Investment Spotlight

Global Alpha and Domestic Growth

Two recent additions to U.S. Trust’s customized investment strategies provide parallels and contrasts.

Clockwise from left: David Glennon, Stephen Evans, Martin Chanzit, Brian O'Toole,
Chris Pineno

Photos by Andy Ryan (top row), Andy McMillan (bottom left), Jeffery Salter (bottom right)

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In this Investment Spotlight, we present interviews with the portfolio managers of World Thematic Alpha (WTA) and Emerging Growth Leaders (EGL). For more information on these and the firm’s other portfolio strategies, please contact your U.S. Trust advisor.

WORLD THEMATIC ALPHA STRATEGY, U.S. TRUST

Portfolio Managers:
Martin Chanzit, CFA
Stephen Evans, CFA
David Glennon, CFA

What’s the fund’s strategy, Martin?
Chanzit: We search globally for equity investment opportunities that our analyses indicate will produce alpha, or outperformance versus the market. We focus not only on market inefficiencies and promising market themes over the long term but also on a stock’s fundamental, technical and valuation characteristics, which can drive excess performance over the short term, a period that seems to be getting more volatile with time.

Who develops your thematic ideas?
Evans: Initially we incorporate a range of high-level macroeconomic and strategic ideas drawn from U.S. Trust’s Thought Leadership team and Investment Strategy Committee. Then the entire WTA team helps shape our investment focus. Contributors include Chris Hyzy, chief investment officer; Robert T. McGee, director of macro strategy and research; and Joe Quinlan, chief market strategist. They provide tactical calls, strategic calls, and sector and geographic preferences. Our current themes include the growing strength of the emerging markets consumer and dividend yield.

We have a disciplined investment process that incorporates ideas from the Thought Leadership Team at U.S. Trust.

Tell us more about the search for alpha.
Glennon: We’ve looked back at specific, quantifiable metrics that led to outperformance, or alpha generation, in the past, and we continually test those metrics to determine whether they’re still statistically significant. We consider more than 90 factors, including such basic measures as price/earnings ratios and dividend yields, as well as more complex measures, in credit default swaps, for instance. Then we search for stocks with similar characteristics that our models indicate are likely to be significant during the next 6-, 12- or 18-month periods.

Talk about those characteristics.
Chanzit: In general we look for the potential to generate alpha. When our work indicates that the market will reward a specific characteristic, we reposition the portfolio in ways we think will take advantage of it. Right now we are looking for companies with accelerating growth, names we expect to capture larger market share. We also search for improving fundamentals, particularly valuation metrics.

Glennon: Another important factor is positive momentum. We look at different periods of price movements to try to avoid serial underperformers. We’re also on the lookout for companies with an increase in defensive characteristics, such as historically higher dividend yields and lower volatility, particularly in the current environment.

Where do you look?
Evans: Our search encompasses almost all industries, geographic areas, investment styles and capitalizations, for an investable universe of about 8,500 stocks. Our quantitative tools allow us to focus on a much smaller number of securities, particularly those with characteristics we believe can provide attractive future returns.

Our search encompasses almost all industries, geographic areas, investment styles and capitalizations.

Describe the qualities of the overall portfolio.
Glennon: We have a clearly defined and disciplined investment process that incorporates ideas from the Thought Leadership team at U.S. Trust. The portfolio includes individual stocks from the United States, developed international markets and emerging markets. Because of the need to diversify across these markets, the number of holdings is almost always greater than 150.

When is it time to sell?
Chanzit: We frequently review underperformers in the portfolio. We’ll typically remove stocks that are no longer associated with our themes or if their quantitative rankings have deteriorated. We might adjust the portfolio if we find other stocks that provide what we consider more attractive investment opportunities or better risk/reward tradeoffs.

Evans: Our discipline is dynamic and focused on alpha generation. When our models indicate that a new factor or factors will likely yield improved future performance, we will reposition the portfolio to potentially take advantage of those opportunities. This is definitely not a buy-and-hold strategy.

What about portfolio turnover and related tax consequences?
Glennon: We expect our annual turnover rate to be in the area of 50%, compared with a more typical portfolio’s rate of 20% to 25%. Whenever we sell a stock, we are mindful of the possibilities of tax loss harvesting and incorporate those into our efforts to manage net realized capital gains exposure.

How does your team’s experience affect the portfolio?
Chanzit: All three of us have had long careers in the financial markets and as portfolio managers. We understand that there’s no one set of valuation parameters that always works across market cycles. We try to use our work on the portfolio, along with our knowledge of the markets, to capture the best of the factors as we identify and validate them through our discipline.

EMERGING GROWTH LEADERS STRATEGY, U.S. TRUST

Portfolio Managers:
Brian O’Toole
Chris Pineno, CFA

Please describe the fund’s strategy.
O’Toole: We developed the strategy designed to offer clients a high-quality small and mid cap equity portfolio with an emphasis on growth. We like to say we are “investing in tomorrow’s leaders today.” Our goal is to deliver consistent results and to outperform the Russell 2500 Growth Index over full market cycles. The EGL portfolio team conducts its own fundamental research. We hold more than 300 meetings with companies each year and leverage fundamental research and quantitative data from both internal and third-party providers. Also, the portfolio incorporates thought leadership from the U.S. Trust Chief Investment Office and Macro Strategy and Research team.

Talk about your investment process.
Pineno: We begin with a universe of 2,500 companies and focus on four investment pillars to narrow our opportunity set to 300 investable names. First, we look for companies with positive business momentum, which includes the potential for growth in sales and net income that’s better than the industry average. Next, we focus on quality companies that have had strong balance sheets and high returns on equity. Third, we search for value: the value of the enterprise compared with its sales, and the stock price compared with the company’s earnings, or its P/E ratio. Finally, we focus on price momentum, looking for positive relative performance versus the company’s peer group.

We like to say we are “investing in tomorrow’s leaders today.”

O’Toole: We also evaluate the stocks that align with our optimal business model, which is epitomized by four characteristics: 1) the company should show past results as a growing franchise and hold a leadership position within its industry; 2) the company should exhibit high barriers to entry, a competitive advantage and a defensible market position; 3) the company should be innovative, with differentiated products or services; 4) finally, management should communicate openly with the investment community and have consistently met or exceeded the objectives it set for itself.

Pineno: Companies that we want to own in the portfolio typically offer accelerating earnings growth and earnings estimates that are revised upward by Wall Street analysts. Finally, valuation is an important component of our investment process. We do not pursue growth at any price, but rather seek companies trading at a discount to their long-term earnings potential.

What are your portfolio’s construction parameters?
O’Toole: In an effort to focus on our best stock ideas and appropriate portfolio diversification, we typically hold from 65 to 80 stocks and less than 5% cash. We invest primarily in domestic stocks, but if and when we buy international names, they typically generate a large percentage of their revenues in the United States. When it comes to the size of a position, we try to balance several factors, including the stock’s appreciation potential and how much exposure the portfolio already has to each sector. We also look at how the security fits into our overall risk profile and liquidity needs. An initial position will typically be 0.75% to 2% of the portfolio.

When earnings growth is scarce, high-quality growth companies have an advantage relative to the broad equity market.

What is your sell discipline?
Pineno: We will consider reducing or selling outright a particular holding if a security has reached our valuation target; if there are significant changes in our fundamental analysis; or if we find more attractive opportunities. We evaluate regular, independent reviews of the portfolio’s risk level and as a result may adjust our individual stock exposures to optimize the portfolio. We expect our annual turnover rate to be about 50%.

What about the turnover rate’s potential tax consequences?
O’Toole: We are very aware that for individual investors tax consequences play a major role in maximizing wealth, so we always consider the tax implications of our trades on behalf of our clients.

What do you foresee for the portfolio over the next year or so?
Pineno: There was a pickup in the number of mergers and acquisitions (M&A) in the early part of 2012, which we believe could be a harbinger of M&A activity over the remainder of the year. We also think there will be a deceleration in earnings growth in the coming months, especially among large cap names; and typically, when earnings growth is scarce, high-quality growth companies have an advantage relative to the broad equity market. We think the EGL strategy, with its focus on small and mid cap companies, stands to benefit from this environment in 2012.

IMPORTANT INFORMATION

Projections made may not come to pass due to market conditions and fluctuations.

Asset allocation, diversification and rebalancing do not assure a profit or protect against loss in declining markets.

Investing involves risk. There is always the potential of losing money when you invest in securities.

Any information presented about tax considerations affecting client financial transactions or arrangements is not intended as tax advice and should not be relied upon for the purpose of avoiding any tax penalties. Neither U.S. Trust, Merrill Lynch, and its represen-tatives nor its financial advisors provide tax, accounting or legal advice. Clients should review any planned financial transactions or arrangements that may have tax, accounting or legal implications with their personal professional advisors.

Always consult with your independent attorney, tax advisor, investment manager, and insurance agent for final recommendations and before changing or implementing any financial, tax, or estate planning strategy.

OTHER IMPORTANT INFORMATION

Equities Equity securities are subject to stock market fluctuations that occur in response to economic and business developments.

Stocks of small- and mid-cap companies pose special risks, including possible illiquidity and greater price volatility than stocks of larger, more established companies.

Fixed Income Investing in fixed income securities may involve certain risks, including the credit quality of individual issuers, possible prepayments, market or economic developments and yields and share price fluctuations due to changes in interest rates. When interest rates go up, bond prices generally drop and vice versa.

International Investing International investing involves special risks, including foreign taxation, currency risks, risks associated with possible differences in financial standards and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility.

OtherDividend payments are not guaranteed. The amount of a dividend payment, if any, can vary over time.