From the September 2004 issue of Investment Advisor • Subscribe!

September 1, 2004

Like Father, Like Son

Judged by most standards, Thompson Plumb Growth Fund looks pretty good. It's a no-load, large-cap blend fund without a 12b-1 fee and with lower expenses than its peer group. S&P gave it five stars in April 2003 and Morningstar seconded that vote of confidence with a five-star rating of its own. For the 10-year period ended June 30, 2004, THPGX boasts an average annualized return of 17.9%, compared to an 11.8% return for the S&P 500. It also has attracted $1.4 billion in assets.

The fund was launched in 1992 by John W. Thompson and Thompson, Plumb & Associates, a predecessor firm to the current fund advisor, Thompson Investment Management, LLC, of Madison, Wisconsin. John W. is still active in an oversight capacity, but day-to-day management has been handled since 1998 by his son, John C. Thompson. While the portfolio is predominantly composed of large-cap companies, the fund's management style is flexible enough to include smaller companies and both growth and value stocks as market conditions dictate.

How would you describe the fund's investment philosophy? Growth at a reasonable price is a description that sometimes has been used for the fund. That's our core strategy. We have a definite preference for large caps, although we'll occasionally use mid caps.

Are you using any benchmark other than the S&P 500? No. Well, yes and no. When the Nasdaq's up 60% and we're up 6%, our clients gauge us on what the Nasdaq is doing. We find that regardless of what index you peg yourself to, the clients end up looking at the index that's done the best and then ask, "Why haven't you done that well?" But basically we're trying to beat the S&P.

What are you looking for in terms of the investments that you make for the fund? Every idea we come up with doesn't fit into this exactly, but in general, we're looking for companies that meet certain criteria that apply to probably 90% of our buys. We're looking for companies that have high returns on equity--15% or higher. We want a relatively high-quality company from a credit rating or a Standard & Poor's quality rating standpoint. They should have at least a B+ quality rating, and we prefer an A or better on credit rating. We're looking for P/Es underneath their 10-year averages, hopefully significantly under. We also look for price-to-sales under their averages, because we don't want to buy a company whose margins have just doubled and then watch those margins fall back to where they were.

Another point that's important for us is that the companies need to be generating free cash flows. We don't like that "Build it and they will come" type model, where the company spends every dime that comes in the door and is continuously reinvesting.

The companies we really like are ones that can grow and make huge amounts of free cash flow at the same time. There aren't many that can do that, but good examples are Microsoft, Coca-Cola, and Viacom. Each of those companies can continue to grow and could basically pay all their earnings back to shareholders if they chose to.

And the fund has a considerable stake in those three companies. Right. They're all among our biggest holdings.

How does the recently announced Microsoft dividend payout affect the fund? Do you stand to get a huge infusion of cash from that? Yes, we will. We still haven't decided how we're going to handle that, whether we're just going to turn around and buy some more Microsoft shares or use it for something else. We may just increase our investment, but we haven't decided yet. We'll see what the stock is doing right around the time they pay the dividend. In theory, the stock will drop $3 the day after they pay. Frankly, it's just going to be a tax event for a lot of folks.

How often do you adjust the portfolio's contents? It depends on the year. Some years we trade quite a bit because the markets are creating a divergence, for example, between huge companies and tech companies and middle- to larger-size companies. That's what happened in 1999. The tech companies got to huge multiples while people were selling Wells Fargo Bank and Associates First Capital and stocks like that down to ridiculously low multiples. That created a large incentive for us to trade. In other periods of time, like the last six to eight months, we haven't traded a lot. When you look at the market, you see that the stocks are moving together, both up and down, to a significant degree. Our turnover rate, on a fiscal year-to-date basis, is somewhere in the 10% range. In past years we've had as high as 70% turnover, so it's considerably lower right now.

When turnover is that high, is it because you're trying to keep the performance numbers up? That's exactly why we're doing it. We'd rather not trade, but when you're trying to buy stocks at low P/E multiples, sometimes you have to. A high-quality company that has a high ROE and a low multiple is usually that way because of some bad news. Maybe they're off on their earnings or it's some other relatively short-term issue. We're waiting for that company to repair itself and begin growing again. We want to watch the P/E multiple expand and then sell [the stock] and do it again. If our stocks have done real well, our process requires us to sell, and we usually have plenty of ideas to buy; that's what creates the turnover.

The fund seems to be heavily concentrated in financial and healthcare stocks. Why is that? Half of our financials are in two stocks: Fannie Mae and Freddie Mac. [The two make up more than 13% of the fund's holdings.] We think they are drastically undervalued compared to their historical P/E multiples. We think that the future of these companies is actually quite bright and they will be very good performers. They are trading at roughly eight or nine times forward earnings estimates, when they've averaged 15 times [forward earnings estimates] over the last 10 or 15 years and they've traded as high as 24 times each. The stocks' multiples are a third of their peaks and at a 50% and 40% discount, respectively, to their averages. That's why we have a huge weighting there.

As for healthcare, in the technology part--meaning drugs and devices--we've had more of a concentration on the drug side, although we do have some devices in the portfolio. Those stocks have not performed very well, but we think their low multiples and the demographics of the U.S. are going to be a good combination. So we see it as a growing market while the stocks have low multiples.

The fund has assets of $1.4 billion. Are you looking to set a ceiling for its size? Well, market willing, [the ceiling] could be pretty large since we do have this preference toward large-cap stocks. I don't think we would have any problem if the fund were to grow to about $10 billion. Once it starts getting over that level maybe we'd have to start taking a look at what's best for shareholders in the long run.

What would cause you to invest in companies outside that large-cap realm and, as you mentioned earlier, make some moves into mid caps? That would happen if, for example, the valuation spreads between large cap and mid cap get very wide, such as they did in the late 1990s. At that time we were finding mid-caps at 8 to 10 times earnings while big caps were 50 or 60 times on average. If a spread like that ever happens again, it would cause us to move, but I have a feeling that that type of spread may not happen again for the rest of my career, although stranger things have happened.

That's why we moved to mid caps when we did. More than half the fund has always been in big caps, so it's not like we just shifted entirely. But when you see a train coming at you, you're not going to stand on the track; you're going to get off and go somewhere else.

I noticed that your holdings list a very small amount of cash. Is that intentional and is it always the case? That's pretty much by design. There have been occasions where we've had maybe 5% or 10% cash for a month or so. That's happened maybe once or twice in the past 10 years, but 99% of the days, we're at 1% or less in cash. We're sort of at odds with many other managers in that we're finding tons of good [investment] ideas. The market is trading at under 16 times 2005 [earnings] estimates. Our portfolio is trading at something like 14.2 times '05 estimates. To me that seems really attractive, especially when you consider that the figure on 10-year bonds is at 4.5%. On an earnings yield basis, if you take that 14.2 figure and divide it into one [year], it works out to a 7% earnings yield. So you're getting 250 basis points over the 10-year Treasury, plus these companies are growing. If they grow 7% a year, you could easily see a 10%, 12%, 14% return profile at that P/E multiple. I think the market's very attractive and I think it's going to have a heck of a rally by the end of the year.

Where do you see the Thompson Plumb Growth Fund fitting into an investor's portfolio? It's probably more of a core offering. We're not going to be an aggressive growth fund that's high momentum, investing in Yahoo! and that type of thing. Nor are we deep value, investing in AT&T and Dow Chemical. We're just trying to buy quality companies that have had great long-term growth histories and great long- term growth outlooks, that may just have a few short-term issues in front of them and can regain their past glory. It's a core offering where you don't have to worry quite as much about us losing a substantial amount of money but on the other hand we won't keep up in a really aggressive growth environment.

Do you personally have a big stake in this particular fund? Yes. All of my publicly traded equities are in the fund.

Where do investment advisors fit into sales of this fund? We'd very much like to expand our relationship with the investment advisor community, although we haven't been able to afford the direct sales resource yet. We have one salesman and have just hired our second in the last few months.

Do you manage any other funds? We also manage the Thompson Plumb Bond Fund and I serve as an analyst on that one. I think there's a big benefit to knowing what the bond market is doing as well as the stock market. The bond market offers a different perspective on the world. For example, at certain points in time the bond market could be predicting a difficult economy where the stock market could be predicting a great economy, but the bond market tends to be more accurate at predicting things than the stock market.

Do you think that the outcome of the Presidential race is going to have any effect on the market and on this fund? It's unpredictable, but I do think that if we elect a President in November the market will go up. Whatever happens, just getting past it will be cause for the market to rally. I think there's always a lot of worry when there's uncertainty. If Kerry wins, what about the drug stocks? If Bush wins, what about Fannie Mae and Freddie Mac? Those two sectors are the poster children for each potential administration's want list. Just to have a little bit of certainty about who's going to be running the country will create a better market.

Staff Editor Robert F. Keane can be reached at bkeane@ia-mag.com.

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