Q:  What is the investment philosophy behind managing the Johnson Disciplined Mid-Cap Fund?

A: Our investment philosophy is based on the belief that a disciplined, multi-factor approach to stock selection is critical for the long-term success of a portfolio. We believe that while no single factor consistently delivers superior results, a diversified mix of quantitative factors with low correlations does. As a result, our holdings have a combination of growth in earnings and revenue, reasonable valuation, good momentum, and improving profitability.

In other words, we have a quantitative philosophy that embraces both growth and value factors. We have relied on this style and philosophy since 2003, when we formally changed the investment process towards a quantitative approach. Previously, we relied on buying quality growth stocks at a reasonable price. We opted for the change because our analysis suggested that by applying a disciplined framework, we could avoid the behavioral pitfalls and the emotions that sometimes can get in the way of investment decisions.

More importantly, our approach is not a black box. When we identify the factors that we use in our model, the familiarity and the transparency of the factors are very important. With a 42-year company history, we have the benefit of working with many previously used factors and that brings consistency and a track record.

Q:  How does that philosophy translate into an investment strategy and process?

A: Our investment approach is entirely bottom-up. Since this is a mid-cap fund, we use the mid-cap universe as defined by the Russell Midcap Index for our stock selection. We rank each stock in that universe on a weekly basis through our proprietary quantitative model.

That model is based on ten proven broad factors, which include metrics of growth, profitability, valuation, and momentum. Taking a weighted average of those rankings, we calculate a quantitative score for every stock. The weighted average is done through a dynamic weighting process, where we use a combination of recent factor effectiveness and the economic environment. The weights of those factors range between 6% and 14% for any single factor.

The quantitative score derived through this factor model drives our investment decisions. The highest ranked stocks in the universe are selected for purchase, while the stocks with the lowest ranks are targeted for sale.

Q:  How many factors do you have in total? Could you explain them in more detail?

A: We use more than 50 factors but we group them into 10 broad factors, which become part of our model. Those factors fall in five categories – growth, profitability, momentum, valuation, and technical trends.

The growth factors include both historical and expected growth. We measure not just the earnings growth, but also the revenue and cash flow growth. In terms of profitability, we look at margins and accelerating growth. The momentum factors have a price momentum component and an earnings momentum component, so they represent a blend of fundamental and technical momentum.

The valuation factors include relative and absolute valuation. In the technical trends category, we include stock price reversal, which is a short-term indicator that reflects price movement, and the size of the company. One of the proven factors that we believe in is small companies outperform large companies over time and that’s also part of our model.

But the result is a rank that compares the stocks within the universe; it is not an absolute number. Theoretically, if every stock in the universe had negative revenue growth and negative acceleration, we would still have a top-ranked stock, which would be the one with the smallest decline.

Q:  How do you weight the importance of each factor in the final calculation?

A: The weightings change as they are part of the dynamic process with two main inputs. We believe that all ten factors are important for our model, and we allocate weight to them in any environment. We start with equal weights of 10% and then we make adjustments with our dynamic weighting process.

The first step is evaluating the recent factor effectiveness. We measure the performance of each of the ten factors using a long-short portfolio, and we make adjustments based on the recent performance trends for the factors. For example, growth might have a weight of 12%, and relative value might have a weight of 8%.

The second adjustment is tilting the growth or the value factors using our leading economic indicators model. The idea is that certain economic environments favor growth stocks and other environments favor value stocks, so the environment is reflected in our model. That indicator has been sending mixed signals this summer, which probably indicates that we’re transitioning to the growth overlay. Prior to that period, there was a preference for valuation factors. So the factor effectiveness and the economic conditions are the major steps of the weighting process.

Q:  How would you describe your buy and sell discipline? What are the other criteria in addition to the ranking?

A: Because we try to balance the turnover and the transaction costs, rather than changing the portfolio every day, we have rules that determine what an appropriate value-added swap would be. For instance, if a stock has a weighted average score of 7, while another stock has a score of 6.5, the difference between the two doesn’t justify a swap.

We have a “two-point” rule that says that the portfolio can be improved by adding the stock with a score two points higher than the stock that’s already in the portfolio. That’s a value-added swap and we’ll make that trade. Our turnover is in the 80% to 90% range because in a typical week we would find two or three stocks that score low enough on the portfolio to be replaced.