Forward Small Cap and Mini Cap Funds are both funds I use in some investment portfolios in my practice. Irene Hoover does a great job of managing risk while generating a great return. Her strength is in her firms ability to find stocks that no one else is following. This knack is more prevelent in her Mini Cap fund, which is the fund I use the most. Here is research report on her Small Cap fund which will give you some insight into her investment management style. Enjoy!
The Financial Pragmatist
Libby Mihalka
DUE DILIGENCE: Forward Hoover Small Cap Fund (FFHIX, Inst’l)
Category: Smaller-Cap Growth-at-a-Reasonable-Price Manager: Irene Hoover
We’ve recently completed our due diligence on Forward Hoover Small Cap Fund. Our research consisted of several face-to-face meetings with portfolio manager Irene Hoover both in our office and in her San Francisco office, where we also met with the team’s five analysts. As a result of our research, we are adding the fund’s institutional share class to our Approved list in the Smaller-Cap Growth-at-a-Reasonable-Price category. Below we provide an overview of Hoover’s investment philosophy and process, the investment team, and the reasons for our favorable opinion. We should note that because the fund is Approved, we have gone into less detail in this due diligence report than we would for a Recommended fund.
Investment Philosophy and Process
Hoover’s overriding objective for the fund is to generate high rates of return, but with low volatility and risk. In a nutshell, she wants to preserve capital and provide superior risk-adjusted returns over time. Her philosophy is somewhat contrarian in that she emphasizes businesses in out-of-favor industries, with minimal Wall Street coverage.
The bulk of investment ideas come from quantitative screens that highlight underperforming industries, but ideas also come from bottom-up research, sell-side contacts, and the identification of themes. Although Hoover looks for cheap stocks (those with at least a 25% upside), she emphasizes that she only wants to own profitable and growing businesses. To be considered for purchase, companies must have a growth catalyst (e.g., new product introduction, geographic expansion, or new management, etc.) that will lead to higher earnings and/or higher market multiples that result from increased investor recognition in order to achieve her upside target. Although Hoover looks for out-of-favor names, she avoids deep-value stocks and tries to avoid buying a name too early. In Hoover’s words, “We want to be the last value buyer.”
Growing stocks in out-of-favor industries are candidates for fundamental analysis. An initial step in this process is to run a stock through the team’s “risk checklist,” a list of potential problems that is based on their past mistakes. The list ensures that they consider business risks such as turnarounds that rely on difficult-to-predict macro factors, threats of a larger competitor entering the market, high customer concentration, and legal or environmental issues. It also covers organizational risks such as aggressive revenue-recognition policies, as well as valuation risk, to mention a few factors. The risk checklist helps emphasize predictability and minimize the risk of losing money.
Because the focus is on companies in out-of-favor industries, further fundamental analysis focuses on whether stocks are down because of issues that are permanent or temporary. As part of this analysis, the analysts study industry trends, companies’ operating histories, and financial statements. The team will sometimes meet with suppliers, customers, and competitors to gauge demand for the company’s product or services, as well as its competitive advantage. Management evaluation is also important. The team typically meets with companies to assess operations and whether management’s goals are achievable.
When buying stocks, Hoover is looking for at least a 25% upside over an 18- to 24-month horizon. Price targets are based on a P/E multiple, which is based on their earnings-growth expectations for the next 18 months. For example, if they think earnings will grow at 20% over the next 18 months, they will put a 20x multiple on the earnings 18 months out. However, price targets are dynamic and change with the fundamentals of the company. It’s very important for Hoover’s internal earnings estimate to be above Wall Street consensus as they’re looking to capture earnings growth and P/E-multiple expansion. Assessing a stock’s downside risk is also important, as Hoover won’t buy stocks with huge downside potential, regardless of the upside potential.
Hoover sells when a stock has hit the team’s price target, to raise money for better opportunities, if they see a deterioration of fundamentals, or when the stock has “run ahead” of improving fundamentals.
The portfolio typically holds 60 to 80 names, but that number can occasionally be higher because of “transition holdings,” i.e., holdings that she is still buying or selling. During periods of market uncertainty/volatility, Hoover will slightly increase the number of holdings to lessen stock-specific risk. Sector weightings are a byproduct of where the team is finding ideas, and Hoover spends very little time thinking about the portfolio’s weightings versus the index. Initial position size is a function of conviction and liquidity. Positions typically start out between 1% and 1.5%, although Hoover will occasionally establish a larger position in a high-conviction idea. But larger holdings are usually a function of price appreciation and tend to top out at 2%. The fund is usually fully invested.
Team and Team Interactions
Hoover Investment Management was formed in 1997 by Irene Hoover, who is portfolio manager and chief investment officer. Hoover has almost 30 years of investment experience. Prior to forming Hoover Investment Management, Hoover was at Jurika & Voyles (1991-1997), where she was a director of research and also managed Jurika & Voyles Mini Cap Fund. In 1999, Hoover teamed up with Forward Management, who is the advisor, and provides marketing and client services for the fund. Forward Funds does not have an ownership stake in Hoover Investment Management.
Today, Hoover heads a six-member investment team, and the analysts are all generalists though each has a specific sector emphasis. Once a security is selected for purchase, Hoover and the analyst work together to determine portfolio weightings and target sell prices, however, Hoover is the final decision maker. The team meets weekly in a comprehensive investment-strategy meeting to discuss economic policy, monetary and fiscal policy, as well as news events and trend analysis as they relate to portfolio holdings.
Style Analysis
When evaluating a fund’s investment style, we examine both quantitative and qualitative factors. Quantitatively, we consider a portfolio’s valuation statistics, sector weightings, performance history and correlations with various benchmarks, etc. Qualitatively, we consider a manager’s valuation methodology and the aggressiveness of assumptions used in their analysis. Based on our assessment of these factors for Hoover, we are categorizing the fund as Smaller-Cap Growth-at-a-Reasonable-Price. We should note that some fund-rating firms categorize the fund as a growth fund, which we disagree with.
Touching on some quantitative measures, the portfolio’s valuation and sector weighting statistics tend to be more in line with the GARP category over time. Performance also tends to correlate best with the GARP index. Qualitatively, we think Hoover’s valuation methodology–deriving price targets based on the team’s forward earnings estimate–falls between GARP and Growth. Many pure growth investors pay little (if any) attention to valuation, while value investors typically require a much steeper discount than Hoover is looking for. Hoover falls between Value and Growth. As for modeling assumptions, the analysts seems to strike a balance of assessing what a company can reasonably do, while not giving much, if any credence to “what-if” scenarios (which is more typical of growth investors). As for the timing of investments, while Hoover is looking for out-of-favor stocks, she also wants to be “the last value buyer” in an effort to minimize the opportunity cost of waiting for a stock to appreciate. This differs from pure value investors who are typically more patient and are willing to hold stocks for years before realizing a stock’s value. Hoover has a shorter investment timeframe that is evident in the portfolio’s turnover, which is relatively high at 150-200%. A lot of the turnover is due to trimming and adding to names, as opposed to a complete turnover of names. Meanwhile, Hoover runs a fully invested portfolio, as she says there are always stocks that are moving up, regardless of the market environment. This is in contrast to many pure-value investors who are willing to let cash build in times when they consider the market expensive and opportunities limited.
As for performance expectations, Hoover invests in a risk-averse manner. Our expectation is that the fund will underperform when speculative stocks are leading the market, and outperform in more “normal” markets where companies with sound fundamentals are being rewarded. We also expect the fund to outperform during steep market corrections where speculative stocks perform proportionately worse, as the team avoids this type of company. Since the fund’s inception in September 1998, the fund has a compounded annual return of 11% versus 10% for the Russell 2000 iShares. As for risk parameters, the fund’s worst 12-month return is a 24% loss compared to 27% loss for the benchmark. Meanwhile the standard deviation of three-month returns is 17.7, which is much lower than 21.3 for the Russell 2000 iShares.
Litman/Gregory Opinion
As a result of our research, we are comfortable adding Forward Hoover Small Cap to our Approved list in the Smaller-Cap Growth-at-a-Reasonable-Price category. Our favorable opinion of the fund is based not a single edge, but rather on several things that we think they do very well that collectively constitute an edge. The positives are as follows.
We believe the investment philosophy and investment process are consistently applied across the team. We have observed a systematic framework for identifying new investment ideas, clearly laid out criteria for buys and how these criteria are weighted, and the analysis seems very thoughtful. The research process is very fundamentally driven, and the team is clearly looking for catalysts that will drive a company’s future growth. They try to benefit from the excitement of strong earnings growth but they also want to measure it very carefully by understanding what the risks are to achieving that growth. As for information gathering, analysis is not built off of numerous third-party checks, but it is clear that the analysts gather the necessary information to make informed decisions. This research includes meeting with company management and talking to suppliers, customers, and competitors. There are also tools in place (e.g., quantitative screens and the risk checklist) to ensure that the team brings specific types of companies to Hoover for inclusion to the portfolio.
There are also positives at the investment-team level. One plus is the team’s investment experience. Hoover has been in the business for over 25 years, while the analysts each have several years of investment experience. As for the quality of the research, we have generally been impressed with the team’s stock discussions, where they walked us through their fundamental analysis. They seem to know their industry/sectors and stocks very well, and strike us as independent thinkers who are enthusiastic about their work. Another positive is that the team has minimal non-research responsibilities, which allows them to focus on investing. The team has also been cohesive, and most of the team members have worked together for about five or more years. Hoover seems to think a lot about retention of analysts, e.g., sharing equity in the firm and handing off some decision-making autonomy, which reduces the odds of personnel departures. There has been no turnover of investment personnel in the past few years. Hoover has also implemented a compensation structure that we think encourages analysts to identify their best long-term ideas, as well as aligns the team’s interests with shareholders’ interest.
The asset base in the strategy is closing in on $1.5 billion and Hoover is starting to think very seriously about closing institutional accounts, although she plans to leave the fund open to new shareholders. The fund currently has about $500 million in assets. Hoover does not strike us as an empire builder, and seems to genuinely want to do well for shareholders. The fund is not marketed very heavily and because of the relationship with Forward Funds, she has very minimal client-service responsibilities on the mutual fund side of the business. Hoover is responsible for handling client-service responsibilities for institutional clients. As for running the business, Hoover has an internal staff that handles the majority of business decisions, compliance, and client servicing.
As for why the fund is not Recommended, we don’t have any major concerns, but there are a few areas of the investment process that we were not able to fully get our arms around, despite discussing them with Hoover. For example, during times of perceived market uncertainty or highly volatile markets, Hoover will diversify the portfolio by increasing the number of names. Related to this are questions we have around Hoover’s sell discipline. Hoover says that selling is where she makes most of her mistakes because she gets nervous when she loses money on a stock. The source of her nervousness seems to be losing clients’ money, as we discussed a number of examples where Hoover sold a stock because it was down, and ultimately missed an upside move, despite analysts suggesting to buy more. On the flip side, Hoover has also sold names and avoided further losses.
The potential risk is that Hoover makes decision errors or gets whipsawed if she makes a bad call when it comes to timing of these decisions, which involve a considerable amount of subjectivity and don’t exhibit the same level of discipline we see elsewhere in the process. After discussing these issues with Hoover, our impression is that these issues seem to be done at the margin, where the goal is to protect shareholder capital. We wouldn’t call these issues concerns, but because we are not clear about her decision-making framework for these aspects of portfolio management, we are currently not comfortable with Recommended. Perhaps over time, if we come to better understand the framework of Hoover’s thinking when it comes to portfolio construction we could raise our opinion.
One area we plan to watch going forward is the structure of the investment team. Our sense is that the analysts may have a larger role in portfolio management of the fund in the future and we plan on monitoring this to see how things play out.
At this time, only the institutional shares meet our 1.5% expense threshold for domestic small-cap funds (the retail shares currently have a 1.69% expense ratio). After discussing this issue with Forward Funds and after doing some back-of-the-envelope math, we doubt retail share expenses will get to 1.5%, so our Approved rating extends only to the higher-minimum institutional shares.
—Jack Chee
Reprinted from AdvisorIntelligence. Copyright© 2007 Litman/Gregory Analytics, LLC.
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