Markets & Finance

Valuing the Long Term -- and Trust


It didn't take the Enron debacle to get Rick Drake, co-manager of ABN AMRO Chicago Capital Growth Fund (CHTIX), to formulate his investing rules, especially when it comes to management credibility. Along with an insistence on honest company management when picking stocks, Drake has stuck with a focused portfolio of companies that have demonstrated steady revenue and earnings growth over the long term. This strategy, plus gains in some holdings such as Cardinal Health (CAH), has recently shielded the fund from some of the market's sharper losses.

For the one-year period through Jan. 31, the fund fell 13.1%, while the average large-cap growth fund skidded 21.9%. The longer-term record is more positive, with Chicago Capital rising 13.4% for the five-year period through Jan. 31, while its peers were up 8.3%. Bill Gerdes of Standard & Poor's FundAdvisor recently spoke with Drake about the fund's investing strategy, top holdings, and recent portfolio moves. Edited excerpts of their conversation follow:

Q: How would you describe your investment process?

A: It's both qualitative and quantitative. We screen for several criteria, including low debt and five-year earnings and revenue growth, which leads to about 250 companies. From there, our process is all qualitative. We have four research analysts, divided by industry, who talk to companies, Wall Street, competitors, and customers, and do a lot of in-depth research.

For instance, our tech analyst goes to user conferences, for companies such as Oracle Corp. (ORCL), Sun Microsystems (SUNW), and Nortel Networks (NT). We get a good feel for technology from the people who use the products.

Wall Street analysts generate good information, but we don't rely on their buy and sell recommendations, because their long-term outlook is much shorter than ours. The long-term for Wall Street is this June.

Q: You run a concentrated portfolio?

A: It's a focused portfolio of about 35 to 40 stocks. Running a concentrated portfolio for the long term, we can spend a lot of time getting to know a company before we buy it. With a 25% turnover and a portfolio of 35 to 40 names, we theoretically add 10 new names a year, though we bought seven or eight companies last year.

Q: What stocks did you add last year?

A: Our technology weighting increased relative to the S&P 500. We went from 115% of the S&P 500 tech weighting last March to about 140% currently. Last December, we replaced Computer Sciences (CSC) with International Business Machines (IBM), though we added more to IBM than we took from Computer Sciences. Last year, we also purchased Southwest Airlines (LUV) and Mellon Financial (MEL).

Q: Your risk profile is lower than many growth funds. How do you achieve this with a concentrated portfolio?

A: Being diversified, we limit each sector weighting to 150% of the corresponding S&P 500 sector weighting. Also, no stock position is more than 5% of the portfolio. We also screen for risk by ruling out companies with very volatile earnings or high debt.

We won't buy highfliers like JDS Uniphase (JDSU) or Qualcomm (QCOM) because they don't have five-year growth records. Technology companies tend not to meet our stable earnings criteria. It will be interesting to see what happens when we screen in a month or so, using 2001 as a final year, when a lot of companies had low earnings.

Q: With earnings so poor in 2001, do you see yourself loosening up on your stable-earnings requirement this year?

A: It's not a hard and fast rule that we'll sell a company when it falls out of our universe. My guess is that this year we'll make more exceptions to our five-year-earnings rule because the overall growth rate was low last year.

Q: Have the accounting issues raised by the Enron mess affected your process?

A: We're not taking different steps, but we're questioning any company that makes a lot of acquisitions or write-offs. Medtronic (MDT) became an issue recently, but former SEC chairman Arthur Levitt said Medtronic's balance sheet is a model.

Q: What's your view of General Electric (GE), a holding whose balance sheet has been called into question?

A: No one doubts GE's management credibility. GE has been fairly aggressive and sophisticated in its accounting, but that won't lead to anything like Enron or Tyco International (TYC).

Q: Have you ever owned Tyco?

A: We sold it in September 1999, when accounting issues were raised. It's fair to say that we'll never own it again.

Q: Credibility must be an important management trait to you?

A: There are certain things that an auditor can't find without direction from a client. A company can hide an awful lot of stuff in computers and filing cabinets that auditors won't find. That's why management credibility is so important.

Q: Do you see any accounting problems in the technology sector?

A: Tech companies have more complicated products than many sectors, but their accounting isn't more complicated. They generally don't rely on manufactured growth or play games with their debt structure, since they tend to have little debt.

Q: Do you see buying opportunities because of Enron?

A: No more than usual. Stocks are also depressed because the economy hasn't recovered yet. Last quarter, people began to expect an economic improvement too soon.

Q: What's behind the fund's good performance record?

A: We didn't change our style when growth fell out of favor in 1999. We never tried market timing or sector rotations. Our tech weighting never reached 60% or 70% like many other growth funds. Looking outside mega-caps also helps us. A lot of our holdings are smaller large-caps, and we have some mid-cap holdings in the $5 billion to $10 billion range. Cardinal Health (CAH), with a $14 billion market cap, is a stock that many large-cap managers won't own. Mid-caps aren't a big percentage of the fund, but if they're up 100% a year, they can add a lot to your performance.

Q: What's your view of valuations in the overall market?

A: I think that current valuations are O.K. Comparisons between 2003 forward earnings and 2001 or 2002 earnings should be favorable because the earlier earnings were depressed. As we come out of the recession over the next 12 months, earnings and investor confidence will improve. Now, investor confidence is low because of Enron.


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