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Experience Counts

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Throughout his career, fund manager Thomas Barry has worked through market times when every investor felt they were so deep under water they’d never again surface, and times when every investor felt they were flying so high they’d never again touch down. Those experiences keep him well grounded amid today’s challenging market conditions.

His take on the subject of handling the exuberant and the depressive times: “You make more rational decisions [when you've been through a number of bear and bull markets]. You get concerned, but you don’t get scared at the bottom. You realize that when you’re most concerned, when all the negative news is hitting, that is the time to buy stocks.”

After being in the investment business for more than 30 years, Barry, the CIO, senior executive VP, and senior portfolio manager of Los Angeles-based Bjurman, Barry & Associates, knows a thing or two about picking investments. “I don’t like bear markets, but you realize you can get a great sale like you do at Christmas,” he says. “You can buy stocks at half price. Most people sell when [the market] hits the bottom, but that is the worst thing you can do. That is the irrational investor; it’s the emotional investor taking over rationality.”

As manager and founder of Bjurman Micro Cap Growth Fund (BMCFX), Barry’s stock-picking philosophy has not gone unnoticed–the fund has been awarded five stars by both Morningstar and S&P, and is the top fund in its peer group of 304 funds, according to S&P. “Most people want to hold on to their losers because they don’t want to acknowledge that they made a mistake,” he says. His philosophy: hold onto the winners as long as they’re good, and get rid of the losers–and do it quickly.

Using a five-model screening process, Barry looks through a universe of 1,000 to 2,500 companies in the $30-to-$300 million market cap range for investments that meet his qualifications of EPS growth, cash flow/price, EPS strength, P/E-to-growth ratio, and EPS revision. “Each of these models might be used by other managers, but combining these models helps predict stock price movement and smooths out the down time [that one model alone might indicate],” he explains. “You can make decisions based on quantitative facts alone, but many times those aren’t going to make you better than anyone else. You have to adhere strictly and unemotionally to sale disciplines. Some of it is implementation and some is intuition, and many people follow their intuition in the wrong direction.”

Categorized by Barry as a growth fund that pays attention to price, BMCFX has outperformed both its benchmark and its category in both the short and the long term. For the five-year period ended July 31, 2002, according to Standard & Poor’s, Bjurman Micro Cap Growth Fund had an average annualized return of 22.4%, while the S&P 500 Composite Index had a total return of 0.4%, and all small-cap growth funds had a -1.4% total return. Moreover, the Bjurman fund ranked third within the entire universe of 3,341 funds in the domestic equity category on a total return basis, according to S&P.

Barry has seen his fund’s assets grow threefold since its inception in 1997, and after being closed initially on December 7, 2001, when fund assets reached $358.9 million, the fund reopened to new investors on May 1, 2002.

We spoke with Barry about the risky-by-reputation micro caps he chooses, about investors sticking it out through today’s less-than-predictable markets, and about the continued success of his fund.

You’ve been with this firm since 1978; how has that experience changed the way you manage the fund and control fund investors’ expectations? I think experience in going through bear markets in the past makes you realize when there is irrational exuberance and irrational glum. That is what experience does for you. You can just see it. There are a lot of numbers that help predict peaks and valleys, but when you have experience you just sense it.

By their very nature, micro-cap stocks tend to be riskier. How do you control that risk in picking your companies? We only emphasize companies that have very solid earnings growth, revenue growth, and products and services likely to continue to do well in the future. We limit [single] company purchases to less than 2% of the portfolio, and we don’t have more than 15% in any one industry. And lastly, we have a very strong sales discipline. Micro caps have really been less volatile than large-cap stocks over the last five years. Historically, small-cap stocks are more volatile, but when you adhere strictly to your investment discipline and even your sale discipline, you can reduce a great deal of that volatility.

Your sales literature says you seek “superior management capability” in each of your investments. How do you define that characteristic? It’s defined as how well a manager contributes to the bottom line relative to his peer group. Everything we do is according to the numbers. I can listen to the manager, a CEO, or a CFO of a company, tell me how great his company is, and how one should be impressed with the company, but if he isn’t delivering to the bottom line–meaning earnings growth and revenue growth–then I don’t consider that superior management.

Another characteristic you seek is “conservative accounting procedures.” Have the recent revelations of creative accounting procedures changed the way you look at companies in general? The news hasn’t changed the way we look at the small caps. There is a lot less small-cap companies can hide in their balance sheets. We have really not had anything in the small-cap market that even slightly compares to what is going on in the large-cap market. Small-cap companies are fairly simple. They have one product or a few products, or one service; they specialize in those services; and they don’t have many subsidiaries. So it’s very hard to hide items like they do in some of the large-cap companies.

Why do you use these five specific criteria–EPS growth, cash flow/price, EPS strength, P/E-to-growth ratio, and EPS revisions–in your screening process? Twenty-five years ago I was given the task of using whatever computers I could to determine what models worked best in predicting future price movements, and which models worked best in smoothing out the periods where one model didn’t work very well. I came up with these models. Seven or eight years ago I found that these models were showing many very small companies to be much better than many big companies. And yet we didn’t have a micro-cap product. All big companies form from small companies, and this is the feeding ground where you could actually find the future big companies. We decided to start a mutual fund, find all these [companies], and have some really good returns.

You limit your commitment to 5% in any one issue and 15% in any one industry. Over time, have you stayed consistently high in one industry or consistently low in another? I’d like to modify that just a bit. Five percent is the very maximum we will allow a stock to be as a percent of the portfolio. We have never been over 2.5% in any one company.

There are certain industries in which we have had long-term overrepresentation. The health care services industry is one, and the defense sector is another. Technology has traditionally been a stronghold of most growth managers, and we were very heavily invested in technology from 1997 to [early] 2000. In 2000, we significantly reduced our technology exposure. In our quantitative systems, [tech stocks] became highly overvalued relative to companies in other industries, like oil, finance, and health care. Health care and defense technology have been fairly heavily represented for some time. Even prior to September 11, we had a pretty healthy exposure to some defense stocks.

What is the average number of stocks held in the fund? It’s gone up from an average of 100 last year to 130 this year. The fund has grown from zero assets in March of 1997 to $275 million [now]. And to keep the diversification intact, you need to be able to buy more stocks. For every one stock I buy, there are others that look just as good. We could have more stocks in the portfolio but we don’t want to have too many.

So how do you decide which ones to include? If they meet all of our quantitative specifications, then I dig into what kind of products the company has. What is the consistency of earnings that they have had over the last five to 10 years? What is the likelihood, given the economic outlook, that they are going to continue to grow over the next three to five years? And relative performance of the stock price tells me plenty. If the company looks better on all of those criteria, or even slightly better, I would generally pick the one that has the best relative performance stockwise but still is undervalued on our screens.

There is a lot of intuition in this business. Everyone likes to get into the exact methodology. But when it comes down to it, picking out of four or five stocks that look relatively the same is somewhat intuitive.

The average turnover rate for the whole five years is 189%. And a big part of that came from 2000 when we sold an awful lot of tech stocks. We went from 70% to 40% in tech in March 2000. Turnover is like an expense ratio. If some say turnover is too high, I say, “Well, would you rather we had held onto our technology stocks in 2000 and been down 30% for the year?” No. When you have high turnover and you’re right, it’s not bad.

With attributes like above-average projected growth rates in earnings and good marketability as part of your screening process, how do you decide which stocks to invest in, and when to get out? Number one, it’s time to get out of a stock if the P/E rises significantly above the expected future growth of the company, meaning if the stock gets overvalued relative to the other 1,900 companies we follow. Two, if a company reports worse-than-expected earnings or if it starts to lose its earnings growth momentum. Three, if a stock price loses its relative strength and starts to fall in a sideways or upward market, this is a clear sign that I will move out of a stock.

Those are our chief factors. Our quantitative systems will tell us weekly which stocks are either overvalued or undervalued; which companies are reporting better- or worse-than-expected earnings; and what kind of movement we have in the stock price.

We have had very strict adherence to our sale disciplines. I don’t worry about my ego. If I have to sell something a week after I bought it, then I was wrong. I would rather take my loss now than let the stock fall to half of what it was.

For micro caps and small caps in general, an issue is always whether the manager has to sell his best holdings. At what point do you sell your best companies? If we held onto to our winners forever we wouldn’t stay a micro-cap portfolio; we would be a small cap or a mid cap. In our case, the very best winning stocks will become a bigger portion of the portfolio. As [a company] gets anywhere from a market cap of $1 billion to $1.5 billion, it could be 2.5% of the portfolio, but we begin to trim that stock back even though it is a big winner. When it gets to be $1.8 billion, we sell the whole position and then look for others that are still growing rapidly, and are within the $30 million to $300 million market cap.

Our median market capitalization has stayed at $220 million fairly consistently for a long time because we sell the companies that get too big. I think investors that want to be in this fund want to be sure they are in a micro-cap fund. So many managers leave their winners in their portfolios and they are no longer a small-cap portfolio.

Why the $1.8 billion limit? Because there are very few stocks that get up there in this type of market environment. Once the market cap gets to $500 million, or even over $300 million, we can start buying it in our small-cap portfolios. Once it gets to $1.8 billion we can start buying it in our all-cap and large-cap portfolios. So we really don’t need it in the micro cap anymore. We think that we can find more winners in the micro-cap area, and at $1.8 billion everyone else is starting to buy. We find them first, buy them, let them run, let them get to a billion eight, and by that time all the other institutions are in there buying these stocks, and that is a great time for us to sell it and find the next big winner.

What stocks in the portfolio are you particularly pleased with? Probably my favorite right now is FTI Consulting [which accounted for 1.9% of the fund's holdings as of June 30]. FTI Consulting [ticker: FCN] provides litigation and claims management consulting to corporations and law firms. It’s growing very rapidly and just bought out a division of PricewaterhouseCoopers, which is going to add to the earnings and the earnings growth. So I am beginning to trim it back.

Panera Bread Co. (PNRA) is definitely one of my favorites; they have been a big winner for us for a long time; I just really like what they do. They’re a bakery caf? and own 110 different retail outlets, and have about 259 franchised caf?s in the U.S. The company is growing over 50% a year, and will be entering the Los Angeles market next year. And the stock is only selling at 28 times earnings.

I also like D&K Health Care Services (DKWD). It is expected to grow in earnings this year at around 40%, and it is selling at 17 times earnings. What is good about this company is that it has very consistent earnings growth and it is not dependent whatsoever on the general nature of the economy. That is what is so great about these micro-cap stocks in general. They don’t get bashed around with every international problem that is broadcast on television. The average median growth in earnings of our companies over the last 12 months is 43%. This is the only sector of the market where I can find that.

It’s also the most inefficient sector because fewer analysts follow these companies, but this is where you can get the most value. When you get into the large-cap area, how does the manager add value? It is pretty hard to do. With micros you can add major value because not everybody is out there searching for the same thing in this sector.

Can you explain the team approach your firm follows when choosing investments? I do get input from the other three people on the team, but I am not a very good person to comment about the benefits of a team approach. I have chosen 99% of the investments [in the micro cap fund]. I don’t really think that you can get this kind of return with a team approach. Teams tend to make popular decisions and not always the best decisions. They stick to the middle of the road. I think you have to have one person in charge if you are going to be at the top. You have to make decisions quickly, and you can’t sit around and talk to people. A team does help as far as giving me some ideas on the buy side, but what is more important than having a good team is having a good trader.

The fund’s expenses (a 1.8% expense ratio) seem high relative to its category, but is this true? When we are adding as much value as we add in this particular category, and work as hard as we do, we would rather limit the assets under management and have a higher expense ratio than have a lower expense ratio and have $3 billion.

There isn’t one person who has invested in this fund over the last five years that has complained about the expense ratio.

Who is the best investor for the fund? Someone who can tolerate a higher-than-average amount of risk? There is that term again, “higher risk.” If you look at the fund’s performance for the last five years on a quarterly basis, we have had lower risk [than large-cap funds]. But the most important investor for us is the investor who can focus on the three-to-five-year period and not the day-to-day market actions. We don’t want day traders. The investors that stick with us are the ones that make the most amount of money.

Why was the fund closed and when will you close it again? We are going to close it when it hits $400 million. It is going to be a hard close, meaning there won’t be any transfers; only existing investors will be able to invest in it. There were a couple of factors we had in deciding to close it initially. This was the first mutual fund we had ever managed, so we weren’t really sure how good of a job we could do as assets got to certain sizes. We found that when we closed it the first time, the market was kind of high, and we were getting tremendous amounts of cash flow, so we wanted to slow all that down. Once the market went back down again we found so many good bargains that we felt it was time to reopen, and we felt more comfortable managing bigger amounts of money. So it was a function of not only the market and how many bargains we could find in this sector, which is a pretty key issue, but also allowing more investors in at lower valuation levels in the market.

What else should we know about your fund? One, this fund is a pure play in the micro-cap sector, which is of course the most attractive sector in the market today. Two, you have a manager who’s been managing the fund since inception, plus I have 30 years of investment experience. Three, we focus on the very best companies: fast growing, with the best price/earnings ratios. You don’t want to put 100% of your money in any one sector; you wouldn’t put it all in micro caps (I would, but most investors wouldn’t do that. Investors get worried about the fluctuations). I am going to stay the manager for the next 100 years or so; I plan on living to 157.

Staff Editor Megan Fowler can be reached at [email protected].


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