When it comes to running a mutual fund, every manager has an angle. Some may focus on an arcane logarithm, while others highlight a specific performance number that makes them stand out. But then there are those managers who keep it simple. Case in point: Kevin Callahan, of Century Capital Management, Inc, who, when asked to describe his and his co-manager’s investment process, simply says, “It isn’t rocket science, but a process.”
Callahan and Alexander “Lanny” Thorndike manage the Century Small Cap Select Investor Fund (CSMVX), which has been awarded five stars from both Morningstar and S&P. The three-and-a-half-year-old fund is on its way to a fourth consecutive year of positive returns, and its return numbers for the three-year period ended June 30 place the fund 12th within the universe of 327 small-cap value funds, according to Standard & Poor’s. “We describe ourselves as growth investors in value industries, or value investors in growth industries,” says Thorndike. “The earnings and the revenue growth rates of our companies tend to be a little bit faster than their peer group in the overall market.”
Looking to invest in each position for at least two years, Callahan notes that a potential investment must go through an initial filtering and then an additional six-step screening process before it is even considered for the portfolio. At each of the six steps, both managers and analysts must sign off before a company can move on to the next step. “We try to break up the S&P or the Russell by different industries and sectors and have Lanny, myself, and our analysts focus on different sectors so we can leverage that knowledge and not have too many people focusing on the same thing,” Callahan says. If one person isn’t happy with a company, then “we have to research it further” to answer that person’s reservations, he says.
The approach seems to be working. For the three-year period ended June 30, 2003, CSMVX had an average annualized return of 18.4%, versus a total return of -11.2% for the S&P 500 and 8.7% for all small-cap value funds. “With small-cap stocks, especially in this market, you are seeing a return to fundamental investing, and that requires a fair amount of homework,” says Thorndike. “It was easy for a fair amount of time to just go on earnings growth to be a successful investor.” But now investors have to look at “balance sheets and cash flow, which is something they have ignored for a long time.”
We spoke to Thorndike and Callahan in July about their fund.
How do you work together in managing this fund? Thorndike: Kevin and I have been working together just shy of two years. I joined Century in the beginning of 1999, and at that point we only had a large-cap fund, a small-cap limited partnership, and a large separate account that we managed for a large pension fund. It was at that point that we decided to bulk up our resources. We added to our analyst core, and then almost two years ago we brought Kevin on board to be director of research. We kind of play yin and yang [when it comes to managing this fund]. We break out by sectors [to cover more ground]. Although I am the lead manager, we very much follow a consensus-oriented investment style and a six-step investment program.
Callahan: Lanny is more of the chief investment officer type and I am more focused on research responsibilities.
Do you rely more on the numbers alone to help you identify well-run companies that are undervalued? Thorndike: We follow our six steps but there is an initial screening process that is very much quantitative. We do a lot of research, but we can’t look at 8,000 stocks, so we have a filtering process that narrows them down to a manageable number of buy and sell ideas. Then we are able to go into due diligence. But it is the top of that funnel that allows us to get there.
Callahan: Step 1 is new idea generation. We sort through 3,500 to 4,000 companies and we emphasize first, return on equity; second, valuation; and finally, growth. Going through this screen generates anywhere from 60 to 80 new companies and ideas a month. Then each of the analysts–including Lanny and myself–take those companies and we look at two or three each week and do what we call a “quick and dirty” on the company. Here we find out all sorts of data and discuss the companies as a group. We take a quantitative approach: How do the hard numbers look? Do they look reasonable, including valuation? We weigh those factors and then make a judgment as to whether one of us should delve deeper into the company. When we look to sell, we need to have new ideas coming into the fund and we [always] look at the same characteristics.
Step 2 is due diligence. Here we build income statement models and look at the balance sheet, cash flow, etc. If we know of a competitor, we try and meet them and get some qualitative feedback. This is where we get a sense of the management. Do they manage ethically? All those little tidbits of information from their competitors and suppliers add [to the picture]. It is amazing how much you can learn from a competitor.
Step 3 is to rank the holding and put it on a watch list. If we like the company, we’ll start with a small position and build it over time.
Step 4 is an in-depth presentation. We will come back together and [present all of the information to the group]. There have been situations where one of us did not like the company but everyone else did, so in that situation we could not just stop. We have to research it further to answer everyone’s questions.
Step 5 is portfolio construction. When we add a company to our portfolio, it goes through three stages. At first, it’s the new position, meaning it’s less than 1% of the portfolio. Second are the secondary positions: only 1% to 3%. Third are core holdings, at 3% to 5%.
Step 6 is paranoid investing. That entails following up on any changing events that may hit a company.
The fund invests in companies that are “capable of growing revenues and earnings faster than industry averages over an extended period of time.” Do you look at companies that are already growing their revenues, or do you forecast that they will grow? Thorndike: We want companies that are already growing. It is easier to believe in a story that has already demonstrated evidence of growth than one that is promising growth in the future. The earnings and the revenue growth rates of our companies tend to be a little bit faster than their peer group in the overall market. The average P/E multiple currently is about 12 times earnings. That gives us a favorable risk/reward profile in the types of companies we look at. In fact, the P/E multiple on next year’s earnings is about 15.5 times and the earnings growth rate is about 18 times. We look at companies that can grow return on equity and book value above 15% over rolling three- and five-year periods. We think return on equity is the one metric that ties the income statement to the balance sheet. Companies that manage their capital well have fairly high returns on the amount of equity that shareholders have given them. [Finding] that prudent type of management is how we differentiate ourselves as investors. We are more singles and doubles hitters looking for predictable boring stories than we are looking for fast-growing stories.
So you don’t jump on the investment du jour? Thorndike: Because what we do is a little bit different, it takes us a fair amount of time to research. The down side of our process is that it may take us three or four or five weeks to get comfortable with a story before we add it to the portfolio. I wouldn’t describe us as momentum or nimble investors, we tend to be more thoughtful and do much more due diligence.
Callahan: Our style is sensitive to valuation. We buy above-average companies with high ROEs, but we want to get them at below-average valuations and we will ride them for a single or double, and occasionally get a triple or home run out of them. But in doing so we will buy them cheap, and as they move up, we will sell into some of that strength and move on to new names that are more attractively valued. We are also focused on cash flows. We like companies with strong cash flow that can cover their capital expenditures. It’s a very positive sign when a company has a healthy free cash flow over a number of years.