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Mutual Fund Q&A: 
Value Through Earnings
Author: Manish Shah
123jump.com
Last Update: 10:57 AM EST January 15 2008



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Alan W. Breed
  “Since we look at companies as though we are buying the whole business, we seek those that show consistent earnings performance, a proven track record in the market and a strong balance sheet with attractive fundamental valuations.”
Edgewood Growth Retail Fund

Investing in growth stocks restricted to U.S.-located and traded businesses is quite a challenging task today, when the US economy is clearly not the growth engine of the world. Edgewood Growth Retail Fund manager Alan W. Breed and his team of portfolio managers face this challenge and look to invest in high-quality, large-cap growth companies when they are trading at very attractive valuation.

 
Q:  What is your investment philosophy?

A: The basic philosophy of Edgewood Growth Retail Fund is to invest in high-quality, largecap growth companies when they are trading at very attractive valuation. We believe that earnings growth will drive stock prices over the long term.

Since we look at companies as though we are buying the whole business, we seek those that show consistent earnings performance, a proven track record in the market and a strong balance sheet with attractive fundamental valuations. We also look for a competent management that will ensure that this performance will continue in the forthcoming five to ten-year period.

Q:  What is your investment strategy?

A: We restrict ourselves to owning U.S. located and traded business and since we look at industries on a global basis, many of the companies in our universe are either U.S. companies that have a significant export business or those that are doing a lot of business in foreign markets.

We are bottom-up investors and we are always fully invested in the market. Since we operate in a tight box, at any one time we will probably have only 45 to 50 growth companies on our radar screen that fit our business criteria – such as companies with low debt, unit volume growth, strong cash flow, and earnings growth.

Our strategy is to identify the best businesses that we can as indicated by balance street strength, predictability of earnings and quality of management team and then create a portfolio of those that show a 20% earnings growth over the forthcoming five-year period. We consider this approach to be a good riskadjusted process. Therefore, most of our companies are in industries that are growing.

Our investment process is multi-tiered. We evaluate potential candidates by first starting with their current earnings and then grow them out for the next five years. We put a multiple on those future earnings to get what we think the evaluation of the business might look like for the next five years and to bring into account the declining multiple that we foresee in all large-cap companies over this period. We then discount that back at a required rate of return. Our rate of return includes the rate that you get by investing in ten-year treasury and add a risk premium to the earnings predictability. These cash flows are again adjusted for risks.

Next, we rank the companies on a present value basis versus where they are today. Those with the biggest discount to present value are the most attractive and those that are closest to fair value are the least attractive.

Q:  How is your research process organized? Where do you get ideas?

A: Our research process is quite simple. Since we look at any potential investment as though we are buying the whole business, we spend a lot of time studying the industry, the industry participants, and the drivers of the revenue and expenses so that we can come up with an accurate industry growth rate for the future.

Next, we visit every company that we invest in and spend time with customers, suppliers and competitors to understand the business and see how that business fits within its industry so that we can come up with an accurate fiveyear earnings forecast.

We look at the next five years too. So, zero to five and then look at five to ten as well. This is because when we try to evaluate particularly a large-cap growth company, we are looking at decelerating earnings growth over that period of time, and, consequently, at a multiple that will compress it. We try to discover how quickly that multiple will compress so that when we build our evaluation model, we have an idea of whether this is just a three-year wonder or has longer term sustainability.

We end up with 50 to 55 companies that make our research list. There are screens that we go through looking for companies that grow at a certain rate in earnings in the trailing five years, and have had a 20% price correction that might attract us to consider them. These companies will be ranked top-down. Once on the list, the companies are assigned to one of the six portfolio managers, according to their area of expertise, who form our committee. That person draws up a five-year earnings model and presents the idea to the whole committee. The committee then discusses and decides unanimously as a team as to whether or not the idea should be actively followed.

If approved, the idea goes on to the watch list which is then monitored closely. We then do all the due diligence that a private equity firm would to get all relevant data. Then, assuming that the stock is trading at a discount to its present value, and then the team will select the stock for the portfolio.

Q:  What exactly are the characteristics that attract you towards a company?

A: Besides looking at fundamentals like balance sheet strength we avoid industries that are based on commodity pricing as we don’t feel we can add a tremendous amount of value to forecasting the direction of copper or oil, for example. We are looking for unit volume growth in the industry and in the company that we consider to invest. So, for instance, we are not going to buy Exxon because oil is at $95 and ExxonMobil is making a lot of money. We might look at alternative energy as a category and do a lot of work to find the companies that are going to benefit as a result of a move to alternative power.

We will not buy airlines because we don’t like businesses that are highly regulated by the government or have heavy union exposure. By definition those aren’t going to have very good margins and we look for industry-leading margins in industries that have above-average margins. This also implies we look for a good underlying value in the growth stocks that we’re invested in.

Q:  Can you give an example of how you discovered the underlying value of a potential investment?

A: Corning Inc, where we have a large position. Now, LCD flat-screen technology is changing the world and our research revealed that, though there are many companies in this arena, not all of them are correctly valued. We found Corning, a flat-screen maker that makes 65 % of all the glass used in LCD televisions, as an attractively valued investment.

Corning has two other businesses that are important - fiber optic cable and related equipment and ceramic filters used in diesel engines for pollution control – but we believe that they are not accurately reflected in the stock price. In fact, they own 50 % of Dow Corning which is worth between $6 billion and $8 billion and if they were to ever spin that out or sell that stake and buy back stock, it would be a significant value-enhancing event for the company.

Q:  How do you go about constructing your portfolio?

A: At any point of time, we have a strict cap of just 22 companies in our portfolio. Mutual fund rules dictate that to be a diversified fund, we cannot go below 22 positions.

Therefore if you wanted to put say, IBM in the portfolio, you would have to make a case to sell something else and that too from the same sector or group. This is because, while creating it, we try to cut the portfolio on many different dimensions. So one is across industry where we won’t allow more than 25% to be in any one industry; the other is across valuation where we don’t want our portfolio to have huge multiples.

We divide the portfolio into three classes namely, those that grow 10% to 15%, those that grow 15% to 20% and those that grow 20% and up. We then try to have a balance among the three groups.
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