Quick Take: Kevin Wenck, founder and president of San Francisco-based Polynous Capital Management Inc., considers himself an `opportunistic growth’ investor — he likes buying stocks when they’re in decline due to some temporary problem, as long as their underlying growth profile is sound.
Although his Polynous Growth Fund (PAGFX) had a tough year in 2002, dropping 40.7%, it has lately been coming on strong. For the six-months ended March 31, the fund gained 54.3%, making it one of the top performing funds for that period. For the three years ended in March, the portfolio lost 4.6% on average, versus a loss of 23.1% for its small-cap growth peers. In March, 2003, the fund’s star ranking was upgraded to 3 from 2.
Wenck has managed the portfolio since its inception in August 1996. Despite the recent outperformance and comparatively favorable three-year loss, the fund’s volatility, evidenced by its standard deviation and beta, is higher than that of its peers. In addition, the largest position in the fund stands at about 30% of assets.
The Full Interview:
S&P: What kind of stocks do you look for and how would you describe your style?
WENCK: We invest in U.S. stocks with market caps of between $50 million and $5 billion that we think can deliver annual revenue growth rates of between 15% and 30%. We seek to provide our shareholders with growth in excess of market averages, but at P/E’s below market averages.
We are opportunistic, somewhat `contrarian,’ investors. Although we are growth investors, we will not pay ridiculously high prices for our holdings. To illustrate, the fund’s average P/E is currently only about 12.9. Typically, our average P/E is at a 10% to 30% discount from the overall market P/E.
S&P: What about the timing of your stock purchases?
I will wait to purchase a stock until the price discounts every possible risk that I can identify. I’m not a `story-oriented’ stock buyer. Quite often, I will wait for some controversy to occur that will knock a stock’s price down by 20% or 30%, and buy it opportunistically.
S&P: Are there certain types of stocks that you will stay away from?
We will not invest in stocks that are growing in sales by more than 30% annually, because that would introduce too much risk and volatility. It would be a big gamble to think that any company can maintain such an anomalous growth rate. Moreover, these `aggressive growth’ stocks are highly vulnerable to price multiple compression.
S&P: Is your research proprietary?
We use our own complete financial models for our research, including our own earnings estimates, and stock target prices. We don’t use Wall Street buy ideas at all, and we don’t bother meeting with company managements.
S&P: You are trying to take advantage of inefficiencies in market pricing?
WENCK: Yes. Stock prices fluctuate much more than fundamentals do. The typical variation between the 12-month high and low of any individual stock is between 30% and 40%, whereas the market’s long-term rate of return is about 11%. Keep in mind that the statistical variability of earnings is relatively minimal. So as long as a company’s growth rates are sound, I will happily buy the stock when some event hurts its price.
For example, I recently bought some hospital stocks at 50% of where they were selling at six months ago. I also just bought some contract research companies trading at prices 40% to 50% of their 52-week highs. But I am not a `contrarian’ just for the sake of taking the opposite point of view — there has to be a fundamental integrity to these companies with temporarily depressed stock prices.
S&P: What does `Polynous’ mean?
WENCK: Polynous is ancient Greek for `many thoughts’, reflecting our philosophy that many factors are considered in our stock picks, beyond just the growth parameters. For example, say you have two companies which are each growing by 20% annually. One has no debt, the other has debt equal to 50% of capital. You wouldn’t expect to pay the same P/E for these stocks.
S&P: Are you strictly a bottom-up stockpicker?
WENCK: While there is no top-down element to our individual stock-picking and asset allocations, we do use top-down analyses to support the bottom-up research. I am primarily an economist, and my first task is to construct a reasonable framework for a company’s prospects, based on projections for the economy and for various industries and sectors. For example, if the overall U.S. economy is expected to see just 3% growth, I would be highly skeptical of a company that claims it can grow by 40% annually.
S&P: You have a wide latitude in market-cap size, from micro to mid-cap. What is the fund’s average market cap size?
WENCK: Currently, the fund’s average weighted market cap is about $1 billion. Typically, this figure ranges between $500 million and $1 billion. At the moment, we have a couple of larger-cap stocks, including Tenet Healthcare (THC), a $7-billion company, which skews our average cap size higher than normal. The fund has about $6.9 million in assets.
S&P: Do you use the Russell 2000 Growth Index as your benchmark?
WENCK: Although we are growth investors, we often dip into more value-oriented stocks. As such, we think the Russell 2000 Index is an appropriate benchmark for our fund.
S&P: What are your top sectors?
WENCK: We currently have about 32% in capital goods; 22% in health care; 21% in cash; 10% in consumer services; 7% in technology; 6% in business services; and 2% in consumer non-durables.
S&P: Why do you have such a large cash stake?
WENCK: The cash position has been somewhat inflated by new subscriptions that we’ve received for shares in recent weeks. I will keep some cash on the sidelines if I can’t identify any attractive investments.
S&P: What are your largest holdings?
WENCK: As of April 11, Optical Cable (OCCF), 29.9%; Daisytek Intl (DZTK), 3.2%; VeriSign Inc (VRSN), 2.6%; GameStop Corp`A` (GME), 2.2%; Electronics Boutique Hldgs (ELBO), 2.2%; Priority Healthcare`B` (PHCC), 2.2%; TherImmune Research, 2.2%; Tenet Healthcare (THC), 2.1%; Cytyc Corp (CYTC), 2.0%; AnnTaylor Stores (ANN), 2.0%; and NCI Building Systems (NCS), 2.0%.
S&P: To what do you attribute the fund’s recent outperformance?
WENCK: Optical Cable contributed about one-third of that performance. Other stocks, though they occupied a much smaller weighting in our fund, had similar discounts in valuation.
After the market declines we saw in the first three quarters of 2002, there were many stocks trading at 50% of book value, at less than 10 times earnings, and at less than the cash on their balance sheets. I’d estimate that we have 12 to 15 stocks like that in our fund. Some of these holdings have doubled in value over the past six months, including Optical Cable.
S&P: Why do you have such a large stake in Optical Cable Corp.?
WENCK: Optical Cable makes fiber-optic cables providing high-bandwidth transmission of data, video and voice communications. The founder and former president of the company, Robert Kopstein, who had owned 96% of the stock, had margined all of his shares across seven different brokerage firms. Margin calls were triggered after September 11, 2001, and in the process of all of his shares being sold, the stock finally bottomed at only 40% of book value. We were not involved in the margin loans. We bought the shares on the open market when the brokers sold them off.
The stock has since appreciated, but it is still at only about 30% to 50% of the value of its publicly traded competitors, even though Optical Cable has continued to be profitable on an operating basis throughout the downturn in the telecom/networking sector. Moreover, the company has almost no debt, while its rivals typically carry huge debt loads.
The company’s stock price was under pressure for well over a year after the margins were triggered. We purchased it at a point when the stock had dropped nearly 90% in value. From April, 2002, to August, the stock plunged and bottomed out at about $1.70 per share. This represented 40% of book value. It was severely under priced. I determined at that point to purchase as many shares as I could. It has appreciated nicely since.
S&P: Isn’t having such a large exposure to one stock rather risky?
WENCK: On a fundamental basis, I’m very comfortable with this investment. Their revenues are actually declining a bit now, but they will be well-positioned when IT spending rebounds.
The size of the position in the fund has been controversial, and also very atypical for me. The situation, however, was also atypical, since there was suddenly a period of a year when 96% of the company’s stock had to be sold. The company’s financial characteristics: positive cash flow, operating profitability during a downturn, and almost no debt, made me comfortable from a risk standpoint. Also, the stock is still only selling for approximately book value.
As for appreciation potential, I am also comfortable with the position. Consider that the largest company in the fiber business, Corning Inc. (GLW), which also gets the bulk of its revenues from its less profitable and lower growth long-haul fiber business, is currently valued at about two times revenues on an equity value basis. If Optical Cable were valued at two times revenues, the stock would be triple its current price. If you look at Corning’s total enterprise value, including all of its debt of about three times revenues, Optical Cable’s stock would be over four times its current price.
S&P: Can you discuss a recent purchase?
WENCK: Daisytek International is a global distributor of computer and office supplies and professional tape products. The stock is currently priced at $2, its book value is at $9, and they will probably earn $0.40 to $0.50/share this year. The controversy with this company was a strange clause in their debt covenants, which stated that if they ever reached into the last $20 million of their credit line, they would have to raise equity capital. When that covenant was triggered, the stock price was hammered from $6 to $1, and certain fringe elements in the market — including day traders — were probably aggressively shorting the stock. Then suddenly last month, the company’s banks surprisingly decided to waive the covenant, but the stock has only rebounded up to about $2.
S&P: What’s your take on Tenet Healthcare?
WENCK: I think that the company’s issues with corporate governance and litigation are just a distraction. Our research indicates the company has pretty solid underlying fundamentals. We bought it last autumn when the stock got crushed by all these outside events. Tenet Healthcare is a dominant hospital company with huge cash flow characteristics. The stock is trading at only 10 P/E, although the company will likely grow 15%-20% annually over the next five years.
S&P: What are your sell criteria?
WENCK: We happily sell when a stock reaches its price target. The unhappy reasons for selling occurs when we determine an investment has become too risky, or when we deem a company’s growth rate will slow down.
S&P: Can you cite a recent sale?
WENCK: We sold off Option Care (OPTN), a supplier of home infusion products, and a specialty distributor of pharmaceuticals. We bought it four or five months ago when its price declined to a P/E of about 7. It was a nice, low-profile, profitable company with positive cash flow. Afterwards, its price appreciated something like 60%, almost reaching the price target we had set. Then, early last week, a competing company called Accredo Health (ACDO) announced an earnings disaster. It made me think. What if Option Care, which is thinly traded, has similar problems in the near future? Investor sentiment would easily trash the stock based on fears for the industry as a whole. So I sold it and took my profits.
S&P: The fund seems to have a high turnover. How would you characterize this?
WENCK: In calendar 2002, it was roughly 300%, which, although higher than normal, largely reflected the market’s high volatility. We typically have a turnover rate of about 100%.