(Fundsupermart.com) This American fund manager was already a nifty stock picker in high school in 1980. And while most people were scarred for life from their initiation into the market, Michael McCarthy's memories of his maiden attempt at investment were definitely pleasant. One of his winning picks was shares of a video rental chain which was later bought over by a media giant. The takeover gave the young McCarthy's holdings an octane lift - the share price skyrocketed by 500%! Recalling that life-changing experience, he says he honestly cannot remember how much he pocketed and adds in double quick time that he didn't put in much in the first place. And giving credit where it's due, he admits that the five-bagger came not so much from any keen insight into the mechanics of the stock market. Rather, it was a tip-off from his father - the senior McCarthy was then working in Merrill Lynch. Still, the episode piqued his interest - from then on, he knew where he wanted to leave his mark.
Today, the Silicon Valley-based McCarthy is a Vice President and portfolio manager at Franklin Advisors. Far from bragging about his early triumphs, he's chagrined that people think making money from stocks is a piece of cake (Gosh! Who can help it after hearing his story!) "My investment pet peeve is the public perception that it's very easy to make money in the stock market - that you just have to buy the big technology companies. Over time, that's going to be the most dangerous formula for individual investors! They should leave it to the professionals." McCarthy should know. He's been managing a technology-laden aggressive growth fund since June 1999. Over a tumultuous one-year period ending 29 September 2000, his portfolio doubled investors' money, and was among the top 3% in Micropal's aggressive growth funds category (US).
Visiting Singapore for the first time to train distributors on marketing a similar product to investors here, McCarthy finds time to chat about where the technology sector is heading, and whether he falls into temptation - over popular but overpriced stocks. He even reveals how he gathers first-hand information by working from an office that's within 30 miles of the companies that he invests in! Talk about being aggressive!
Q: Your marketing brochure says the fund invests in companies that demonstrate accelerating growth, increasing profitability or growth potential. Do you put money in companies with no earnings?
A: Yes. Our philosophy is to invest in the best positioned growth companies regardless of industry and market cap size. In terms of how we look at profitability, we will invest in companies that are not currently profitable but we want to see at least some path to profitability. So we will look at companies very closely, understand their business and the markets they are addressing, and from that, try to determine our expectations of profitability. We certainly don't want to penalise a company that has a great opportunity in the market place and spending to address that opportunity.
Q: Give some examples of these companies in your US version of the aggressive growth fund.
A: I'll give you examples of the ones we invested in and have turned profitable. One would be companies in the consulting space - companies helping organisation to develop internet strategies. These companies are inherently profitable. They are people based and they charged their services by the hour and by projects. Their profit margins over the long term are going to be kind of 50 percent gross margin and mid-teens (i.e. 15 percent) for operating margin. A lot of these companies were spending very heavily to get their brand names out there so they weren't showing profit when they became public but are now turning profitable. Companies like Scient and Predictive Systems are two names. One of our bigger positions is Exodus, which is a web hosting company. They are not profitable but they've just turned EBITDA (earnings before interests, taxes, depreciation and amortisation) positive. They are rapidly expanding and part of their plans is to build new facilities; so the cost of that in the short term is very high, but they'll be very profitable once they are up and running.
"Certainly we try to be very good at determining what expectations can be. If a company is not hitting those expectations, we do re-evaluate the way we look at the company. But in terms of whether we buy or sell, it doesn't matter if it's our fault or the company's fault."
Q: Can you talk about the stocks that you've dumped in the last one year because they fell short of your expectations?
A: I guess it's important to walk you through our sell criteria. First, and most obvious, is when a stock reaches our target price. We ask our analysts to rate their companies "buy" or "sell", and to assign target prices. And when a stock reaches a target price, we sit with them and discuss whether the target price should be raised or whether we should sell. Any deterioration in the fundamentals of a company is a reason to sell stock as well. And then we'll also sell a stock if they disappoint. For example, if a company misses an earnings expectation; that usually tends to be a longer term problem even though the company may say it's a one-quarter problem. So most of our sells in the last one year were due to those reasons. There's been a pretty good shakeout in the past year. I think one name was GAP Stores. They've got a new management team and they've lost some people. In our minds, the issues facing Gap were longer term in nature. So we sold that stock a couple of months ago, at a slight loss.
Q: These "sells" that you mentioned, were they due to wrong analyses of earnings expectations, or the companies' disappointing results were really a surprise to everybody?
A: We look at every stock and try to gauge the growth potential. Based on that, we come up with a price. So it's always a relative game. Certainly we try to be very good at determining what expectations can be. If a company is not hitting those expectations, we do re-evaluate the way we look at the company. But in terms of whether we sell, it doesn't matter if it's our fault or the company's fault.
"I think the key is really we can go where the growth is. Today it happens to be technology. I won't be surprised a few years from now, there'll be a few other areas showing better growth characteristics. Certainly today it looks like a technology fund, but the benefit of this fund versus a technology fund is that if technology stocks go down we can invest in other areas."
Q: In your video presentation on the web, you talked about zooming in on growth sector stocks which are not cyclical. How do you do that? These days, everyone gets hammered when a major bellwether stock like Intel gets affected?
A: I think there are some key long-term secular trends that are pretty important. Technology and healthcare are some examples. In terms of avoiding companies that disappoint, like Intel, it's hard. Intel, just two months ago, thought their business was going to be much better than it was. And they publicly stated that. And it's difficult for a company that does that amount of sales to predict too accurately what they're going to do. We try to understand what's happening in the end market. Intel is not a name that we are overweight in any fund, partly because some of the information we're getting about PC (personal computer market) was questionable. I think alot of the issues surrounding that are very specific to Intel - their expectations and forecasting got out of whack.
Q: Looking at the fund, I'm playing the devil's advocate, some investors will probably say: "Hey, they've got 70 percent of their portfolio in technology stocks. Isn't this just another tech fund under a different name?"
A: I think the key is really we can go where the growth is. Today it happens to be technology. I won't be surprised a few years from now, there'll be a few other areas showing better growth characteristics. Certainly today it looks like a technology fund, but the benefit of this fund versus a technology fund is that if technology stocks go down, we can invest in other areas.
"The March-April time period was a healthy time for technology.... the correction was a valuation correction, it wasn't a fundamental correction. The recent Intel news dampened growth expectation somewhat, but I still think there's going to be tremendous opportunity for technology....It's been dangerous over the years to call for an end to investing in technology stocks. People have underestimated technology for a number of years!"
Q: What's the story for technology going forward? Most people were probably traumatised for life from the March tech correction and we see shades of that volatility again in the last few weeks?
A: The March-April time period was a healthy time for technology because a lot of stocks were priced in such a way that was not reflective of their long-term profit potential. So the correction was a valuation correction, it wasn't a fundamental correction. The recent Intel news dampened growth expectation somewhat, but I still think there's going to be tremendous opportunity for technology to continue to grow. It's been dangerous over the years to call for an end to investing in technology stocks. People have underestimated technology for a number of years!
Q: How do you manage the risk and volatility from being heavily weighted in technology stocks?
A: The number one thing we do is try to closely monitor the companies we invest in. We take a bottom-up approach, and so our investment decisions are not based on the hottest sectors but the best positioned companies from an earnings perspective longer term. You know, I think to characterise us as vastly overweight in technology stocks is a little bit of a mischaracterisation. That's because the Russell 3000 Growth, which is our primary benchmark, is almost 50 percent technology today! Indices are much higher weighted in technology stocks these days, and it's becoming more difficult to separate what's a technology company and what's not.
Q: You know, one of the criticisms of aggressive growth funds is that the fund managers tend to get sucked into buying an overpriced stock because everybody has it in his bag? Is that a temptation for you?
A: Hahaha...no, I never want to buy an overpriced stock, I always want to buy an underpriced stock! But I think what happens is people get caught up in a static PE (price-earnings ratio) number. That's very dangerous - to value a company based on its PE last year. People need to understand that valuation is based on a number of criteria. One of which is the ability to generate cash flow and profits. Equally important are the growth rate and business risk. To me, a lot of the fastest growing technology companies have alot less business risk than some of the slower growth cheap companies! For example, a company like Cisco Systems or Yahoo has less business risk than say, Clorox (US company that makes cleaning, bleach and other home care products), a consumer product company where their competitive advantage lies in their brand name and not any defensible..erm.....
Q: The ones running on empty?
A: Yeah! So we try to keep in mind that valuation is not just the multiple of earnings or cashflows. We really try to see where a company is going to be 3 to 5 years from now. I have a slide that shows what some technology stocks were trading in 1995 - when everyone thought they were expensive - compared to what they were earning in 1999. Dell, for example, 1995 versus 1999 earnings had a PE of less than 1! Yahoo in 1996 was trading at 4 times its earnings in 1999! So I think people look too much backwards, and not enough on what the potential of a company is going forward.
"...within 30 miles of our headquarters is 45 percent of the companies we have in our portfolio....Our friends and family work for these companies and we pick up a lot of great information from them, in addition to the local papers. So we are very early in identifying the key technology trends affecting the market place."
Q: Aggressive growth funds tend to be actively traded leading to higher expense ratios, is that the experience from running this fund?
A: Our focus is not trading but buy and hold. In the first year, our turnover was 150 percent which was abnormally high because we saw a very volatile year. So I think going forward, we'll see a lower level of turnover than that. The average equity fund turnover in the US is about 100 percent; so we're not too far from average even though we're an aggressive growth fund.
Q: One more criticism that I've heard about aggressive growth funds - they tend to be dependent on one particular manager because quick decision making in buying and selling stocks is crucial.
A: Hahaha......I would love to say our success is all due to me. In reality, nothing could be further from the truth. Our success is due to our analysts. We rely on them on alot of our ideas. So it's really a team effort. I feel very lucky in managing this fund because I do get to use our resources, not only the 35 analysts - 11 of which are technology specialists - but also the managers of our other sector funds. For instance, I can go into Kurt von Emster's (lead manager of Franklin Templeton Life Discovery Fund) office and say: "Hey, what are your top three picks for your biotech fund?" I can invest in those too. So I get to interact with these guys and take the best ideas from all areas of our research.
Q: Talk about your intelligence gathering. I hear that you live within 30 miles of most of the companies that you invest in?
A: Yes, within 30 miles of our headquarters is 45 percent of the companies we have in our portfolio. Certainly we don't target any percentage but it just happens. It's a huge advantage. The obvious one is that we can visit these companies very easily. Much more importantly, we are part of this community which is a very dynamic area to be in these days. Our friends and family work for these companies and we pick up a lot of great information from them, in addition to the local papers. So we are very early in identifying the key technology trends affecting the market place. Most of our research is also done speaking to suppliers, customers and competitors, not necessarily just talking to the management team of a company.
Q: Last question, talk about the possible impact of rising oil prices and a slowdown in the US economy on the fund.
A: If we do continue to see oil price where they are, we'll probably see a slowdown. One of the numbers that I read is that for every 10 dollar increase in oil prices, we'll see a half percentage point drop in economic growth. That's not our internal forecast but it's a reasonable assumption. In some regards, that's a little healthy because it may lead to a better interest rate environment if growth does slow down. But for the most parts, it will have less of an impact on technology companies than on more cyclical companies. So we feel it's less of an impact on our fund than alot of other funds. My view going forward? People always talk about what you expect in terms of returns. I certainly don't think we'll see the kind of returns we have seen in the last few years, but we'll at least see normal or above normal returns which would mean anywhere between 10 and 20 percent.
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Michael McCarthy is Vice President and portfolio manager of Franklin Advisors, Inc. Among the products he manages are the Franklin Aggressive Growth and Small Cap funds. McCarthy has been with Franklin since 1992 and specialises in the analysis of the computer services sector. He also heads the technology research team. McCarthy is a Chartered Financial Analyst and has a Bachelor of Arts degree in History from the University of California at Los Angeles.