A tight discipline, rigidly adhered to, is a key secret of investment success, according to John Hotchkis, principal and co-founder of Hotchkis and Wiley, the Los Angeles investment management firm.
"If you had a discipline that allowed you to buy only the stocks of companies with left-handed presidents, you would be better off than just buying 'value' without a discipline," he said in an interview in Los Angeles the day after the big earthquake. "That's because value is in the eye of the beholder. You can buy anything at any price and rationalize it, if you perceive value."
Hotchkis and Wiley's disciplines, applied since the firm was founded in 1980, are: a stock must have an earnings yield (earnings per share divided by share price) three percentage points higher than the yield of the high-quality long-term bond market. That is, if 30-year Treasuries are yielding 6.3% then a company's earnings yield must be 9.3% for it to be considered.
Second, the stock must have a current dividend yield higher than the average dividend yield for the market, and third, the company must have financial strength verified through detailed security analysis, independent industry analysis and management interviews.
The search for high-earnings yield stocks leads to out-of-favor companies, and if you are going to buy those stocks, you need the high current dividend yield to give you a compounding effect "so you have something working for you" while waiting for the market to discover the stocks, Mr. Hotchkis said. And you need the financial strength so you can be sure the dividend is safe and might even be increased.
The process has served Hotchkis and Wiley well. The firm's portfolios have outperformed the Standard & Poor's 500 Stock Index in 10 of the past 14 years, and the compound annual return since the firm's inception is 18.7% compared with 15.5% for the index.
The investment success has brought $6 billion in tax-exempt assets to the firm, and vindication for Messrs. Hotchkis and Wiley.
But perhaps just as rewarding is that the discipline appears to work also in non-U.S. markets. The firm started applying it to international portfolios three years ago when it established Hotchkis and Wiley International. For the three years, the international portfolios returned 19.4% compounded annually. In 1993, they were up 49.6%. By contrast, for the respective periods, the Morgan Stanley Capital International Europe Australasia Far East Index was up 9.7% and 32.9%.
Now the firm manages $260 million in international assets, including $10 million in a mutual fund, using the strategy.
"Many managers try to get the country right first," Mr. Hotchkis said. "We find the discipline leads us to the right companies, and they lead us to the right countries."
Another point of pride for Mr. Hotchkis is that his daughter, Sarah Hotchkis Ketterer, is co-portfolio manager, with Dennis Bouwer, managing director, at Hotchkis and Wiley International.
She's following in her father's disciplined footsteps.