Buy the Numbers

Craig Callahan isn't interested in a tech company'

Dean Smith, the legendary former coach of the men's varsity basketball team at the University of North Carolina, took a lot of heat during his career for the rigid offensive system his teams employed. "You have Michael Jordan and James Worthy," his critics would say. "Why don't you just let them play and express the considerable talents and abilities they were born with and have honed to this day?"

The same could be said of the inflexible system applied by Craig Callahan to the management of the Icon Group of Mutual Funds, which he co-founded in 1996 and continues to oversee as president and chief investment officer. In a world where investors seem to have totally tuned out such fundamentals as price, earnings, and betas, Callahan's system never wavers. He doesn't read the many promotional reports that are sent to his Denver office by public relations officers. He doesn't listen to what stock analysts have to say about a company's future prospects. And he never, ever visits the headquarters of a company. "There's no need to," the 50-year-old Callahan says dryly. "There isn't anything that's there that could possibly help my fund's decision-making process."

Yes, the man is a rock. This is especially the case when it comes to the world of technology and the Icon Information Technology Fund (ICTEX). Callahan isn't swayed by the latest world-changing developments in broadband access, optical networking, or pump lasers. What turns him on is hard-earned numbers that he can sink his teeth into. There is one other likeness he shares with Smith: the roaring success his system has spawned. Smith rode his system to two NCAA championships and more victories than any other Division I men's basketball coach in the history of the sport. Icon Technology has racked up an impressive annualized average return of 35.86% over the past three years as of February 28,2001, and was able to post an outstanding 14.08% return in 2000 despite the Nasdaq's loss of close to 3,000 points. "I think we've been doing pretty good so far, don't you?" Callahan asks.

You had an incredible year in 2000, while it seemed that everyone involved with technology got hammered. How were you able to select the tech stocks that actually did well? We use a quantitative system. We do not read brokerage reports, we don't listen to outside opinions, and we don't have autonomous portfolio managers weighing in with their ideas. Out team implements a system. We use an equation to compute the intrinsic value of a company's stock. It's based on one that was published by Benjamin Graham in 1962 in the Financial Analysts' Journal. We then try to buy companies below or as close to their intrinsic value as possible.

What do you mean by intrinsic value? The intrinsic value of a stock is its value based on all the cash that share of stock will generate in the future, discounted back to the present by risk and what returns can be gained in so-called risk-free investments like fixed-income securities. A dollar of earnings five years from now is not worth the same amount as a dollar today. So you have to discount those future earnings to their present value according to how risky it is and our opportunity cost, which is what can be gained through fixed interest rates.

What does the equation look like? Well, I don't know if I want to give that away.

Oh, I see. It's kind of like the secret recipe for Coke? Yeah, I suppose so.

Well, can you give us an idea? Sure. In the numerator you have the average earnings for a company over a varying time scale depending on how fast the earnings are growing, along with the rate of how fast those earnings will grow in the future. We normally start with a five-year projection and then override and change it accordingly. In the denominator, you have the Triple A Bond yield and beta, where beta is risk.

Doesn't Warren Buffet use a similar calculation to come up with his investment choices? If you look at the famous letters he wrote to the stockholders of Berkshire Hathaway, you see intrinsic value often.Yes. Warren Buffet was a student of Benjamin Graham at Columbia and thought of him as a mentor. My equation is slightly modified from the one he uses, but it's relatively the same.

It's well known that Buffet doesn't buy any stocks that are involved in technology since he doesn't understand the underlying businesses. Would you say that your fund is a good way for people who appreciate Buffet's style to invest in technology? Yes. I would say it's accurate to say that.

How many other tech funds employ this style? I don't know of any others. A lot of people don't think that intrinsic value can be applied to tech stocks since they have such high growth rates, but I believe that our system can be applied to any kind of stock, whether it be biotech, tech, automotive, or whatever.

How do you actually make your selections? A few years ago Standard & Poor's came out with two other indexes of U.S. stocks to supplement the S&P 500: the Small Cap 600 and the Mid Cap 400. If you add to these the S&P 500, you get the Supercomposite Index. We take this and add about 200 more companies to round out certain industries and then compute the intrinsic value of all of these companies.

You mean, you actually sit down and do the math for each of them? Yes. Myself, and the three other analysts working with me, do the math every Monday morning.

Then what do you do? We first divide the 1,700 companies into 123 sectors. We then take the intrinsic values of the companies in each sector and use them to compute the average intrinsic value of each sector.

Why do you deal with sectors? It eliminates much of the risk of dealing with individual companies. You might have lightning strike th

Icon Information Technology

Icon Funds

12835 East Arapahoe Road

Tower #2, Penthouse

Englewood, Colorado 80112

800-764-0442

www.iconfunds.com

Ticker: ICTEX

Portfolio manager: Craig Callahan

Managers' tenure: 4 years

Fund started: February 1997

Minimum initial investment: $1,000

Load (front-end): 0%

12(b)-1 fee: 0%

Net assets: $36 million

Dist. yld (trailing 12 months): 0%

P/E ratio: 21.5

P/B ratio: 5.6

Median market cap: $2.2 billion

Expense ratio: 1.37%

Turnover: 32%

3-year alpha: 31.23

3-year beta: 1.43

3-year r-squared: 53.0

3-year standard deviation: 51.03

Returns
2000: 14.08%
1999: 111.03%
1998: 33.96%
1997: NA
1996: NA
12-month (annualized): -16.54%
3-year (annualized): 35.86%
5-year (annualized): NA
Top Five Holdings
Applied Materials 5.70%
Microchip Technologies 5.40%
Helix 4.30%
NCR 4.30%
Anixter International 3.90%

e manufacturing plant of one company, but it's unlikely that it's going to happen to all the companies in an industry. So what we do is compare the average intrinsic values of the companies in each industry to their average prices. When we see a sector where the average price is less than the intrinsic value, we start buying companies in that sector. So what we have is four or five stocks in a given sector in our portfolio at once. We then wait until the average price of the companies in a sector equals or goes over their average intrinsic value and then trade out of that sector for one that is undervalued. We're rotating in that way.

Why are companies so cyclical? We can recall when people loved biotech and [then] didn't love biotech. Industries come and go from favor. People are emotional, and at times they take prices too high and other times they let them fall too low. By computing intrinsic value, we can tell when that emotional pendulum has swung too far in any direction.

You mean your system is designed to avoid emotion? You could say that. We deliberately take out the emotion and the stories involved with these companies.

This must have really played well the last couple of years, since so much of the market was based on emotion. You could say that our system has been a good one to have in this environment. For instance, we were weighted throughout 1999 with large-cap stocks like Qualcomm, Lucent, Motorola, Intel, LSI Logic, and Altera. In January and February, our numbers began to show that these companies were beginning to stray from their intrinsic values, so we began to sell.

That was right before things started to go south last year. It wasn't that we predicted it or were so smart, but rather it was the system's numbers. We were actually in cash at one point early last year, up to 25%, and then we started buying small- and mid- cap technology companies that provided a service rather than built hardware. Those companies were the only ones we found where their intrinsic values were higher than their price.

I notice you have a lot of companies involved in credit histories, ATMs, and unmanned cashiers. It wasn't that we believed in those businesses or stories. Those companies were the only ones we found where their intrinsic values were higher than their price. It's not a top-down method that starts with a theme, but rather all about the system.

But what about all the inspiration that comes along with the great technological advances of our day, the products that will change things? I don't have any interest in that. I don't like to talk about that at dinner parties, I don't like reading the reports about it. I don't even hire people who come from other brokerage houses because then we would just have to deprogram them to think in terms of the system and numbers.

How about your background? I grew up in northwest Ohio, went to the University of Florida for two years, and then finished my undergraduate at Ohio State with a degree in psychology. I was taught the system while I was a graduate student at Kent State University. I got a doctorate there in business administration in 1979 but couldn't find a job in the financial services industry, so I interviewed at schools around the country and wound up teaching at the University of Denver. While I was there, I worked on the side for the research department of a brokerage house coming up with recommendations for the brokers. I remember that most times a promotional guy would come by the house, and the story wouldn't match up with how things turned out.

When did you get into Icon? First, it was called Meridian Capital Management, a firm I started in with another guy in 1985. We started managing private accounts and today, we still manage over $585 million from more than 3,500 private accounts, with all of that money being brought to us by financial planners.

What made you start the mutual funds? We had been using Fidelity's and Invesco's funds for the accounts, but more and more we thought we could do it better ourselves. We wouldn't have a load, and we wanted to be able to control the rotation of the stock selections in and out of different sectors. In 1996, we started several Icon Funds and shifted much of the money we had in our private accounts there.

Are you ready to rotate back into the bigger chip makers and tech names that you unloaded in the beginning of last year? We already have. We believe technology is definitely on sale right now. Our top five holdings are Applied Materials, Microchip Technologies, Helix, NCR, and Anixter International.

Do you ever once want to get into a company because you're fascinated by the story or inspired by the product? Never. I wouldn't even know about the stories. I don't watch CNBC. I don't read analyst reports, I don't read newsletters. I don't even like to talk about that kind of stuff at dinner parties. It's all about the numbers for me.

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