Good news for those wanting to start positions in Morgan
Stanley Small Company Growth Fund through brokers, 401(k) plans
and pensions. The $1.7 billion fund's I-class shares recently
reopened to new investors.
The I shares had been closed to new investors wanting access
to Dennis Lynch's brand of small-cap investing since 2004. Other
classes remain closed to new investors.
The fund gained 23.73% gain this year through June 28. That
topped 96% of its small-cap growth rivals tracked by Morningstar
Inc. Those peers averaged 16.02%. The S&P 500 gained
Lynch, 42-year-old lead manager, talked shop with IBD from his
office in midtown Manhattan.
Why is the fund reopening?
Our decision to reopen was based on our assessment that we could
effectively manage additional net inflows without facing capacity
or liquidity issues.
You run concentrated portfolios. Why?
Our big difference is that we have conviction in our picks, and
our portfolio is very active, very different from our benchmark
(Russell 2000 Growth index).
Our number of names is smaller than typical small-cap funds.
Our turnover tends to be 20% to 30% a year (vs. 76% for small-cap
in general and 85% small-cap growth), so our average holding
period is three to five years.
Also, we try to collect unique companies across different
end-markets to create diversification. Most of our time is spent
trying to recognize a company's competitive advantages.
A unique feature of your investment analysis is your reading
network. How does it work?
We look for interesting ideas from sources that are not typical
business reading. Instead, it may be articles from a publication
like Scientific American about network (computing) theory.
Sometimes we get ideas about things like behavioral finance,
about how people make decisions, that help us become better
decision makers. We all want to be better learning machines,
which is how (Berkshire Hathaway vice chairman) Charlie Munger
describes (Berkshire Hathaway chairman) Warren Buffett.
And your reading network extends beyond your immediate team,
Yes, over 150 people internally participate. Those people get our
weekly readings and are potential contributors to it. They all
have different interests and passions. Our core group, about 13
investors, meets twice a week and discusses some of the reading.
Our group is like a librarian in terms of sharing ideas.
What's an example of something you invested in as a result of the
Maybe five or six or seven years ago, this was how we first heard
about cloud computing and software-as-a-service. That's how we
learned about those new business models and how they would be
disruptive to conventional software companies.
What holdings illustrate some macro themes you're playing?
One isEagle Materials (
), which benefits from greater construction activity.
As a local producer of cement and aggregates, they are hard to
replicate. Those commodities are hard to transport. They're
heavy. If you already have a local quarry or facility like Eagle,
it's hard to be displaced. It's hard to beat a local monopoly
Do you lean away from cyclicals because you prefer long-term
We prefer companies that have more stability and more
annuity-like revenues streams than cyclicals.
We've ownedCorporate Executive Board (
) andAdvisory Board (
) for many years. Both produce consulting, but they don't sell it
like normal consultants. They don't have billable hours.
They produce best practices research by meeting with companies
that are their clients, and then they sell subscriptions for them
and others that want to understand how best to, let's say,
organize the office of chief financial officer in certain
industries or how to incentivize their sales force.
No one else can provide that kind of research that way. As a
result, they have high renewal rates -- 85% to 90% -- lots of
visibility, and over time the ability to raise prices because
annual subscriptions might cost around $30,000 to $35,000 for
many topics vs. hiring a consultant to do one project that might
cost hundreds of thousands of dollars. Clients get a smaller fee
but pay every year and get updated content.
Executive Board and Advisory Board target different areas,
Yes, Advisory Board focuses only on health-care companies.
Executive Board focuses on companies outside health care.
Your cash weighting was 5.8% as of March 31. That is a little
more than double the average for small-cap growth funds. It's
also well above the average for U.S. diversified stock funds.
Does your cash position reflect a bearish outlook for the overall
I can see why you'd think that. But it's not that. We had a few
short-term successful companies graduate to the mid- and
large-cap categories. We sold them as they were inappropriate for
this vehicle. That boosted our cash.
We don't redeploy it until we have a high-quality place to put
it. Within three to six months, our cash won't be as high. Or
maybe it will be higher!
I know you don't make strategic decisions based on short-term
market moves. But the fund has done well in the past three
months. Is there anything in particular that explains its
recently low volatility?
One thing I can point to is that we don't own biotech. It's a
very tricky area. Especially in small caps, you might get one in
10 companies right. We don't like situations where you're one
data point away from a big loss.
Our benchmark is 5% to 6% biotech. So by avoiding that area,
our portfolio tends to have lower volatility.
Name a holding that's been a big contributor, please.
One we bought late last year wasFirst Solar (
). We watched it go down. It lost 80% to 90% of its value (as it
plunged below 12 last June from a high of 317 in May 2008). It
got to a point where it was trading below the value of its book
of business over the next three years. We bought. That was a
contrarian view. But we thought things could go very right.
If its technology does not play out to be a major leader, we
were still buying their book of business at a discount. And once
they reported major fundamental news, we've seen it go up a lot
quickly. Now it's trading in the 40s.
In addition to this fund, you run or co-run large-cap and midcap
portfolios. Do they all use the same investment philosophy?
They're all relatively concentrated. The large-cap funds tend to
hold 35 to 40 names vs. 100 on average for the category. The
small- and midcap funds tend to around 65 names. (Small Company
Growth held 54 stocks plus 15 other securities such as private
placements as of March 31).
Earnings per share ofOasis Petroleum (
) have grown 65%, 63% and 123% the past three quarters. Why have
you been trimming in recent quarters?
Our decision was more to reallocate to energy ideas we liked, not
that we didn't like Oasis.
Within energy, we don't try to get the underlying commodity
price right. We try to focus on low-cost providers of either gas
or oil because there's a natural volatility to the commodity
Krispy Kreme Doughnut's (KKD) three- and five-year annual
earnings growth rates are each 134%. How's this comeback
They came public with a lot of fanfare. Management at that time
tried to match their initial growth, which hurt them long-term.
They were doing things like competing with themselves in new
stores and selling goods in supermarkets. So their uniqueness and
quality were undermined.
New management is going in the opposite direction. They're
putting together a strong consumer brand and consumer
satisfaction with conservative management. They're not against
growth. They're just thinking more about long-term growth.
Now it's an interesting turnaround situation.
Medidata Solutions' (MDSO) EPS jumped 59% in their most recent
report, after having shrunk three quarters in a row. What's
They're applying the software-as-a-service model to clinical
development for companies trying to design pharmaceuticals trials
and research new pharmaceuticals and biotech solutions.
This can disrupt an industry by bringing cloud solutions to
research organizations. It's a big market and penetration is
still low. But Medidata has first mover advantage. So it's hard
to compete with them. It's a unique first mover.
CoStar Group (CSGP) is up more than 50% in the past 52 weeks. Is
this a real-estate recovery story?
CoStar has databases with information about commercial real
estate in the top 100 U.S. market. If you're doing research or
trying to figure out whether to buy or sell, you need to go to
this company and pay for a subscription to their information.
We like management's willingness to invest in the business.
They went on a big investment spending spree, which hurt their
income statement and made their earnings look low as they tried
to dominate in the top 100 markets from just the top 50.
Now they're more profitable than they've been in the past
three or four years. Going forward, their margins will be higher
as their spending continues to unwind.
You've been building your stake inFiesta Restaurant (FRGI). What
do you like?
They have two core brands. But Pollo Tropical is the exciting
part. It was a Florida brand until recently. Their unit economics
are off the charts, at the high end of the restaurant spectrum
withPanera (PNRA) andChipotle (CMG). And they have the potential
to grow their unit base from regional to beyond that.