Quick Take: By using a discounted cash flow model, the managers of the Loomis Sayles Growth Fund/A (LGRRX) select stocks that are growing earnings through internal revenue generation, rather than by cutting costs. The fund invests in larger-cap stocks exhibiting at least 11% annual EPS growth, and delivering upward earnings revisions.
For the one-year period through Oct. 29, 2004, the $74-million fund gained 6.8%, versus 3.5% for the average large-cap growth fund. For the three-year period, it has returned 5.9% annualized, while the peer group rose just 0.5%. The portfolio is somewhat less volatile than its large-cap growth peers, as reflected by its lower standard deviation. It also carries lower expenses than its peers. However, turnover runs high, making it a better fit for non-taxable accounts.
While the fund started operations in May 1991, the current management team — Mark Baribeau (since 4/99), Pamela Czekanski (since 1/00), and Richard Skaggs (since 1/00) — is approaching its fifth anniversary together. The team also manages the USAA Mutual Growth Fund (USAAX) and USAA Growth & Tax Strategy Fund (USBLX).
The Full Interview:
S&P: How do you select stocks for this fund?
SKAGGS: We screen companies with a market caps of at least $3-billion — our median market-cap is about $20 billion, our weighted-cap is about $53 billion — that are chartered in the U.S. This gives us a universe of between 500-600 stocks. Next, we screen for companies with a minimum annual earnings growth rate of 11%. We avoid those that are increasing earnings primarily by cutting costs. Instead, we seek profit growth driven by internal revenue generation.
We like companies that can become market leaders, and that possess leading products, sustainable competitive advantages and strong management teams. The company must also have an above-average, preferably rising, return-on-capital, and stable or upward earnings revisions.
At this stage, we have filtered our universe down to 100-125 stocks. (Our goal is to construct a portfolio of 45 to 55 stocks, and we currently have 51.) We use disciplined fundamental analysis, including meeting with management and reviewing financial statements to measure risk-reward profiles.We measure a stock’s prospects for price appreciation by evaluating the company on a discounted cash flow model.
S&P: How, if at all, did your team change the way the portfolio was run when you took it over?
SKAGGS: We moved the fund exclusively to large-cap growth. The prior managers adhered to a more multi-cap growth strategy.
S&P: What are your largest holdings?
SKAGGS: As of Sept. 30, 2004: eBay Inc. (EBAY), 3.7%; Microsoft Corp. (MSFT), 3.4%; Avon Products Inc. (AVP), 2.6%; Home Depot Inc. (HD), 2.6%; QUALCOMM Inc., (QCOM) 2.5%; Apple Computer (AAPL), 2.5%; Procter & Gamble (PG), 2.5%; UnitedHealth Group Inc. (UNH), 2.4%; Zimmer Holdings (ZMH), 2.4%; and Johnson & Johnson (JNJ), 2.4%. The top ten stocks accounted for 26.9% of total assets.
S&P: What steps do you take to control risk?
SKAGGS: Although our stock selection process is bottom up, we impose certain constraints to control risk and volatility. For example, none of our individual holdings can exceed 5% of total assets, and we typically do not go above 4%. An individual stocks’s weighting in the fund reflects the magnitude of our conviction in that company.
Also, our industry exposure is typically under 25%. Our sector exposures are never twice the allocation in our benchmark, the Russell 1000 Growth Index, for sectors that represent more than 10% of that Index.
S&P: Can you illustrate how your discounted cash flow analysis works?
SKAGGS: We maintain a discounted cash flow model for all our holdings, and update them periodically. For example, one of our smaller holdings, Chico’s FAS Inc. (CHS), a specialty retailer, just reported quarterly earnings that we thought would be negatively impacted by their presence in Hurricane-ravaged Florida. However, Chico’s posted better-than-expected profits, in-line revenues, and much better-than-expected margins. Based on the earnings surprise and the company’s expansion plans in 2005, we updated our discounted cash flow model, and raised the stock’s price target to about $50. It is currently at about $38, and we think it can reach the target in six to 12 months, convincing us to add to our position.
S&P: What are your top sectors?
SKAGGS: As of Sept. 30, 2004: technology, 22.5%; consumer discretionary, 21.5%; health care, 16.0%; financial services, 14.4%, and energy, 7.2%. Relative to our benchmark, we currently have an overweight position in consumer discretionary, technology and financial services, and a significant underweight stake in health care and energy.
These sector weightings do not reflect any macro-economic bets at all; they are simply a result of certain individual stocks showing up on our screens. For example, our exposure to the consumer discretionary sector includes eBay, VeriSign Inc. (VRSN), retailers like Home Depot, Coach Inc. (COH), Chico’s FAS, and Starwood Hotels & Resorts Worldwide Inc. (HOT) We like these individual companies, but not because we are necessarily so bullish on the consumer. On a bottom-up basis, we have identified these stocks as having strong earnings power with moderate risk and reasonable valuations.
S&P: Can you discuss some of your top holdings?
SKAGGS: eBay Inc. is our top holding, and we have owned it for three continuous years. Even though eBay has a high P/E, the company is growing its revenues by 50% annually, and has a solid franchise and globally recognized brand name. eBay’s acquisition of Paypal was brilliant, solidifying the company’s trading platform. Three years ago, eBay’s chief executive, Meg Whitman, laid out an outstanding business strategy and the company has executed it perfectly. We think eBay’s stock can move up to the $135-$150/share range over the next six to 18 months.
We purchased Home Depot in the second quarter of 2004 after the company reported significantly better-than-expected margin acceleration. After listening to management’s conference call, we updated our discount cash model on the stock. Margin expansion, on top of consistently steady sales growth, makes it very attractive.
Johnson & Johnson is the one large-cap pharmaceutical stock that we like. The company has a nearly unmatched record of earnings consistency, unlike peers such as Merck (MRK) or Bristol-Myers Squibb Co. Johnson has superior return-on-equity and double-digit revenue growth. It generates about 25% of its sales from consumer staples products, giving it a better mix of businesses than the pure pharmas. JNJ has also been less impacted by drug patent expirations, which have hurt Merck and Pfizer.
S&P: What has driven the fund’s performance this year?
SKAGGS: We think the market is rewarding companies whose earnings growth has been driven by internal revenue growth, including such names as eBay, Apple Computer (AAPL), Home Depot, Coach Inc., Moody’s Corp. (MOC), and Dell Inc (DELL).
Apple Computer, which once reached a 4% position in the fund, has been particularly strong for us. The stock price has tripled in value this year as the company’s iPod franchise and iTunes brand have been highly successful.
S&P: You have no exposure to consumer staples?
SKAGGS: We are underweight there because we are not seeing any internal revenue-driven earnings growth from companies like Colgate-Palmolive Co. (CL) and Procter & Gamble. Although Procter was one of our top holdings as of September 30, we’ve been scaling it back over the past six months. P&G executed their turnaround wonderfully. They’re generating solid numbers and they are likely to benefit from the weak U.S. dollar. But the bottom line is that this a high single-digit revenue grower, not our ideal type of holding.
However, within consumer staples, we like Whole Foods Market (WFMI), which has consistently generated 15%-20% annual revenue growth, and boasts a solid store-opening expansion strategy.
S&P: What are your sell criteria?
SKAGGS: We typically sell when a stock hits our price target, or when we identify the potential for deteriorating returns; namely a negative earnings surprise, a failure by the company to realize a positive catalyst, a weakening of competitive positions, or a significant management change.
S&P: Can you cite a recent sale?
SKAGGS: Avon Products (AVP), which was one of our top ten stocks as of Sept. 30, has been reduced to a zero position in the past month. While Avon’s global cosmetics business is terrific, with enormous potential in Asia, their U.S. operations have delivered sluggish results for three consecutive quarters.
Contact Bob Keane with questions or comments at: firstname.lastname@example.org.