From the February 2008 issue of Investment Advisor • Subscribe!

Go Anywhere

Free of market cap constraints, and sector agnostic, Michael Carmen uses a unique metric called A-TOM to drive performance through varying market environments

By now advisors have heard the hue and cry of many experts imploring them to move away from value investing and into growth investing, and it's something that may be worth considering, especially for advisors who believe that the markets tend to revert to the mean after the long run that value investing has had.

Finding a growth fund that has performed well during the period in which value investing was in favor can be daunting, but it is not impossible. One such fund is the all-cap $1 billion Hartford Growth Opportunities Fund (HGOAX), sub-advised by Wellington Management Company, LLP, and managed by Michael Carmen since 2001. Carmen, senior VP and partner at Boston-based Wellington, credits his success with the fund to his "contrarian" tendencies and "sector agnostic...go-anywhere" strategy that permits investment across the market-cap universe, in stocks that could be considered at different times in the growth or value camp "depending on where they are in their cycle."

The fund gets five stars across the board from Standard & Poor's, and has had average annual total returns of 20.53%, versus 9.88% for the S&P/Citigroup 1500 Growth index, for the five years ended November 30; 19.98% compared with 8.65% for three years; and 28.72% compared to 9.44% for the one-year period.

We spoke to fund manager Mike Carmen by telephone from Boston in early January.

How much money do you manage over all?

For Hartford I run almost exactly $4 billion now, [however, including money managed for Wellington Management] it's closer to $9 billion.

What's your investment process?

My overall investment process involves fundamentally seeking companies that have accelerating tangible operating momentum, or what I refer to as A-TOM [aay-tom]. At the core what that means is that I'm seeking companies that have accelerating revenue growth, and improving operating margins, and earnings growth that is going to exceed consensus expectations.

Do you screen these quantitatively first?

The problem is it's very hard to screen for [accelerating growth in the future] because most screening is historically looking backwards, so it really is a lot of blocking and tackling. It's meeting with and talking with hundreds and hundreds of companies over the course of the year, between myself, my team of dedicated analysts (six dedicated analysts), and Wellington's (54) global industry analysts. It's culling, from all of those meetings, the companies where we qualitatively see some catalyst or driver--whether it's a retailer with a new merchandising strategy, or a technology company with a new product cycle, or it's a biotech company with a new approvable product--that's going to drive the better-than-expected results. It's going to drive better top-line results and improving operating margins. So it starts, really, with those meetings; you can't really screen for it.

Once we do those meetings we try to quantify what those catalysts mean for the earnings progression of that company, and we're usually looking out two calendar years--so right now everything we do is predicated on what we believe a company can do in calendar '09. Once we do that analysis we can compare that to consensus and we ask ourselves, "How are we differentiated versus consensus?" because that's the core of what we're trying to do. [It] is to try to find these companies that have accelerating trends--but we want to buy the ones that have not just accelerating trends, but [also where] we have a differentiated view relative to the consensus. So the result after doing that analysis is we think that company is going to earn X. Is X equal to, less than, or more than what consensus is looking for? We want to identify the ones [in which] our view is above consensus and those are the ones that we want to buy in the portfolio, predicated [on the fact] that those stocks have, in our mind, at least 30% to 40% upside from where we initiate the position.

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So this is strictly growth--there's no value component at all?

It's strictly growth--the only value component is that we do have price targets for every stock in the portfolio. Yes, we want to find the best growth companies with the best prospects, but we don't want to overpay for those companies. The last part of the process is based on the level of earnings growth, the sustainability of that earnings growth, the quality of the earnings growth, the quality of the company, the quality of the management team, and the relative attractiveness of that industry. We're going to say, "We believe that this company, in calendar '09, is going to earn X amount. What do we think is the right multiple to place on that earning? Does it deserve a market multiple, a greater-than-market multiple, a below-market multiple?" That's how we determine what we think is the right multiple to pay. Once we apply what we believe is the right multiple, we compare that to the current stock price, and we like to see at least 30% to 40% upside before we initiate a position. If it only had 20% upside, most likely we would put it on our target list with a lower buy-point and wait to see if we get a correction in that stock.

Is this how you sustained your growth objective through a market that was so favorable to value investing?

We did very well--obviously last year was more growth, but [we did well] even in '02 [through] '06 when it was more of a value market. Number one, in any market [when] companies are beating expectations, those stocks are going to react positively. Maintaining that discipline of looking for those kinds of companies was very helpful. Second, because of the way we think about stocks, we are basically sector-agnostic. If we think the best opportunities are in energy, or basic materials, or gold, we'll go to those sectors. We're not married to the "traditional growth sectors." Last year, one of our best-performing sectors was fertilizer stocks (see "When Value Means Growth" sidebar).

Is that what makes this fund different from other growth funds?

I think so. One of the differentiating factors is the go-anywhere aspect of the fund. I try not to really define what growth and value are. If you look at the indexes--the Russell 3000 Growth versus Value, the names constantly switch from one to the other, depending on where they are in their cycle. What I'm trying to do is capture stocks early in their growth cycle because one of my tenets is that pretty much every company is cyclical. For every Cisco out there that you find that has a good 10-year run, there are a lot of other companies out will have great runs for some period of time and will have some cyclicality to them. I want to capture that part of the growth cycle as early as possible. Going back to the fertilizer stocks that's what happened. They were in a period where they were in a lull, and then things were setting up last year between ethanol, and China, India, and other emerging markets on the food side, and the fuel side, and everything came together and culminated in a very tight market last year--that's what really drove pretty strong earnings growth for these companies.

I noticed you are light on the financial sector?

I think this was a great call. Wellington has so many phenomenal, experienced analysts that cover that particular sector, and they were, very early, saying that things were going to get very dicey in the financial sector, particularly in the banks, and S&Ls, and companies in the housing sector. So that was a good warning for me. Second, the financial sector last year was the opposite of what I do. It was what I'd call D-TOM--things were decelerating across the board, so to me, it was a very easy call. There were no accelerating trends there, there were strong decelerating trends, and so based on my process it was very easy to say this is a sector we don't need to be fishing in very much this year. That's what drove the underweight, and we continue to underweight today.

Do you still see the financial sector as not ready to accelerate?

Absolutely. What I see is a lot of value managers that are now fretting about whether they should be getting more involved in the financial sector, and based on the way investment trends go, if the value managers are fretting about it, it's probably way too early for me to even be thinking about it. There's no visibility in terms of seeing improving trends in that sector right now--we're still in kind of the stopping-the-bleeding mode, and that's not usually where I make the most money.

Your portfolio's leaning to large cap right now--is it typically large cap?

No, we have the ability to be from small cap to large cap, and over the past two years now we've been migrating a little bit more to the large cap sector because we just feel as though there are better opportunities there based on the fact that mid cap and small cap had a great run early in the decade and there's less opportunity to differentiate yourselves, particularly in the small-cap area, still somewhat in the mid caps. But we're finding more opportunities in the larger-cap stocks that have been unloved for a while and there's a lot of apathy in that area. We've seen some stocks that have had better trends, so between mid caps and large caps, that's where more of our time has been spent.

Would you talk about some larger holdings?

Sure. One stock that I'm excited about right now is Electronic Arts [ERTS]. We've been very successful investing in the videogame cycles and since I've run the fund, this is the second videogame cycle we've played. Electronic Arts is not one of the stocks that we'd owned earlier in the cycle because we felt that there were other companies that were going to gain share partly at Electronic Arts's expense, and also we didn't feel that they were running the company as well as we thought that they could. What's changed over the past few months and why we've bought the stock, number one, is they've brought back the ex-chief operating officer who had gone to the VC world. We felt that he was going to be a lot tougher on the cost structure of the company, and we thought that was gong to be very helpful, and they were going to reorganize their game development effort, so we felt that we now could have a higher estimate of what operating margins could do during this cycle. Secondly we thought their product development was going to get stronger and a good example of that is that they just came out with a product in the last couple of months called Rock Band. That's a competitor [to] Guitar Hero, which has been very successful, from Activision. The same people who developed Guitar Hero are the people who developed Rock Band, and we're hearing some very good vibes about that. That, layered on top of the great franchises they have, like Madden, and in soccer or basketball, we felt that they were going to see some better top-line momentum and it's going to translate to better bottom-line momentum over the next couple of years, so that's become one of our bigger positions over the past few months.

In the October 31 portfolio you had some large holdings in solar power. Is that something that's gaining momentum now?

Yes, we've been involved in the solar space over the last couple of years and one of the analysts that works on my team, Mario Abularach, has done a phenomenal job in being very early in identifying the winners in the solar space. Given the energy issues we have on a global basis, alternative energy has been an area that we've spent a lot more time on; it was actually one of the reasons we got involved in fertilizer stocks--we were looking at ethanol plays and the we ended up buying fertilizer stocks instead. It's one of the reasons we've been very enthusiastic about the solar space and we've had a couple of different holdings there over the last couple of years and we're still very bullish on that space.

Is there a holding that's worked out better than your original thesis?

One that we still own in the portfolio [is] Focus Media, [FMCN, which] is basically an out-of-home advertising play in China. It's not TV advertising. The biggest part of their business is when you walk into an office building in tier-one, even tier-two cities in China, and you're standing in the lobby waiting for an elevator, they have flat-panel displays at the bottom of the elevator bank that play continuous advertisements, mostly from top advertisers. They have a whole network, so the same commercial is playing in every office building in China that they have flat panels in, and they'll run a number of different advertisements per hour. They bought a company that has billboard displays n residential buildings in China, poster boards within the elevators, which have more localized advertising. They also have advertising in hypermarket stores in China, where...they'll have tens of flat panels over different parts of the stores...more consumer based advertising for napkins, and tissues, and things that are actually in the store. They have also done electronic billboard advertising in Shanghai and they're going to expand to other cities. They do mobile advertising also, which has actually become very profitable for them and has been much more successful in China than it has been in the U.S. One of the reasons it's done better than expected is when we first bought this company all they had was the bottom-of-the-elevator office building advertising effort--everything else that I've told you about they've bought over the last couple of years...so the magnitude of the company, and the opportunity for the company over the next three or four years has become a lot better than we ever expected when we first bought this company a couple of years ago. So it's been a very good stock for us but we still think there's considerable upside from where the stock is trading today. It's one where we have very strong top-line growth, and we have our own internal earnings estimates for the next couple of years that are much higher than Wall Street is predicting.

Is there a holding that was more of a disappointment?

Sure. One that we actually still own, that didn't work out well but we think it will, is Kohl's [KSS], the department store. We had everything that we look for in a particular stock, and Kohl's has been a really well run company. It's done a lot of smart things on the merchandising side. You probably have heard they did this exclusive with Vera Wang and that's been very popular in terms of the apparel side; they've done things with the Food Channel, they've done exclusives with Candie's, and a number of other brands. They've really taken [charge] of having these exclusive brands within the store and it's one of the few department store level brands that still has good store growth ahead of them--good square footage growth.

They were doing very well, particularly in the beginning of last year and the stock had a very nice run in the first half of the year, but then I think they were hit, mostly, with the fact that the consumer has gotten very, very challenged--particularly a lot of subprime borrowers have done poorly--and that's one of their core customers, because they're more of a middle-class brand in terms of who shops in their stores. They've been pinched by not only the issues of the housing market but by the fact that [the price of] gasoline, now over $3, has crimped their spending. Despite the fact that Kohl's has done a lot of great things over the last year, the environment has been way too much of a headwind for them, and the stock has fallen from a high of around $70 down to where it is now, around $45 [January 3]. Even though we're not that bullish about the retail environment, we've chosen to hold that company number one because we're not market timers. I don't know exactly when the consumer is going to turn around, but I still think it's a very well-positioned company for the future that just has some very major consumer-based headwinds right now that are impacting not just Kohl's but just about every other apparel-based, consumer-based company's store-based model. I think we might have some continued difficulties in the nearer term, but we still think that our thesis will play out in the longer term, and so we've been willing to hold on to that stock even through a period of difficult earnings growth.

Do you have a sell discipline?

I have a sell discipline that's driven by losers and winners. On the winning side, we have a price target for every stock that we put in the portfolio. We drive that price target off of our multiple and our earnings [estimates]. It's dynamic so as earnings are changing, as the situation is changing, we might raise what our multiple projection should be, or we might raise or lower earnings depending on what's happening in the environment. That drives our price target. Once that stock hits our price target, if we cannot justify raising that price target any higher than it is, at that point, then we're going to start to pare back, and eventually sell, that position.

The second reason we sell a stock is for lack of execution...when we're wrong. We basically have our differentiated view on that company and reasons why we think they're going to do better, what the catalysts and drivers are going to be, and if those catalysts and drivers do not come to fruition--the company falls short of achieving and executing on those drivers, and earnings fall short--it's great if we find out early and we're able to sell before there's a disappointment; obviously we're not always going to be perfect in that respect and we are going to have some losers, and so we do sell the stock. We tend to be very quick sellers of stock. If we see things are not working out the way we expected, that the company is underperforming, we'll be a very quick seller of that company, because my belief is that once you identify that things are not working out well, that usually you're going to be in a period of underperformance that will last longer than you expect. Most investors tend to underestimate how poor things can get, just like you underestimate how good things can get, and so we believe in selling as soon as possible in that respect.

So if it's not the fundamentals of the company then you might hold on a bit longer?

Exactly.

What kind of client would belong in a fund like this?

It's not my job to tell people how to invest, I just try to find a couple of good stocks along the way, but it's part of a good mix in a portfolio where you want to have balance between growth and value and you're looking for a growth manager who is doing his or her best to make money on the upside, but also is very focused on the potential downside of the portfolio. We pride ourselves on the fact that we do very well in up markets and if you look historically at the fund you'll see that since I've been running the fund, [starting] in 2001, that we tend to do reasonably well in the down markets and we tend to protect reasonably well. I don't expect, necessarily, to be in the first quartile in a down market, but I want to be in-line. If I can be in-line in a down market and I can outperform in an up market, given the fact that cycles tend to be more up than down, then we're going to deliver very good performance for investors over the long term. I think that if you have somebody that has a long-term focus who wants to do well in a growth cycle and get some protection in a down cycle, that's the kind of investor that would be happy to be in our fund.


Senior Editor Kathleen M. McBride writes regularly about mutual funds. She can be reached at kmcbride@investmentadvisor.com.

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