'll probably look back in a few years and say, "I'm glad I stuck with it."

One last question for people who are invested heavily in mutual funds. If they're not experienced in the market, they're probably feeling very nervous right now. What do you think they need to keep in mind as market investors? The biggest mistake investors make is probably trying to chase the latest, greatest investment, rather than finding solid philosophy and a solid fund and then sticking with it. In fact, studies have borne that out; investors move around so much, always chasing what did well lately, that they miss more opportunities than just staying put. So if they find something they can believe in, and they agree with the philosophy, they should stick with it. And over a long period — that's what investing really is; it's a long-term event — it's not a quarter-to-quarter game.

Thank you for giving me your time in a difficult week.

Contact Mosaic Funds at www.mosaicfunds.com or 800 368-3195.