Q:† Would you describe the investment philosophy of your fund?
A: We (Baribeau along with coportfolio managers Richard Skaggs and Pamela Czekanski) firmly believe in owning stocks of businesses that are growing rapidly, have defensible competitive advantages, and are exploiting good market opportunities. Stocks perform best when the companies are going through a strong growth phase with barriers against competition, so that profit margins are expanding and return on invested capital is accelerating.
Weíre very active investors. We donít mind taking big bets against the benchmark or the market itself. We let the process tell us where we should focus as investors rather than picking stocks from the index components. Weíre looking for profit growth no matter where we find it.
In the last three years growth stocks havenít done that well on average, but active managers have done very well as thereís been a whole new group of companies coming along with strong fundamental leadership. These new leaders are not the ones from the 1990s, which happen to dominate most of the indexes. So it's been a very interesting time for the good stock pickers.
Q:† How do you implement that philosophy into an investment process and strategy?
A: The process involves three steps. First, we run quantitative screens looking for a minimum of 11% per year EPS growth for the next three to five years.
Second, we'll look for positive earnings revisions after a company has reported fundamental news. If analystsí consensus has been far too conservative regarding the earnings power of a company, youíll see that reflected in an upward revision for this year and the next year. Thatís an indicator that a security may be systematically undervalued because analysts have been too conservative in their profitability estimates. We track that every month as an indicator to take a look at the stock.
Another key element is looking for strong or accelerating revenue growth. We donít want to be weighed down by companies with sluggish sales growth that are driving their earnings up through cost cutting or financial restructuring. If strong unit demand is backing the sales growth, then the earnings estimates are more likely to be sustained over time.
Once weíve gone through that process, weíll take a look at the valuation to decide if it isn't too late to buy the stock. We use discounted cash flow models to determine the intrinsic value of a company and what the market is already embedding in this security. Other methods of valuation, including P/E ratios, tell you what a company is worth, but they donít tell you why itís worth that relative to any other competitor.
The third step in the process is risk management, which helps us determine the position size we should establish in a stock.
Q:† What are the milestones in terms of portfolio construction and risk management?
A: There are three variables that help us determine the position size we should establish in a stock. The first one is the volatility of the historical stock price that will influence the level of the allocation we make. The second is the correlation of similar risk factors embedded in that security with other stocks in our portfolio. The higher the correlation, the lower the position size weíre likely to take.
Third, we match our fundamental conviction level with the position size. Even if a stock is not very big in the market, it may come in as a large holding in the portfolio if our conviction level is very high, the stock has unique noncorrelated risk factors versus the rest of the portfolio, and a unique business model with very little competition.
The risk management part of the process is important as the last filter in terms of building the portfolio. We always stay fully invested. Cash will only go to a maximum of 5%. A single position in the portfolio can grow only to 5% of the portfolio's market value and then weíll start selling it.
We only have 45 to 55 stocks. The turnover historically is about 175% and thatís where the active manager discipline comes in. The turnover is not due to new names; half of it is trimming from or adding to existing positions.
Q:† Since you define growth based on projected earnings, there is always the factor of guessing and hoping. At the same time, historical earnings are a fact, but they aren't necessarily reflecting the direction in which the company is going. How do you handle this situation?
A: We definitely look at historical earnings because they help to establish the execution profile of the business, whether itís a growth business or not, how well the company executes versus its peers, whether itís gaining or losing share. All of these are important in evaluating the investment case.
What we donít do is top-down macro bets. We donít get involved in economic forecasts that could disrupt or change, because the business dynamics is not forecastable. Instead, we focus on the individual business and how the company is executing in the current environment, because this is the best indicator of what could happen in the next three to 12 months. While all valuation models are based on long-term forward cash flows, the reality is that short-term stock performance is based on very short-term fundamental results.
Q:† Active management also creates some tax liability for the investors. Is that something that you manage or the tax implications are just part of the fund?
A: Yes, itís something that comes with the fund. Given the bear market of five years ago, thereís still a lot of tax loss carry-forward in the fund. The tax issue should not be a major ocncern for investors for a couple of years to come.
Q:† So why would you use the discounted cash flow, which requires assumption of interest rates and a longer-term view of the earnings stream?
A: Once you understand what is built into the valuation structure of the security, let's say 18% growth, then you look at the company. If you see that it isn't even capable of achieving 15% growth in the next three or five years, then you know that itís overvalued. Otherwise you need a place to start, which you can break down by assumption and test whether thereís upside in the security. Every equity price is based on the long term value of the business, itís not based on the short term. Whether it works as a stock in your portfolio, however, is a function of the short term.
Q:† Do you create your own estimates or do you rely on Wall Street estimates?
A: When weíre tracking earnings revisions, weíre only interested in the consensus. Once weíve looked at the revisions, we drill down and look at the quality of earnings, the accounting adjustments, and the tax rate assumptions that may be changing. We want to know if itís just an accounting-based earnings revision or a fundamental revenuebased change. If the quality of earnings looks good, then weíll take a harder look at the fundamental drivers, create our own earnings estimates, and decide where we think the business is headed. The revisions are a signal that we should take a harder look at the business because it may be undergoing an inflection.
The best example of that case is Apple Computer, which we bought in the middle of last year. Apple was a stock we've never owned before. The company has a history of great product innovation and it has struggled to maintain consistency in execution, but it has been working hard to get going again. The earnings revision was significant and was indicating that a big change was due in the profitability of the business.