) seek what they call inefficiencies in stock prices to boost returns. The fund's three co-managers, Tony Weber, Chuck McCurdy, and Charlie Mercer, scan the large-cap universe for stocks they estimate to be substantially underpriced by Wall Street. They run a fairly concentrated portfolio of about 50 names and like to trade their positions to get the best price.
Founded at the end of 2001 with U.S. markets in correction mode, the fund lost 29.4% in its first year of operation, vs. a losses of 22.1% for the S&P 500 and 22.2% for the average large-cap blend fund. But the fund soon found footing, and the portfolio has beaten its peers and the index for the three years ended Aug. 31, registering an average annualized return of 15.9%, vs. gains of 12% for the S&P, and 10.6% for the peer group. The portfolio is ranked 5 Stars by Standard & Poor's.
HIGH TURNOVER. Though Weber and McCurdy stress that they use the Russell 1000 Growth Index as their bogey, they don't follow the index's weightings. Nor do they observe any division between growth and value, or other metrics typically relied on by fundamentally managed funds.
Most recently, the managers say they've moved away from some industrial and basic-materials stocks and added a few names in health care, consumer, and homebuilding. The top five holdings in the portfolio as of Aug. 31 were Johnson & Johnson (JNJ
); Dell (DELL
); Genzyme (GENZ
); Bear Stearns (BSC
); and Gilead Sciences (GILD
Turnover on the fund runs high, making it a better option for nontaxable accounts and defined contribution plans. The fund's expense ratio (1.3%) is slightly higher than other blend funds (1.04%), but lower than large-cap growth funds (1.41%).
Carol Wood of Standard & Poor's Fund Advisor spoke recently with Weber and McCurdy about their investing strategy. Here are edited excerpts of their conversation:
How would you describe your investment philosophy?
Weber: The foundation starts with screening for earnings surprises and subsequent asset revisions. Our universe is essentially the number of companies that have sell-side research published on them. We're not focused on earnings growth, p-e, return on assets, or return on equity, but where we feel the inefficiencies of the market lie.
Tell me about your process of selecting stocks.
Weber: Chuck, Charlie, and I get together once a week to take care of any problems the portfolio might have. Our nine analysts are focused on the new names popping up on our screens. They'll give us a one- or two-page bullet-point write-up -- we don't write research reports -- and a model of where the leverage is between our expectations and the Street's. We'll make a determination within an hour as to whether that name should make its way into the portfolio.
We typically buy a 2%-to-2.5% position initially. This is a more concentrated portfolio, with 30 to 50 names, of which the top 10 make up 40% to 45% of assets. We've got two traders executing our trades.
What are your buy criteria for stocks?
Weber: We want companies that have put up at least two quarters of positive earnings surprises and for which our estimate is well above the Street's -- ideally, 20% to 25% higher. We want them to attack a very large marketplace and to have the ability to build barriers to entry.
We want to make sure that whatever service or product the company provides, it does so in the most efficient way, which should expand gross margins. If management is good, that should drop down to the operating line.
We also want a balance sheet that's growing commensurably with the income statement and don't want to see receivables or inventory outstripping revenues quarter to quarter.
What about your sell criteria?
Weber: We don't base things on valuation because it can go to extremes on both the upside and downside. If we have an earnings disappointment and there's no overriding valuation case we can make, which happens maybe 5% of the time, the stock is sold categorically. Ideally, we want to anticipate that.
What's your time horizon?
Weber: It varies. Homebuilder D.R. Horton (DHI
) has put up 32 straight quarters above expectations. With a technology company, our time horizon may be one or two quarters if they don't execute.
We trade our positions a lot. Often, we'll take a 4% position to 2% and try to buy back cheap to try to add value.
McCurdy: We approach growth differently than traditional growth managers, who look at companies that they think are going to grow earnings at X percent for the next five years. That's a long time to wait to find out if you're wrong.
How are the fund's assets typically allocated?
Weber: We don't benchmark. The sector allocations are built one stock at a time. If the Russell 1000 Growth Index and the S&P 500 have 20% technology, we're not afraid to go to twice that -- or to zero.
McCurdy: It doesn't matter to us whether a name is viewed by the Street or by analysts as a value name or a growth name.
Weber: Here's the beauty of our process. A lot of guys with a growth hat on would never look at a homebuilder. Yet homebuilders have compounded earnings at 30% to 35% for the past six years, sell at six to seven times earnings, and trade at maybe 2 1/2 times book value.
Could you single out a top holding and tell me how it reflects your investment style?
Weber: One of our holdings started out as small cap -- the Chicago Mercantile Exchange (CME
). It has got a $10 billion market cap now. We added it to Select Growth in July 2004. The business has tremendous barriers to entry because of the technology needed to effect trades. These guys dominate the Treasury bond futures market, and they're just now going into the currency market, which is huge. We think this name can sell for a much bigger premium as its margins and market share expand.
How do you manage risk in the portfolio?
Weber: By building it one stock at a time. Though we will allow tech and health care to go to 50% because they have so many subsets, we limit most sectors to 25% of assets. Although we will incur more volatility by not benchmarking, we think that's how to add alpha and extra performance over 5 to 10 years.
Are there any recent additions to the portfolio?
Weber: As of the second quarter, the only major changes were that we moved away from some of the industrial and basic-materials names and added some health care and consumer names and homebuilders.
Do you think that with the rebuilding from Katrina, basic materials might do better?
McCurdy: There's certainly going to be in an increase in the number of housing starts, and that hasn't been reflected in stock prices.
Weber: With regard to materials stocks -- steel and cyclicals -- there's definitely going to be a floor, but we don't think the sector will do what the media is expecting it to.
We believe the economy was slowing down before Katrina. Now that the price of oil has put in a top, we believe the economy is starting to turn down, though not going into recession. It's similar to what happened in 1994 to 95 and 1984 to 85. Once it was perceived that the Fed was in a neutral position, the markets took off in both '85 and '95. That's what we think is going to happen now -- possibly in the fourth quarter of this year or first of next year.
What accounts for your fund's returns over three years, and do you expect them to continue?
Weber: I think it has to do with good calls we made in homebuilders and materials last year. But we can't get in the business of forecasting returns.
McCurdy: The underpinnings for those themes are still intact. For homebuilders, nothing has changed fundamentally in the demographic trends driving household formation, low interest rates, and market-share gains by publicly traded homebuilders.
With your success with homebuilders, should readers get the impression that this is a closet real estate fund?
Weber: I hope not. We first got in the sector in 2001, buying Ryland Group (RYL
) for our small-cap product and adding Centex (CTX
) to Select Growth in December of that year. As we got to know the industry, it became clear that was probably one of the greatest sector calls we've seen in our careers.
I don't care what the media or Greenspan has said. There's no housing bubble in this country, though there might be one in Naples or San Diego. Home-price increases should settle back into 4% to 6% range, and these guys will still spew off a tremendous amount of cash, buy back a lot of stock in some cases, and continue to expand market share and gross margin.
McCurdy: The housing group constitutes less than 15% of the weight in the portfolio. That we have been involved in it for that long speaks to durability of the secular trend in homebuilding. So long as the fundamental underpinnings are intact and the group is broadly beating expectations, they'll be in the portfolio.