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Staying the Course

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These are not the best of times for large-cap growth funds. Like the rest of the sluggish economy, such funds have been hit hard by the slowdown in technology, consumer spending, and the events of September 11. In the midst of this uncertainty, the Whitehall Growth fund (WHGFX) is battling through. Manager Paul Blaustein, who has run the fund since August 1998, has led Whitehall Growth to a five-year annualized return of 13.25% as of September 30, 2001, despite a -22.70 year-to-date return. The fund remains strong among its large-cap peers, ranking 18 out of 467 funds since its inception in February 1995, according to Standard & Poor’s. Blaustein, who was vice president and portfolio manager at Desai Capital Management prior to joining Whitehall Asset Management, sticks to true long-term investment strategies and believes research is essential. “My philosophy is to never put an issue to bed,” Blaustein says. “Never think you’ve got the answer. The investment business is a process and a journey. We’re basically making decisions under substantial uncertainty and as an investor you have to realize that. It’s not ‘Yes’ or ‘No’ and then move on to the next thing.”

Blaustein likes companies that have at least a 10-year track record and that make a product with sustainable growth. “The concept of sustainability and conviction really requires the company and the management to have established some record over time in different market environments,” he argues. “A young company may have a concept, but it’s very possible that in three months another company may come up with a better concept. Or that in 18 months everyone who has any use for a certain product will own it and then it’s all over.”

This is why Blaustein sees future growth even in times as bleak as these. Blaustein believes technology will continue to flourish over the next several years, and says we haven’t seen the end of the tech boom. “I don’t think the 1990s are over,” he claims. “We’ve only gone slightly toward penetrating markets and fully utilizing information technology. I think we will have an above-average growth decade.” Positive words in negative times from a portfolio manager who is able to look past short-term results.

The last 18 months have been tough. Are you poised for a rebound? We have a very strictly defined discipline that is designed to produce long-term performance. We don’t really focus on near-term market forecasts. We try to look at investing as a participant should, figuring if you’re going to be successful over the long term as an investor that you have to invest in things that do well over the long term. We try to identify companies that represent very good businesses and we try to participate as owners over the long term in those businesses. That is what we look for when the market is going up and that’s what we look for when the market is going down.

The theory is that you’ll make a lot of money when the market is strong and you won’t lose as much on the downturns. We’re trying to, first, outperform over the course of a market cycle of five years, and, second, trying to do it consistently.

A superior business is defined in terms of three characteristics. First is growth: if a business is growing, it is increasing in value. Growth is really defined in terms of unit growth, not in terms of a company that had temporarily depressed profit margins and is improving its profit margins. That’s not really growing.

The second factor would be profitability. Again, if you want to have superior performance isn’t it more likely that you can accomplish that with companies that are more profitable than the average? So we focus very much on companies that have superior returns on capital. In looking at the income statement we also prefer a company that has high margins. High margins tell you there’s something different about the business. We want to understand why the potential is there for superior profit and growth and that means we need to really understand the business and what’s unique about it.

The third factor is sustainability. You want to invest in companies with superior performance that can sustain it over time. That’s a combination of our understanding of the business and why it’s done well, management having demonstrated a capability of running it successfully over time, and stability.

With all the short-term volatility that exists right now, what sectors are you looking at? We really don’t do any sector work per se. We don’t say that a sector looks attractive. We don’t say we have a 10% weight, let’s go to 15%. We look at individual companies. That having been said, if you’re looking for companies that have the characteristics that I’ve outlined above, it doesn’t take a great deal of thought to figure out that certain industries or sectors just aren’t going to have them. And certain industries or sectors are more likely to have them. By its very nature we are going to spend more time looking at companies in technology, healthcare, entertainment, financial services, consumer goods, and business services.

What draws you to have such a large allocation to technology? Clearly it’s a lot easier to grow by producing products that didn’t exist before because then you don’t worry that your prospective customers already own it. It’s easier to grow if you can reduce the cost of what you produce so that more people can afford to buy it or afford to use it in different applications. This is seen as expanding the addressable market for the same product. Also, I think technology gives you more opportunity to differentiate the product. For example, if you use copier paper, do you know who made it? Do you really care? But with technology products there’s tremendous opportunity to have non-commodities, to have products that are distinctly different at least in the customer’s perception as to what is available.

So since there’s room to differentiate, there’s room for growth? Room to differentiate means there’s room to establish a relationship with a customer where the customer derives specific value from using your product and is willing to pay more for it. Obviously we prefer a company that can sustain that advantage, like a Microsoft or Wal-Mart. It’s not just that today they have something that you want, but most likely you will continue to want that product or something else from that company a year from now or in 36 months.

Is it mainly established names you look at? By definition it is very hard to make a long-term forecast on a company that’s only been in business for 18 months. As a general rule, we’re not looking at any company that hasn’t been in business for 10 years.

What within technology looks good to you? In terms of where we think long-term values are, I think that what is driving the economy and driving technology is semiconductor technology. I think there is a shifting of value-added backwards such that companies that design systems are increasingly providing less and less of the value and companies that produce the chips and produce the equipment that makes the chips generate more of the value. We believe that on the manufacturing side the real value added is from the companies that provide the equipment, not the companies that do the manufacturing.

Why should advisors steer their clients toward your fund over value funds or money market funds now? If someone is looking to invest for three months, then we’re not the place to go. Our objective is to maximize returns on a three- to five-year basis. We try to be consistent over time, but we are more concerned with the long term. Our belief is that investors should focus on sustainable operating trends. There are people who buy stocks today because they were up yesterday. That’s complete nonsense. We don’t buy things because they were up yesterday, and that might mean the portfolio will not be the best performing portfolio tomorrow. What you really want to do is focus on companies that prosper in different market conditions on a long-term basis because they are sound businesses. The longer your perspective, the better you should do relative to your competitors. It’s hard to do well over the long term without doing well in the short term, but that doesn’t mean you are going to be the best in any three-month period. But if you consistently do reasonably well you’ll wind up doing extremely well over longer periods.

Have you seen a change in inflows into your fund pre-September 11 and post-September 11? There’s been a clear slowdown in the inflow of money, but I think it’s true we have had a net inflow virtually every day since September 11. Inflows have just been a lot smaller than before, but we’re not seeing withdrawals.

What’s your philosophy behind having only around 40 holdings in this fund? I don’t think there’s anything to be gained by being above 40. Obviously if you were running an $80 billion fund you couldn’t do it with 40 names. On the one hand the reason for increasing the number of names is really to provide diversification. I don’t think there’s really any evidence that you can’t sufficiently diversify with 40 names. If you look at academic literature, it suggests you can diversify with less than 30 names. The reason for keeping it down is, let’s face it, the market isn’t so inefficient that you can go out there and want to make a bet against the market on 300 names. Secondly, since we are very disciplined in what we are looking for, there aren’t 500 great companies out there. The marketplace is very harsh and anybody who has an above-average return on capital attracts competition. The only companies that sustain superior performance are companies that haven’t just fallen into something but really have built something of great value that can’t be duplicated. There really aren’t that many of those types of companies. Finally, I’d say that when you do find something you want to own, you want to own enough of it so it’s going to make a difference. We want to be passionate about the names we own, and we really want to own them.

Your relatively low turnover ratio makes this a tax-efficient fund as well. How do you keep turnover low? I think if we look over the last 36 months it is averaging around 30%. Turnover tends to be concentrated. We really don’t sell things because we think we’re going to buy it back at $3 or $5 lower. The market moves violently when people change their expectations. As Woody Allen said, 90% of life is just showing up. Basically, you have to be there. It’s easier to pick what you want to own. It’s harder to figure out what day it’s going to do well. That’s why the long-term strategy works. We don’t sell stocks to be tax-efficient, however. We’ve adapted investment strategies that implicitly are tax-efficient.

Can you speak about your team approach to managing the fund? The core of our operation is made up of two groups: a three-person group consisting of Marc Keller, Jennifer Schaeffer–an analyst who works with us–and myself. We talk every 30 minutes or hourly. The two other members are a portfolio manager and a junior analyst. Essentially we’re people who have been around for a long time. I’ve got 28 years of experience and Mark has a bit more than that. We’ve figured out over time what our strengths are and what works in the marketplace. We’re not an organization that starts out with a list of 3,000 stocks in our universe and runs them through screens to tell us what to buy. Some people do it that way, and that’s fine. I think the less experience you have, the better it is to do that. That’s using a dull tool and saying let’s use a lot of processor cycles where there’s very little intelligence involved. We think our processor cycles are worth a lot, and we want to be very careful where we apply them. What we’re looking for is to find our mistakes before we buy a stock. If we decide we are going to take a look at a company, we take a very in-depth look at the 10-year financial history of the company. We’re not going to take a 10-year look at the financial history of 3,000 companies and try to find value. We want to focus very intensely on a limited number of names that we think meet our criteria as businesses, where we think we understand the businesses, and we think we have some reason to believe they are attractively priced.

What do you see as a recovery time for the current economic slump we are in? There are two ways of looking at it, or maybe three. The typical growth slowdown or recession is really an inventory correction. When you have excess inventory, it takes a couple of quarters to work off the inventory, interest rates come down, and things take off. To the extent that that is the problem, most of that has been worked off already or will be worked off by the end of the year. The second issue is capacity. To the extent that a recession is caused by excess capacity, clearly it takes longer to work through that. There are some areas where there is excess capacity. For example, there is too much optical fiber running from New York to Los Angeles than the country will need. On the other hand, demand for communications services continues to rise, and one of the great things about technology is that things become obsolete. Nobody wants to buy things that are obsolete. And if you have an industry where costs are coming down on an average of 30% a year, things become obsolete pretty quickly. New products are much better than the old products so you do generate demand for new products and cause capacity to become obsolete. Underlying all of this is that the 1990s showed that investment in information technology yields substantial enhancements in productivity. I think as leaders in industry continue to spend, it forces their competitors to go along or fold the tent and give up.

I think the demand for tech services will be strong. Some companies will disappear that didn’t have a good product. Industry leaders always strengthen their competitive positions in these environments and come back strongly. The third issue is September 11. We don’t know how long it will cause the consumer to be concerned and cut back, or what the response, politically and militarily, of the administration will be. But it seems to me that the 1990s were not a mirage, companies that were leaders in applying information technology to their businesses developed enormous competitive advantages, and those advantages are being sustained or getting greater. Whether it’s GE, Cisco Systems, or EMC, they understand that their strength is based on having created a business model with high fixed costs, low incremental costs, and dominant average costs. As we look at 2002 we see growing momentum in the economy and we see 2003 as being an even better year. As for the political situation, my guess is that Osama bin Laden isn’t going to topple the American economy. Much stronger entities have tried and failed.

So you don’t think the events of September 11 have thrown us over the edge? It’s possible it will lead to a sharper and shorter downturn. It’s possible it will lead to a longer downturn. At this point we don’t know. I remember in the time before the Persian Gulf war, Glenn Schaeffer (president of what was then Circus-Circus and is now Mandalay Bay) said when people were talking about how strong Saddam Hussein was and how many American casualties there’d be, he said take the U.S. and give the points. My guess is that if I’m Osama bin Laden I’m more worried than if I’m George Bush.


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