A Growth Fund That Blends Well


The Thompson Plumb Growth Fund (THPGX) is actually a blend portfolio. Lead manager John C. Thompson wants to buy companies that are consistently growing earnings and revenues, regardless of whether they're growth or value stocks. Thompson likes to keep a concentrated portfolio -- usually under 75 holdings -- with big stakes in his top stocks.

The $1.4 billion fund has beaten its large-cap blend peers in recent years. For the 12 months through July, it rose 13.6%, vs. a 11.7% return for its peers. For the three-year period through July, the fund climbed 3.9%, on average, while the peer group dropped 2%. For the five years through July, the variance is even greater -- the fund gained 10.1%, on average, while its peers lost 2%.

The fund is more volatile than its peers, as illustrated by its significantly higher

standard deviation of 22.60 vs. 16.45 for portfolios in the same group, though the fund's expense ratio is lower, at 1.07% vs. 1.15% for its peers. Based on risk and return characteristics during the last three years, S&P gives the fund its highest overall rank of 5 Stars.

Thompson joined the fund's management team in 1994. His father, John W. Thompson, founded the portfolio in February, 1992. Palash R. Ghosh of Standard & Poor's Fund Advisor recently spoke with Thompson about his strategy. Edited excerpts of their conversation follow:

Q: What kind of stocks do you look for?

A: We invest in stocks with at least $1 billion in market cap. We use a strictly bottom-up process to identify companies with top- and bottom-line growth, strong balance sheets, significantly lower price-to-earnings, and price-to-sales ratios than their 10- or 20-year averages, and annual returns-on-equity of at least 15%.

We invest in both growth and value stocks, as value stocks often show good growth characteristics. For example, Federal Home Loan Mortgage (FRE), one of our top holdings, is clearly a value stock -- but try to find a company that has grown as much as they have over the past 20 years.

We emphasize valuations. While we don't stick to absolute quantitative parameters, we rarely hold a stock trading at a p/e of more 30. Based on 2005 earnings estimates, the fund currently has an average p/e of about 13.9.

The fund's average market cap is currently about $45 billion, up from about $7 billion in early 2000. We avoid stocks undergoing significant turmoil or facing little top-line or bottom-line growth.

Q: Do you meet with company managements?

A: No, we do strictly in-house research. Our investment approach is based on valuations, so we don't find it productive to visit company facilities and management. We think that maintaining a proper distance gives us more objectivity.

Q: What are your largest holdings?

A: As of June 30, our top 10 stocks were Federal National Mortgage (FNM), 7.9%; Microsoft (MSFT), 5.9%; First Data (FDC), 5.7%; Freddie Mac, 5.2%; Pfizer (PFE), 5%; Viacom (VIA.B), 5%; Johnson & Johnson (JNJ), 3.5%; Tyco International (TYC), 3.4%; Cardinal Health (CAH), 3%; and Time Warner (TWX), 2.9%.

These top 10 stocks make up almost 48% of the fund's assets. The fund currently has 61 stocks, and we typically range between 45 and 70 holdings. We don't think it's possible to beat the S&P 500-stock index if you own hundreds of stocks.

Q: You make big bets on your top stocks. Is that risky?

A: We define risk as having a good chance to lose money. We keep a concentrated portfolio of very strong ideas. In weak markets, a concentrated fund has much lower risk than a diversified portfolio.

Q: Your largest position, Fannie Mae, has been volatile this year, though it's up year-to-date.

A: Over the last decade, Fannie Mae has had an average p/e of about 14 to 15. It currently trades at about a 9.5 p/e, which is close to its historic low. The company enjoys a return-on-equity of about 25%, and it has grown its earnings consistently for many years.

The stock has been hurt this year by two factors. Since corporate loan demand has been weak in the past few years, banks have used their lending capacity to purchase mortgages, thus competing with both Fannie Mae and Freddie Mac. However, we think this will be a short-term phenomena, since Fannie and Freddie have lower costs of capital than banks. Also, Fannie and Freddie have been hurt by political risk. The Bush Administration threatened to revoke their charters, but we feel this action is unlikely, though the stock has been hurt by this possibility.

Q: Has Microsoft gotten too big to show significant upsides?

A: Microsoft is basically a monopoly and can charge monopoly prices, which makes them extremely profitable. Though their growth has slowed a bit in recent years, they have grown much faster than tech rivals like Cisco Systems (CSCO) and Intel (INTC). Microsoft's earnings grew in 2001 and 2002, during the bear market, while profits at other tech companies fell by 50% to 60%.

Q: What are your top sectors?

A: As of June 30: financials, 22.6%; health care, 21.9%; consumer discretionary, 19%; information technology, 16.7%; consumer staples, 9.2%; industrials, 6.9%; and energy, 3.8%.

Q: You seem to be underweight in tech.

A: In the mid-1990s, we were heavily invested in tech -- double the weighting of the S&P 500 index -- 30% to [its] 15%. We became worried about the enormous rise of p/e's, so we significantly scaled back our tech exposure in 1999. By February, 2000, our tech allocation was only one-third of the index's. We were also worried about the fundamental performance of these companies, but our decisions were primarily based on valuations. At that point, our portfolio took more of a value complexion.

We remain significantly underweight in tech today, though that depends on how you classify companies like First Data and Paychex (PAYX), two big holdings in our fund. We don't consider them to be tech, but Standard & Poor's does.

Q: The fund has beaten the large-cap blend peer group for the one-, three-, and five-year periods through July. What do you attribute this to?

A: We adhere to a strict valuation discipline, so we have significantly underweighted the technology, telecom, and Internet sectors, among others, which performed poorly during the bear market. We also benefited from positions in such rising stocks as AutoZone (AZO), Wells Fargo (WFC), and CIT Group (CIT).

Q: What are your sell criteria?

A: We typically sell when a stock's trading multiple exceeds its long-term average. We also sell when we find a better investment, or if we detect a problem with a company's earnings before the market does. But we don't sell and trade much, so the fund's average annual turnover rate is under 50%.

Q: Have the Fed's recent rate hikes impacted your stock selection process? Will you reduce your financial exposure?

A: Not at all. For example, we initially purchased Fannie Mae in 1994 when the Fed started an aggressive tightening campaign. The stock's price increased four-fold in the next five years. We also bought a lot of financials in late 1999 and early 2000, when the Fed was again raising rates. These kinds of stocks become very attractive after they fall in price.

Q: Crude oil prices are reaching historic highs. Does this affect your stock picking? Will you add to your energy holdings?

A: We recently added to our energy holdings, particularly ChevronTexaco (CVX) and Exxon Mobil (XOM). We think higher energy prices present the biggest short-term risk to the American economy. However, while oil stocks have performed well recently, their gains have paled compared with the dramatic rise of oil prices. Thus, oil and energy stocks have considerable upside potential.


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