Baird Large Cap Team’s Disciplined Approach Exploits Behavioral Errors

MILWAUKEE, September 9 , 2014 – In late 2013, Baird entered into a new subadvisory relationship called Baird Kailash to manage the Baird Large Cap Fund (NASDAQ: BHGIX).  The Baird Kailash team is led by Matt Malgari who works closely in a consultative arrangement with Cornell University’s Dr. Sanjeev Bhojraj to constantly monitor and improve their investment strategy.  We asked Matt a few questions about his approach to managing large cap portfolios.

Q.  Few active managers are consistently able to beat the market. Why is that?

A. We think there are several factors making it difficult for active managers to add value. One primary example can be seen in peer reviewed research by Dr. Bhojraj which showed that Regulation FD (requiring broad, public dissemination of information) has limited the ability of fund managers to receive selective access to information. Without preferential access to information, we believe that large-cap stocks prove conspicuously difficult to research, as identifying the critical value drivers across their expansive and increasingly global economic footprints is challenging. My view is that the reduction in private information when combined with these complex business models has actually amplified the potential for fund managers (myself included) to succumb to behavioral errors. 

While we have enormous respect for the benefits of passive investing, we believe the concept is difficult to digest. If I approached investors and said “my method is going to require me to be structurally underweight smaller firms, despite their tendency to outperform over the long haul, and to mechanically add to positions as they become more expensive,” we would probably not generate too much interest. Yet this is a simple expression of the approach pursued by many investors in passive approaches. 

These beliefs underpin our business model which operates at the intersection of fundamental and quantitative investing. We think bringing a disciplined process to fundamental investing gives us the long-term benefits of that process while allowing us to avoid the pitfalls of indexing and the behavioral errors of traditional active managers. 

Q. Can you expand on what that means and tell us what you do differently?

A. What appeals to us about quantitative investing (or indexing for that matter) is its ability to remove human biases. At the same time (unlike indexing), we believe that understanding the relationship between the fundamental evolution of a firm’s economic profile and its stock price is at the heart of building a competitive advantage in stock-selection. Our investment process is primarily driven by a model we have spent over three years developing. The model uses empirically-proven fundamental constructs to locate firms where investors have meaningfully underestimated the intrinsic value of an organization. Said another way, our process is designed to help us find atypically high-quality businesses for their level of relative valuation. 

Q.  Does that make you a value investor?

A. While research has shown that over long periods of time, value oriented strategies tend to have an edge, we know from both simple analysis and practical experience that growth can be a powerful ally in the search for excess returns. There are wonderful value and growth stocks.  We believe the critical skill is the ability to identify the firms in both categories that are structurally disadvantaged so you can potentially reduce the number of mistakes you make. We believe our ability to find self-funded firms whose growth may be underestimated by other investors or handicap those inexpensive firms most likely to have a positively skewed payoff structure is unique among investment managers. 

Currently, we are surprised to see such narrow value spreads between the most- and least-expensive stocks. Our view is that investors who rely heavily on simple metrics of valuation for returns may face headwinds due to nearly unprecedented levels of price appreciation relative to fundamentals, even among inexpensive firms. Similarly, our research indicates that investors who are fond of pursuing the highest growth firms face a universe increasingly characterized by difficult fundamentals, making process around those disciplines more difficult to maintain. With this in mind we are happy to have such a balanced view on growth and value. 

Q.  What do you do differently that allows you to achieve this advantage?

A. The primary differentiating factor is our commitment to the fundamental review of our portfolio companies. Unlike quantitative products which tend to buy large baskets of stocks based on a collection of numerical signals, our fundamental work gives us the added conviction necessary to run more concentrated portfolios with high levels of active share. We are not afraid to make adjustments in cases where we find things like potential fraud, regulatory risk, deal activity or managerial change that might be lost if we just used the model. This fundamental analysis is also at the heart of an ongoing and intellectually reciprocal research process with Dr. Bhojraj. Our fundamental research underpins a relentless search for structural errors that can be exploited in a process-driven fashion to reduce risk or improve returns. 

Q.  How does your background contribute to your models and approach?

A. I spent 14 years at a large well-known fund company where I had the good fortune to work in virtually every role in the investment process interacting with fundamental and quantitative investors alike. Sanjeev Bhojraj is a professor at Cornell and Director of the Parker Center for Investment Research at Cornell University’s Johnson Graduate School of Management.  Between us, we have extensive experience in portfolio management, fundamental analysis and quantitative analysis.  We believe our backgrounds are highly complementary and that combining our skill-sets improves the odds we can continue to find innovative new ways to identify and capture novel fundamental ideas that benefit from process. 

Q.  Can you share an example of a stock where your fundamental work disagreed with your model’s stock picking?

A. Our model identified Herbalife, a multilevel marketing company that sells nutrition, weight management and skin-care products, as a potential investment based on its remarkably high growth rate, prodigious cash flow and inexpensive valuation. However, a fundamental review of the company left us thinking the firm would either escape the clutches of regulators and run much higher or suffer mightily if the allegations of fraud proved true.  While the model certainly has no view on this hotly debated topic, our fundamental analysis left us thinking it was an outcome we were unlikely to have an edge on and that we could find other risk-adjusted opportunities that were not exposed to such bimodal outcomes.

About Matt Malgari
Matthew Malgari is the Senior Portfolio Manager of the Baird Large Cap strategy, sub-advised by Baird Kailash. He joined the sub-advisor in October 2013.  Matt has over 17 years of investment experience with 14 of those years at Fidelity where he worked in roles that covered every facet of the investment process including equity trading, equity research and portfolio management.  In his last three years there he worked as an Assistant Portfolio Manager on the Fidelity Diversified International Fund (FDIVX). After leaving Fidelity in 2010, Matt became the Managing Director of Equity Research at Knight Capital. At Knight he built and managed an equity research team that integrated quantitative and fundamental processes which generated significant excess returns. Matt received his BA from Middlebury College and his MBA from the Johnson Graduate School of Management at Cornell University.

About Baird
Baird is an employee-owned, international wealth management, capital markets, private equity and asset management firm with offices in the United States, Europe and Asia. Established in 1919, Baird has approximately 3,000 associates serving the needs of individual, corporate, institutional and municipal clients. Baird has more than $125billion in client assets. Committed to being a great place to work, Baird ranked No. 9 on FORTUNE’s 100 Best Companies to Work For in 2014 – its 11th consecutive year on the list. Baird’s principal operating subsidiaries are Robert W. Baird & Co. and McAdams Wright Ragen, Inc. in the United States and Robert W. Baird Group Ltd. in Europe. Baird also has an operating subsidiary in Asia supporting Baird’s investment banking and private equity operations. For more information, please visit Baird’s Web site at www.rwbaird.com.



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