The Market Masters


By Kirk Kazanjian

John Wiley & Sons

ISBN: 0-471-69865-2


Chapter One

MANU DAFTARY

DG Capital Management

When Manu Daftary arrived in the United States from his native India in the 1980s, he never imagined he'd one day be overseeing huge sums of money. After several years of analyzing and selecting investment managers to run college endowments, Daftary was handed a stock portfolio to run on his own. Since he had long observed the styles and techniques of the country's leading money managers, he brought what he considered to be their best practices together in forming the foundation of an investment strategy he continues to follow today.

Daftary, 47, ultimately started his own investment firm in Boston in 1996. He is also subadvisor to the top-performing Quaker Aggressive Growth Fund. Daftary's core beliefs are that earnings drive stock prices, companies with earnings surprises tend to outperform the general market, and avoiding downside volatility is the key to long-term outperformance.

Daftary is an opportunistic investor and enjoys wide discretion when it comes to running his fund. For instance, he is allowed to raise as much cash as he wants, is free to buy companies of all sizes, and can even short stocks as he sees fit. As a result, Quaker Aggressive Growth is often compared to a hedge fund, since it's definitely not for the faint of heart.

As you'll learn, Daftary looks at stocks through a variety of glasses. When it comes to analyzing bigger companies, valuation is of utmost importance. For the smaller names, value is important, but earnings momentum is king. Above all, diversification is crucial since, as Daftary puts it, despite your best efforts, you never truly know which stocks will become your biggest winners.

Kazanjian: I know you grew up in Bombay, India. What originally brought you to the United States?

Daftary: When I graduated from college in India, there wasn't much opportunity there other than joining the family business and I really didn't want to do that. The MBA programs in India were very underdeveloped, so I decided to go overseas to study. I had the choice of going to either London or the United States. My brother was at Long Beach State in California and suggested I apply there. I redid my bachelor's in business and then entered the MBA program at Long Beach State. Quite honestly, it wasn't a great school and I was bored. So before completing my MBA, I applied to a blind ad asking for a financial analyst, assuming it was something related to cost accounting. It turned out to be a position at Cal Tech helping to run the school's endowment program. I got the job and came in as a trainee. At Cal Tech I learned the ropes of the investment business, and ultimately finished my MBA while working there.

Kazanjian: Were you picking stocks at Cal Tech?

Daftary: No. I did plan sponsor work, which included asset allocation studies and the hiring and selecting of managers to run the money. By 1983, I thought about moving on, and considered relocating to New York, since there really wasn't much of an investment community in Los Angeles. I was packing my bags one day and saw an ad in the Wall Street Journal from the University of Southern California looking for someone with my capabilities. I interviewed with the treasurer of the university who was very dynamic and I liked her right away. She called me following the interview and said I was hired. I was still planning to leave for New York, but she persuaded me to come in as the number-two person there. I worked with her for three years on the same sort of plan sponsor projects, picking managers and such.

Kazanjian: When did you actually get to start managing money yourself?

Daftary: In 1985. That year, the treasurer of USC got approval to actually manage a stock portfolio internally, instead of just farming it out to other managers. Once we got the approval, she gave me the portfolio to manage. I didn't have to work with committees or anyone else. It was really great.

Kazanjian: How did you go about choosing stocks, given that this was all new to you?

Daftary: I was learning on the job. The funny thing is I had spent three years at USC thinking a lot about stocks because I was interviewing managers to run money for the university. In that process, I was learning about how to pick stocks from very smart people. We liked to hire managers who were just starting out. Many had left larger management firms and were young and hungry. A lot of them are still friends today. But when I took over the portfolio, I knew the first thing I needed was a Quotron machine. We didn't have one in the office. Then I had to worry about getting accounting systems and establishing relationships with brokers. Since we had none, I called up USC's alumni office and asked whether they had any graduates who had gone on to become brokers. We found three. It was a real bootstrap operation. When I started my own firm in 1996, it was truly my second startup. At USC, we started out managing around $5 or $10 million. That was up to $200 million by the time I left. And we did it all with a very skeletal staff. I had only two assistants.

Kazanjian: You left USC in 1988 and worked at two other firms before going out on your own in 1996. What made you ultimately start your own company?

Daftary: In 1996, I was recruited to help run an investment firm in Boston. But it was clear that the gentleman who brought me in to take it over was never going to leave. Personality-wise we just didn't get along. About a year and a half into the job I decided I had to get out of there. At that point, an old friend of mine called. Jeff King, who had started the Quaker family of funds, said to me, "You're very unemployable right now. You need to go out on your own." He knew I wanted to do it and really egged me on to make that move. He had enough faith in me to hire me to start the Quaker Aggressive Growth Fund, even though I didn't have a track record. But the question was how to raise money. Jeff took me around and I was able to raise about $7 million from an offshore investor as seed money for a hedge fund. So I left my job and started the firm, without much in hand. There was a lot of panic at first, but I felt I didn't have any choice. For the first two years, it was hard growing the firm because we didn't have a track record. Plus, the $7 million we had was hedge fund money with high expectations that could leave any day.

Kazanjian: When did the Quaker Aggressive Growth Fund start?

Daftary: DG Capital, my firm, was incorporated in July 1996 to manage hedge fund money initially. The Quaker Aggressive Growth Fund began operations in November of the same year.

Kazanjian: Your firm now runs about $650 million. That's some pretty good growth.

Daftary: Yes. A little more than half of that is in the Quaker mutual fund. The rest of the money is run for institutional clients like endowments and foundations.

Kazanjian: When it comes to managing money, you seem to have a go-anywhere investment approach.

Daftary: I've always felt that a big problem in the industry is that there is a lot of compartmentalization going on, where managers are hired by plan sponsors for a very specific reason.

Kazanjian: You mean to specifically buy growth or value stocks and the like?

Daftary: Growth, value, small-cap, mid-cap-I philosophically have never believed in that. I feel that a money manager who is on the leading edge of everything that happens in the stock market should be given all flexibility to adjust the profile of the portfolio based on an evaluation of the risk level of the overall market. Even back in the 1980s, I felt that a lot of plan sponsors didn't realize the risk that they were taking in hiring certain managers because they didn't understand the risk level. They just saw the returns. They said, "Okay, we see the returns, and know you have higher risk, but we'll put you in this efficient portfolio and it will all work out." That looks great on paper, but in reality it just does not work over time. Our philosophy as managers is you should enable us to evaluate what risk to take for the assets we are managing, in our case stocks. In order to do so, you basically have to be a multicap manager and have an opportunistic approach.

Kazanjian: So you have the freedom to buy anything you like?

Daftary: Yes. We will go where we think it's necessary based on the risk that we need to take. That is the philosophy. We won't be typecast. The bottom line for all managers is that you have to beat the S&P or you'll be fired. It's interesting. When I started managing money, all I knew was Graham and Dodd and Warren Buffett. I had just read The Intelligent Investor and John Templeton was an idol. So I was really a value manager back in the 1980s. As we diversified the portfolio at USC, we realized we needed to run some of the money as growth. When I looked at the growth sector, I realized that earnings drive stock prices over time and if earnings go up, stocks go up. The problem I had with the growth universe was that it tended to be extremely volatile, especially on the downside. Given that growth managers tended to underperform over time, I wondered why one would hire people in this area. My belief was that the only way you can effectively manage money in the growth area is by avoiding disasters.

Most growth managers are very good stock pickers. Unfortunately they tend to have a lot of blowups in the portfolio, which really kills the performance. The reason they have all these blowups is twofold: First, the U.S. equity markets are mostly value-oriented, because the economy only grows 2 to 3 percent over time. Second, it's very difficult to find a classic growth stock, and when growth managers spot it, they all jam into the stock together. When the trend reverses, they all blow up together. That's the reason the whole growth sector goes out of favor.

I believe the only way you can outperform in the growth universe is to avoid negative surprises and downside volatility. If you go down 40 percent, you must go up 67 percent to break even again. If you can truncate the downside, you'll have all the money to play on the upside, which is where all the money is made in the stock market.

Kazanjian: That's an admirable goal, but how do you achieve it?

Daftary: We are very concerned about buying companies that could have negative earning surprises. We actually spend more time making sure we avoid the losers than finding the winners. We put great care into figuring out supply-demand characteristics, meaning that we avoid stocks where there are a large number of institutional owners of the stock who will most likely be sellers over time. We want to be very early investors in our companies. I should also point out that we look at large-caps differently than mid-caps and small-caps. Large-caps tend to be more efficient, meaning that everyone is looking at and following them.

Kazanjian: Do you take a look at the market and other macroeconomic factors when making this evaluation?

Daftary: Yes. We look at what's going on in the overall economy. One really has no choice, especially if you're a growth manager. For example, we pay close attention to interest rates. We also look at money flows, meaning we want to know whether dollars are going into the market or not. That's a supply-demand characteristic we monitor. The direction of the dollar is important, especially for large-caps with sales overseas. We also look at valuations. For example, in early 2004 I told clients we were getting negative on small- and mid-cap stocks because their valuations were unsustainable, especially if interest rates kept going higher. We look at overall valuations for the various sectors as well.

I've always said that you can be the biggest crackerjack analyst, but after doing all your work on the company, will people care about it? We want to look at stocks people care about. The only reason people care about stocks is because they're either going to blow their earnings numbers away or they're totally undiscovered and will eventually be owned by others.

Kazanjian: You're also not afraid to raise cash when you're negative on the market. In 2000, your fund had 80 percent of its portfolio parked in cash. What led you to make that tactical decision?

Daftary: It wasn't an instant decision. Back in 1998 we had the Russian crisis, the global financial markets were getting killed, and everyone was extremely negative. Luckily for us, in the summer of that year we had raised cash and avoided the severe market decline that had occurred. However, by the end of that year, we began to buy companies that were growing 25 to 30 percent a year, especially in the technology area, but which traded at 10 to 11 times earnings. So we were very early back in October 1996 to take positions in companies that did extremely well in 1999. By the summer of 1999, however, we raised the cash level up to 40 percent. Some of the companies we had bought at 10 to 12 times earnings were now trading at 40 times earnings. I get very concerned when stocks are trading at 30 to 40 times earnings, regardless of what the growth rate is. That's when your risk really starts to ratchet up. While we moved back into the market in September 1999, by February 2000, the same thing started happening again. We had stocks going up 10 to 15 percent a day. I know from past experience that money doesn't grow on trees. When they start doing this, you know there's a problem. We started raising cash into February and March, which is why the cash level got so high. When you see IPOs doubling and tripling on a daily basis, you have to stop and see what's going on. We did not get caught up in the fever of that time. People call this market timing. I say it's risk control. I like being invested. In fact, I think most of the money is made in the market on the long side (being fully invested), not by making these tactical moves that can mess you up mentally. I'd rather be fully invested. The problem is there are certain periods of time where that's not prudent.

Kazanjian: Eventually you were right, but you were a bit early on the move to cash.

Daftary: Yes, and I kind of wish we had moved into some of the more value-oriented stocks, instead of selling out altogether. I didn't realize how effective Greenspan would be in cutting rates and pumping up consumers. I wish I had owned more consumer and housing stocks back then.

Kazanjian: Given the tremendous latitude when putting your portfolios together, how do you begin the process of finding individual stocks?

Daftary: We're really opportunistic in our stock selection. We get ideas from all over. Given that we're multicap in focus, we can look at many ideas. As I previously noted, we look at large-caps differently than small-caps and mid-caps. Most of our performance attribution over time has come from our mid- to small-cap ideas, because that's where you get your triples and quadruples. On the other had, we have very modest expectations for our large-cap ideas. While we don't think we add any long-term value by investing in IBM, there are certain points in time when IBM, on a risk-adjusted basis, can give you 15 to 20 percent rates of return.

Kazanjian: So let's start there. Where do you find, and how do you evaluate, your large-cap ideas?

Daftary: We do screens to see what looks reasonable in this space on a valuation basis. We rely on information from Wall Street for the large-cap names. We talk to specific analysts on a company and look at earnings estimates. For large-caps, we let the Street do the work for us. We don't need to do primary research on these companies. In the large-cap space, we like to buy companies that are out of favor. We realize that when you start buying momentum, you're really playing with fire. There's no downside protection if you buy a stock that's run up 40 to 50 percent and the multiple's expanded but nothing else has changed. We want to own large-cap stocks that have come down to a reasonable historical valuation. We then check the cash flows and balance sheet. If we can buy something at 12 to 13 times forward earnings with a dividend yield, it probably makes sense to own it. Even though valuation is important, these are classic growth stocks we're looking for, meaning we're not buying aluminum or iron ore. We want companies with a very high ROE (return on equity), good growth characteristics, good cash flows, and a good management team in place.

(Continues...)



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