Manager of the Auer Growth Fund Discusses His Top Ideas

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Benjamin Shepherd submits:

It can be tough to remain disciplined when the markets move against you, but the father-son duo of Bryan and Robert Auer has stuck with a tried-and-true approach through both up and down markets. The co-managers of Auer Growth ((AUERX)) demand significant sales and earnings growth as well as low price-to-earnings (P/E) multiples and drop holdings that fail to meet these expectations. Although this strategy doesn't protect the fund from broader sell-offs, periods of weakness offer an opportunity to reload for the next year. We recently spoke with Robert Auer about his outlook for the markets and the value of discipline.

What's your outlook for equities and the economy?

We expect a huge exodus out of fixed-income investments once the Federal Reserve raises rates. That could be a year away, but William Gross at PIMCO has been vocal about the bubble forming in the bond market. His concerns make us extremely bullish on equities.

The equity market hasn't given investors much of a return in 10 years; huge pent-up demand for stocks should produce a reversion to the mean. Our conservative forecast calls for the Dow Jones Industrial Average to hit 20,000 by 2020--an annual growth rate of 7.2 percent.

The US economy continues to recover, albeit at a painfully slow pace. That being said, a double-dip recession is highly unlikely: Only three double dips have occurred after the last 28 recoveries-a one in 10 chance. All three came on the heels of a mild recession, and the latest swoon is one of the biggest contractions the US economy has endured.

Small- and mid-capitalization names are a big part of your portfolio, though many investors are avoiding this group. Is this a normal weighting for the fund?

That's typically where we find growth and undiscovered companies; it's tough to find large-cap companies that meet our expectations.

But we do find large-cap names that resume growth and offer a value proposition-- Intel Corp ( INTC ) is a prime example. The stock has a P/E of 10 but suddenly started growing earnings 30 percent a year. It's been a long time since Intel enjoyed such robust growth, but fear of a double-dip recession has made investors skeptical. These days shares of Intel trade somewhere in the neighborhood of $19, whereas 10 years ago they went for $80 despite inferior profitability and growth.

Oil stocks typically trade at a lower multiple, but not long ago investors had to pay 15 or 16 times earnings for shares of ExxonMobil Corp ( XOM ) when it was growing at a rate of 10 percent. We've been able to pick up names that typically fail to meet our value criteria--Exxon, Chevron ( CVX ) and Apache Corp ( APA )--right when their businesses are coming out of a trough.

This growth focus increases the fund's economic sensitivity. Do these trough periods set up opportunities?

Downturns enable us to position for the future. These positioning years are painful to go through, but conditions will recover gradually. Right now technical trading rules the day; the focus is on the S&P 500 and its 50- and 200-day average. You can make money trading in this manner, but that's not our specialty.

Eventually fundamentals win out. At some point the market won't be near its averages, which will limit technical trading. When the market would have to fall or jump 15 percent for traders to make money, the focus shifts to valuation. That's when our hard work pays off.

Where are you finding opportunities today?

Semiconductors are our favorite group right now. In addition to Intel Corp, we also own a number of smaller names, including Amkor Technology ( AMKR ). The company just posted a record second quarter, and management raised its full-year forecast, but the stock is down 25 percent on the year and is within 30 cents of its 52-week low.

Amkor Technology layers semiconductors on top of each other--a key to producing the increasingly small-but powerful chips in smartphones and other electronics. "Packaging" chips is a real art, and the firm's customer list is a who's who of the industry. I'm not suggesting that the stock deserves a PE ratio of 20, but it should get more respect.

We also own shares of GT Solar International ( SOLR ), a solar-power name with market cap of $1.2 billion that trades at about $8.00 per share. Up roughly 40 percent this year, the stock is at $8 today but traded at $16 per share in 2008. The New Hampshire-based firm developed an improved method of etching solar cells to improve their efficiency.

In 2009 the company earned 60 cents per share; consensus estimates call for earnings per share (( EPS )) of 93 cents this year. Wall Street analysts also forecast EPS of 23 cents in the third quarter, driven by quarterly sales of $201 million--much higher than the $104 million in sales the company posted a year ago.

We love situations like this where analysts continue to underestimate a company's earnings.

How is GT Solar International able to double its quarterly sales from a year ago? The company's products address energy concerns and offer superior efficiency.

Cephalon ( CEPH ), a recent addition to our portfolio, also has exciting metrics. The stock has a PE of 11.8, but the ratio falls to 8.2 when you consider the consensus estimate for 2010 earnings.

The biotech and pharmaceuticals company primarily produces pain medications. Like aspirin, most of these products trick the nervous system into telling the body that there isn't any pain. And most of their drugs aren't habit-forming. The market hates the stock, but the company posted a great second quarter, its fourth consecutive upside surprise. The consensus estimate called for EPS of $1.77 in the second quarter, but profits came in at $2.05 per share.

Pharmaceutical stocks usually don't usually deviate that much from analysts' estimates. We're a little concerned about the next quarter because the analysts are calling for EPS of $1.78 versus $1.62 in the same period last year--less than 25 percent growth. But looking back, earnings have beaten analyst expectations by around 15 percent in three of the last four quarters, so we should hit our target.

A lot of your focus is on companies with new or innovative products. Is that the secret to your long-term success?

In general, we target three growth catalysts. Sometimes a new product will generate the earnings growth we seek. Other times the business enters a sweet spot. Hurco ( HURC ), a company that produces computerized lathes, is a name that's given us three doubles over the years. If you pull up a monthly price chart for the past 20 years, you'll see a stretch of seven or eight years where the stock traded at $4 to $6. Then in 2003 the shares went nuts.

The company didn't change its business; suddenly every manufacturer wanted computerized lathes.

Six years later, the stock reverted to its lower range. Luckily, we had cashed out long before the shares crashed; as soon as a stock fails to grow earnings 25 percent, we're out the door. That's enabled us to do well over the years; our hurdle is so high, we usually get out before things head too far south.

A new CEO or management team can also be an earnings catalyst.

Has it been tough to maintain your strict buy and sell discipline over the years?

Nothing works all the time, but discipline has been the key to our success. If you have an investment strategy that makes sense and has worked for a long time, stick with it. Take the Dogs of the Dow Strategy where you buy the 10 stock with the highest yield on Jan. 1 and then rebalance every year.

Over the long term this strategy produces decent returns, but this approach does go through two- to three-year cycles where it underperforms the broader market. But by sticking to that simple strategy, you'll outperform over a long period of time. The problem is that right after a bad year, people abandon their strategies.

What's your best piece of advice for individual investors?

Allocation is the key to success. Equities should account for at least half of any investors' portfolio. You might want to have part of that in utilities or dividend-paying stocks, but there's going to be a lot of pain in fixed-income markets.

This is the year to reposition because things unravel quickly after bubbles burst. And at these levels you're not going to miss out on much upside in the bond market. At the same time, investors who are overweight bonds could miss out on huge opportunities in equities.

Disclosure: No positions.

See also Understanding the Mechanics of a QE Transaction on seekingalpha.com



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , US Markets


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