Photography By Reid Horn
To get things done, the saying goes, a committee should consist of no more than three people--two of whom are always absent. But the portfolio managers at John McStay Investment Counsel in Dallas would have to disagree. The 13 managers steer their five funds, the Brazos funds, as a team, and in a year where many stock investors pretty much got stomped on, all five funds posted impressive positive returns.
Brazos Micro-Cap Growth Fund, for instance, rose 18.9% in 2000, bringing its three-year annualized returns to 40.3%, according to Morningstar. The team approach is much of the secret, says Brian Gerber, who is the closest thing the fund has to a lead manager. "A lot of firms have a senior person who's backed up by a pool of analysts, but here we're all experienced portfolio managers," he says. "Even though my name is sometimes associated with the fund, the ideas come from all of my partners. Nothing gets into the portfolio just because I think it's a good idea." The result, he says, is a broader perspective, research of greater depth, better stock picking, and of course, better returns.
Though the fund is only four years old, the firm began managing money for universities and endowments in the early 1980s. The years have taught the firm some lessons about style drift and volatility, and the lessons have stuck. "When you have institutional clients that have put money in categories in order to get diversification, the last thing you want is to have four out of six managers all owning the same stock," says Gerber. "When we put out a micro-cap fund, we want it to look like one." New purchases for the fund are never more than $750 million in market capitalization, and those that grow to more than $1 billion are considered primary candidates for sale.
As for volatility, he and his partners use diversification to smooth out what might otherwise be a stomach-churning ride. "People ask us, 'How did you do so well last year?'" says Gerber. "Well, we never got up to a 50%-70% concentration in tech. We never had that exposure." Eschewing what Gerber calls "dot-gone" companies, the team hunted for winners in other sectors, with a sharp eye out for those with good strategies for keeping the money rolling in.
Gerber himself has always enjoyed the smaller end of the capitalization spectrum. He managed money at USAA for seven years, focusing his investing attention on smaller, fast-growing companies. He joined John McStay Investment Counsel in 1991, and continues to work in his favorite area.
So, what do you look for in a micro-cap company? It's difficult to define a good company, and we're not necessarily looking for that one-product wonder stock that has a rocket-ship ride in store. We're really looking for companies that have good visibility in their revenue streams--recurring revenues so they're not so dependent on just trying to 'make the quarter' in the last few days to meet Street expectations. We like to find companies that have small, stable management teams, strong balance sheets, and overall, some control over their model. Not Internet companies, generally, because we like to have companies that have earnings and revenues. Recurring revenues create a lot less volatility in the portfolio.
What's your definition of micro-cap? We define it as $600 million, or the bottom 50% of the Russell 2000 Index.
Are those ballpark guidelines, or do you adhere to them absolutely? I can tell you for a fact that I don't think we've ever bought anything above $750 million. Once a company starts hitting $1 billion, it doesn't feel like a micro-cap anymore. We're pretty much sticklers to our rules. Having managed money in the small- and mid-cap area for institutions and having had the watchful eye of their consultants always on us, we've learned to avoid style drift or market cap drift.
If you buy a stock small and it just keeps on growing, is there a magic number at which you require yourselves to sell? Certainly we do let our winners run, but if we really believe that a stock is distorting the portfolio--if it's well over a billion in market cap--we start having a much more critical view of that company and its fundamentals. It's not a hard and fast rule, where we'd automatically sell as soon as it hits a billion. But if it hits a billion and it's up 80% in the last three weeks, that's one more reason to sell the stock, after it's hit your price target.
Have you ever had any micro-cap stocks where if you'd held them as they kept on growing, you'd have made a mint? In part because we're only four years old, we haven't had any of those super success stories yet. We've always viewed it as a continuum of market caps, so we may not own it any more in the micro-cap fund, but we would probably buy it in the small-cap or mid-cap portfolios. Once we've done the research and grown comfortable with the management, we'd be thrilled to have a stock that graduates from the micro-cap fund and then buy it in small-cap fund.
In the micro-cap area it's kind of hard to find those super home runs, because there's a lot of coming and going in that part of the market--companies that are expanding, companies that are failing. You have to search through hundreds and hundreds of companies to find that one gem. But that's our job, and that's what's fun about what we do.
How do you find the gems? Well, one thing we don't do a lot of is screening. I hear a lot of people talk about screening, and we do do it, but it's one tool among many. Frankly, by having the industry expertise [among the Brazos team of managers], we basically already know what companies are in our space.
For the most part, it's a matter of visiting the companies. We visit with well over 1,000 companies a year, either on the road or inviting them into our office. These are meetings with the key decision makers--the CEOs, the CFOs, the founders. You really need to understand how the business works, and it's hard t
o do that just reading a report or running a screen or going to a conference. You really have to sit down and talk to people and understand how they think.
Often we find names through other stocks. As we learn more about the competitors of a stock we own, we often end up buying the competitor, or buying a supplier. There's a kind of food chain that we sometimes go through to find other companies in the same space. It certainly has happened with the small- and mid-cap stocks, where we've found them first and we say, 'Wow, this is a great area, things are growing fast; let's find a competitor that's the right size for the micro-cap fund.' There's a kind of cascading of ideas: One pops up on your radar and is attractive for the bigger-cap funds, and then you start looking for other names in the space for the micro-cap fund.
Can I ask you a question? We've been having fun asking people this question, and I'm not putting you on the spot, but I think the math is really interesting. Here goes: Given the performance of the Nasdaq in 1999, which was up 85.6%, and the year 2000, in which it was down 39.3%, what do you guess, off the top of your head, would be the two-year annualized performance? No calculators.
My first reaction is 20%, but since you're asking, that's probably wrong. You know, that's what everybody says: 20%, 25%. And this is where you get to the remarkable part: annualized, it was up 6.2% over two years. Everyone says: 'No way. Really? Wow.' And if you do it for three years, annualized, it's maybe a percent higher.
What's interesting is that a lot of people are saying, 'Well, you know, '99 was such a great year, I did really well--last year was a bad year, but '99 makes up for it.' Well, you know what? It really doesn't make up for it. It's actually below the historical trend line returns for the market. The second part of this is, well, what if the 40% drop came first? Then it's really ugly, because then you're digging yourself out of a hole. It's negative, in fact.
What I'm getting at here is what our style is. What we're known for is trying to capture the excess returns inherent in micro-capitalization stocks, but without too much volatility. These stocks are under-researched and under-followed by the Street, so that creates opportunities. But we also realize that because they're smaller, they are more volatile. By going out and buying the smaller capitalization stocks in the Nasdaq, you're really laying on several layers of risk--the inherent risk of small-cap stocks, the risk of higher-beta tech stocks. You've really created a much riskier portfolio than you probably think you did.
What we do is to try and mitigate that risk with a process that includes a number of risk management techniques, and among them is diversification. Some people will ask us, well, how did your fund do so well last year? Well, we never got up to a 50%-70% concentration in tech. We never had that exposure. We've always been able to perform by finding good stocks that operate good businesses. We build the portfolio one stock at a time. And you know what? It doesn't have to be in technology. We find good stocks in energy, in consumer goods, in financials. You don't have to chase the crowd to make good returns.
We're happy just consistently making 20% every year, because compounding 20% growth every year is wonderful.
And just to give you those numbers, the micro-cap, annualized, '99 and 2000, was up 46.6%, versus the Nasdaq, up 6.2%. And just for the record, it isn't just a phenomenon that occurred in our micro-cap fund. Based on our process that we implement across all our funds, we have five funds, all of which were up last year--in a down year.
And you attribute that primarily to diversification? Diversification, yes, and trying to own good, solid companies, rather than a 'dot-gone' type company. We really sit down and try to understand the companies, and there were a lot of companies where we said, 'We don't understand how you're going to make money.' And we have an answer to that now.
Are you a major shareholder in any of these companies since they're so small? Do you use that to influence company policy? We do take some good-sized positions, but we don't particularly like to be the largest shareholder. And we don't particularly want to be more than 5%, but there are some occasions where we've got enough confidence in the company that we might have a 5% position. We certainly have our opinions, and we express them, but we're not what you'd call an active shareholder where we try and change the company. Generally speaking, we own the company because we believe that management is capable of directing the company in the right direction.
So if they did something you disagreed with, you'd be more likely to simply sell? If they did an acquisition we didn't believe in or made some choices that we didn't think were in the best interest of shareholders, we would probably sell. And hopefully we're selling early--usually when companies have problems, they don't come out of nowhere. We're not going to stick around until they've made several mistakes.
These tiny companies must not always have buyers and sellers anxiously waiting to make a transaction. How do you deal with the illiquidity? Well, certainly you have to anticipate. You have to anticipate buying a position before good news, you have to anticipate and sell before the bad news. We have a number of controls, like we try not to own more than seven days' trading volume.
We have four traders, all of whom are experienced in trading these stocks. We probably couldn't do nearly as well without the help of a trading desk that specializes in smaller capitalization stocks.
What are some of your favorite stocks in the portfolio? One is LandAmerica Financial Group, ticker LFG. It's a financial stock, and financials have been a good area for us in the last 12 months. They are a mortgage insurer, and they benefit from lower interest rates because that generates higher mortgage activity and more searches for title insurance. They issue the title insurance policies and perform other real estate-related services for residential and commercial real estate transactions. The reason it's a good business is, one, it's a high margin business, and two, the portfolio they have has a long trail, meaning that it has good visibility in their revenues. In the most recent quarter, they grew 18%.
What's Mini Med, Inc.? That's another of our top holdings. It's kind of a unique company. They provide portable steel storage containers. You might have seen them at a construction site or even a Wal-Mart. They look like railroad cars, and you can store inventory in them, or store construction equipment. What makes it an interesting business is that you lease them on a monthly basis. On average they have a yearlong contract. But you're only paying $75 per month, so it's almost more trouble to get someone to take it away than to just keep it. Generally once they're parked, they're not moved. So you have a nice visibility there in your revenue stream, every month, getting a check.
How about Accredo? Accredo is a provider of specialized pharmacy-related services for the treatment of patients with costly diseases. It's a wonderful way to participate in the growth of biotech, but without the risk, and the company's very profitable. They focus on chronic diseases such as multiple sclerosis and hemophilia. These are chronic diseases, so patients go into therapy for years, which helps provide some of that good visibility in the revenue stream.
Say you're supposed to take your MS medicine, but maybe it makes you feel bad, so you skip it a few times. That's not good for your long-term therapy, and it's not good for the drug companies because that's lost revenue for them. What Accredo does is act as a third party that holds your hand, helps you order the drugs, asks any questions, and improves compliance. Which is a good thing for everybody.
In the biotech area, you've got a lot of companies with great ideas, but you're really not sure if you're right about the stock until four or five years down the road when the drug gets approved. And even then, you don't know if you're right, because it still has to be a success in the marketplace. We like to own the merchants who provide test kits or testing equipment or services to the biotech industry. We'd rather buy the companies who make the picks and shovels than those who are actually mining for the gold.
How much cash do you like to have in the portfolio? I think we ended the year with it in the single digits, around 9%. We view cash as a residual. We don't redeploy our cash automatically just to have it invested. We want to find good ideas to replace what we've sold, and they take time to research.
In what industry sector do you expect to make most of your upcoming purchases? We'll have to wait and see, because we do build the portfolio one stock at a time. I could take a guess at it, though, and say that the consumer area has been picking up as a strong area. We own a number of consumer stocks in the portfolio--Sharper Image, Dress Barn, Genesco, O'Charley's. Dress Barn has had some improved sales recently. Sales have re-accelerated as the company focuses more on their private-label Dress Barn line. The stock is currently at $29.
If I had to pick one area that would outperform in 2001, it would be energy. Every year there's a change of leadership. In 1999, it was tech; in 2000, health care was very strong. This year is starting out a little choppy, and energy is one of the few places that we think can outperform.