Growth Worth Talking About


To Whit Gardner, talk isn't the opposite of action, it's the prerequisite. For the $601.7 million Chesapeake Core Growth Fund (CHCGX), Gardner and co-manager John Lewis instruct their team of 12 analysts to chat with as many company CEOs, CFOs, research directors, suppliers, customers, and competitors as possible. The team tracks the information over time in search of unexpected insights about potentially profitable investments.

The fund returned an annualized 15.73% over the three years through Oct. 31, vs. a 10.81% gain for its large-cap growth peers and 12.84% for the S&P 500 index. In the last year, the fund gained 9.54%, vs. returns of 9.75% and 8.71%, respectively, for the peer group and the S&P 500. Year to date, the fund has lagged somewhat, losing 0.41%, vs. the peers' 1.77% rise and the S&P 500's 1.05% climb.

As benchmarks, the managers use the Russell 1000 Growth Index for comparing short-term results, although over the long term they strive to beat the S&P 500. The fund's expense ratio is 1.33%, vs. 1.38% for large-cap growth peers. Its standard deviation, a measure of volatility, is 13.39, above the peers' 11.65 average.

WORTH WATCHING. The fund features an annual turnover rate of 59.5%, significantly lower than peers' 86.6% figure. Standard & Poor's has a 4-STARS ranking for the fund, based on its risk and return profile.

Of the fund's 47 holdings as of Sept. 30, the five largest were Caremark Rx (CMX

, 3.3% of the fund), CIGNA Corp. (CI

, 3.2%), St. Jude Medical (STJ

, 3.0%), Capital One Financial (COF

, 2.9%), and Monsanto (MON

, 2.5%). The fund's top five sectors comprised information technology (25.3%), health care (20.4%), consumer discretionary (16.8%), financials (13.2%), and industrials (9.9%).

Carol Wood of Standard & Poor's Fund Advisor spoke recently with Gardner about his investing strategy. Edited excerpts of their conversation follow:

How would you describe your investment philosophy?

We think the best way to extract differentiated information is to go directly to the source. We contact company managements, their customers, competitors, and suppliers to try to understand what's occurring in the business, how that differs from what Wall Street expects, and how we could benefit from an appreciation in stock price as that information becomes disseminated.

We will not own more than 50 stocks in our portfolio. The point is to be different enough from the benchmark so we can outperform it.

What's your investment strategy on the fund, and how do you execute your philosophy?

We call companies on a regular basis to understand if things are changing. We attempt to call the entire universe at least once per year, and companies we're interested in far more often that. Our investable universe comprises any company above $5 billion in market cap that isn't heavily cyclical -- or about 600 stocks in total. We average between 6,000 and 8,000 contacts each year. We also make face-to-face visits -- I think we've averaged over 2,000 a year for a decade.

Today, anyone with a Yahoo! (YHOO) Finance subscription can screen for whatever they want. The information isn't differentiated, it doesn't add to value. The same is true for Wall Street analysis. So we don't use screens or Wall Street research.

We want to chase information wherever it takes us. For example, in 2002, while we were looking at Teradyne (TER), we talked to Power-One (PWER), a supplier, and learned that its business with Cisco Systems (CSCO) was particularly strong. So we ended up buying Cisco, which was a good investment.

If we were more traditional, we could have had three different analysts following those companies and never made the connection -- Teradyne is a semiconductor name, Power-One is an industrial, and Cisco is a networker. Or perhaps our semiconductor analyst could have concluded that Teradyne wasn't interesting and gone on to the next semiconductor company.

The point is, if you pigeonhole your analysts, they will become myopic in their view, and your opportunity to create a portfolio of the best names diminishes.

What are your buy criteria?

We look for three main factors. What's the company's growth rate? We try to invest in businesses whose profit (or cash flow) is growing at 15% annually. We look out over three-to-five years and say, what's the longevity associated with the company's products or services?

Second, is the stock priced in a manner which will it allow it to appreciate? The earnings should grow at a specific rate, and the multiple should expand as well. That protects you on the downside if you're in a lousy market.

Third, what's the change -- is there a new product, management, distribution strategy, or manufacturing technology? Is there something going on in the business that may later cause people to pay more for the stock?

What types of stocks do you avoid?

We avoid stocks that are heavily cyclical, whose earnings are more difficult to predict and depend solely on the price of the underlying commodities. However, if the company has intellectual-property protection and a market that needs be served, it could be less susceptible to macroeconomic influences and thus become more interesting to us.

We also avoid compromised balance sheets, where the company is heavily levered or doesn't have strong cash flow. It's a question of its ability to meet our growth projections.

What are your sell criteria?

The principal reason we sell a stock is to displace it with something we like more. The second is that the stock reaches our price objective. The third reason would be if Wall Street expects too much out of a stock. Even if news about the stock is good, there's no opportunity for it to appreciate if Wall Street expects it to be better than we do. The fourth reason we sell is if fundamentals deteriorate.

Who makes the buy/sell decisions?

Our analysts' performance is evaluated based on how well their names do in the portfolio. When they propose specific names to me, I'll talk to John Lewis. If both of us come to a consensus, we'll check with risk control. If it all checks out, we'll look for a stock to displace, and buy the new stock.

Could you single out a top holding and discuss how it reflects your investment style?

Cigna is a classic example of a company that Wall Street wrote off. Years ago, it was thought to have the worst customer service of any of the HMOs. It has undergone a phenomenal reorganization, and has been able to effect higher pricing on renewed contracts. There's a lot of room for that stock to grow. We think in 2006 they'll probably have one of the best years they've had in some time.

How are the fund's assets typically allocated?

Our positions at cost represent 1% to 3% of assets. Once in a while, they go to 5% at market value. We allocate among sectors at plus or minus 10 percentage points relative to the S&P 500.

Sometimes we find names that meet our criteria even though they're in more cyclical sectors. For example, within materials, we own Monsanto -- and it has been a phenomenal stock for us. But the materials sector represents such an insignificant part of the S&P 500 index, we could conceivably keep zero exposure to it.

How would you explain the fund's relative underperformance so far this year?

The answer is simple: We're underweighted in energy, while our peers are mostly overweighted. Our time horizon is longer than just the year this far.

Over the five-year period through October, the fund lost 1% annually, while peers dropped 6.4% on average. How did you protect the fund from higher losses during the tech bust?

All of our work comes from the bottom, company by company. We avoided hyperbolic values in tech names and sold things like Cisco when we felt the values improperly reflected the risks involved. We bought HCA (HCA) and doubled our money.

Do you have an outlook for the market and for your asset class?

It's no secret that growth stocks have underperformed. Corporate capital spending has declined since the tech bubble burst -- it would have to rise 50% to equate to normal levels relative to company sales. Cash is strong on corporate balance sheets -- 10% of assets -- while consumers are stretched. As interest rates rise, the pace of home-equity appreciation declines, if not diminishes, leaving them less to borrow against.

We think there will be a transition of leadership, with the business sector likely to grow more rapidly than the consumer sector and doing more for GDP than it has. Consumer spending isn't going to die, but it will slow as a contribution to GDP. What this means for us is that we want less direct consumer exposure than we have had recently, and more exposure to business-related capital expenditures, like technology.


Later, Baby
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