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Portfolio > Portfolio Construction

Anything but Middling

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During the past several years while virtually all the net flows for mutual funds went to value funds, there was a small cadre of growth funds that performed very well relative to their growth peer group. Are they poised to continue or even improve that performance now that the pendulum seems to be swinging back toward growth? After all, if these growth funds performed so well during the value-favored years, does it make sense that they would do well when growth is in the driver’s seat? With those questions in mind, we picked the brain of a growth fund manager who has consistently beaten his peers during the value years, Tony Y. Dong, director, mid-cap equity and senior portfolio manager at Munder Capital Management in Birmingham, Michigan.

Dong, lead manager of the $1.437 billion Munder Mid-Cap Core Growth/A, (MGOAX), says that one reason the fund has outperformed relative to its peers during the value years is because, “We’re agnostic with regard to where we look for growth, and how we define value. For example, growth managers typically look to favorite industries or sectors such as technology, or consumer discretionary, or health care, for their growth ideas, but we’ll look for growth wherever we can find it. For example, we had home builders for the last few years, and through 2003 and 2004 they were very good performers.”

The fund’s performance numbers support the wisdom of Dong’s approach: For the five years ended February 28th, the fund earned an annualized average total return of 11.51%, versus 2.59% for its mid-cap growth peer group; and an annualized average of 27.10% versus 21.86% for the three-year period, according to Standard & Poor’s, which gives this fund its highest ranking, five stars overall and in the three-and five-year categories.

How much money do you have under management? We have $2.5 billion in mid cap [in all of the classes] and in separately managed accounts.

What’s your investment process for the fund? The style is growth at a reasonable price [GARP], so we look for those companies that show superior growth, but we pay attention to valuation, so on average we’re structuring a portfolio where the growth is much higher than that of the average mid-cap company, but where the price/earnings ratio is only at a small or reasonable premium to the S&P 400. Our stock selection efforts are complemented by portfolio risk controls that control and moderate our tracking error, sector bets, individual stock bets, and also the weighted average capitalization of the portfolio, so that a lot of those large, macro bets are somewhat neutralized, and therefore driving all of the alpha generation to stock selection.

What do you mean by “neutralized”? Our targeted tracking error is 5% to 5.5% relative to the benchmark, and the individual sectors cannot deviate from the benchmark by more than 300 basis points. So, if a sector in the benchmark has a 10% weighting, then our portfolio can go up to 13% in the sector, or we can have as little as 7% in that sector. What these risk controls do is to make sure that good stock selection is not somehow dominated by one of these other factors. At the end of the day it ensures a certain amount of exposure to the mid-cap core or mid-cap growth part of the market.

So alpha and beta? Correct. The risk controls ensure the exposure in the beta; the alpha comes through stock selection. We just think that’s more repeatable, so the selection doesn’t come from a once-in-a-lifetime market-timing call, [or] what could be considered very aggressive sector bets; it comes from a diversified portfolio of growth stocks that have the characteristics that we like to see, and ultimately the probability of repeating past success is higher.

Do you use quantitative modeling? Yes, we use a multifactor model that helps us rank the stocks in our universe, stocks that range from $500 million to $10 billion of market cap, roughly 2,500 names, so the quantitative modeling helps us identify those stocks that look the most attractive. We’ll screen for the rate of earnings growth, acceleration in earnings growth, companies that are beating estimates, high return on invested capital, expanding growth margins, and valuation–those [are] some of the factors that we look at. We look at valuation a lot of different ways too, not just price-to-earnings ratio, but price-to-sales, enterprise-value-to-cash flow, and a few others, too.

Can you talk about some of your largest holdings? Let’s talk about a company called Blackbaud (BLKB). It sells software [that] helps nonprofit organizations improve their fundraising efforts, and helps with the accounting and the back-office work. Nonprofit organizations have been kind of slow at adapting technology, and the value proposition from Blackbaud’s software is extremely compelling, and Blackbaud dominates in that part of the market. So we have a company with dominating market share, with a very clear value proposition in a very underserved, under-penetrated market. It’s probably a mid-teens grower, and they generate a lot of free-cash-flow.

Your top 25 holdings look quite diversified. Do you have a percentage limit on individual stocks? Yes, it’s three percentage points–active bet–so if you go back to the risk controls, just like the maximum sector-exposure is a 300 basis-point deviation, [it's the] same with an individual stock, so the largest constituent in the benchmark might be about one percentage point, and we can hold up to 4% in our portfolio–or hold nothing.

Are there winners that have worked for reasons that surprised you? No, not really, usually we know why they work out. Another stock we can talk about is ResMed (RMD). They manufacture and distribute medical devices for people who suffer from sleep-disordered breathing, such as sleep apnea. They’re one of two companies that dominate that space. Here’s an affliction that is really underdiagnosed, so we think there’s growth from that–and also scientists are discovering that sleep apnea, though it appears relatively tame, [has] an association with heart attacks. Growth is extremely consistent, it’s one of those stocks where if you were to graph the earnings growth it would be as straight as a ruler so we like that.

What about negative surprises? Generally the negative surprises come from earnings disappointments, because the main driver behind our stocks is that we expect these companies to generate superior earnings growth. We have a simple sell discipline, where we maintain a fairly consistent number of names in the portfolio, and in order to add a new name to the portfolio, we have to sell a name to make room for it. We’re trying to create competition between our candidate list and our existing portfolio, so that our best new ideas will crowd out our least attractive stocks in the portfolio.

Where would this fund fit in an investor’s portfolio? In the Morningstar matrix it would fit in that middle box as mid-cap core, or mid-cap growth. We are certainly growth here in both the S&P 400, a core benchmark, and also growth here in the Russell Mid-Cap Growth Index; however the sector weightings will probably be a bit more core-like. Our tracking error is about 5% both to the S&P 400 and also to the Russell Mid-Cap Growth Index.

For the equities part of a portfolio is there a percentage that you would name for a regular investor? There are a lot of ways to approach that allocation–but if you look at the overall mid-cap portion of the domestic market, it constitutes roughly 25% of the U.S. domestic market in market capitalization, so one can argue that to be adequately diversified, perhaps 25% of your portfolio should be invested in mid-cap stocks. That might be a bit on the extreme side, but I believe that most people probably have very little allocated to mid-caps. Most investors start with large, then perhaps go to international, perhaps they go to small-cap domestic, but mid-cap is just not even carved out as an asset class, and my sense is that it probably should be. It’s not so much that I’m advocating investing in mid-caps for the return opportunities, although the returns from mid-caps have been excellent–in fact better than any other asset class for the last 20 years–but I do think there are some diversification benefits, and therefore risk-reduction benefits to a portfolio, by having something in mid caps.

What else should advisors know about the fund? Turnover’s been about 45% per year so it’s relatively low. The key thing about the fund is that the alpha has come from stock selection. Whenever someone is considering a fund, we look at the funds that have a history of good performance–that’s your first screen–but the hard part of any advisor’s job is to then find that small group that’s also going to have good performance going forward. That’s the challenge. In this case, we can point to the fact that the alpha came from a diversified portfolio of stocks, that it came from selection, and I think we can have more confidence that past success can be repeated.

Do you own this fund in your personal portfolio? Yes, I do.

Staff editor Kathleen M. McBride can be reached at [email protected].


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