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Medidata, CoStar, Fiesta: Why Dennis Lynch Owns Them
By: Investor's Business Daily
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 13.82%.
Lynch, 42-year-old lead manager, talked shop with IBD from his office in midtown Manhattan.
IBD: Why is the fund reopening?
Lynch: Our decision to reopen was based on our assessment that we could effectively manage additional net inflows without facing capacity or liquidity issues.
IBD: You run concentrated portfolios. Why?
Lynch: 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.
IBD: A unique feature of your investment analysis is your reading network. How does it work?
Lynch: 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.
IBD: And your reading network extends beyond your immediate team, correct?
Lynch: 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.
IBD: What's an example of something you invested in as a result of the reading network?
Lynch: 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.
IBD: What holdings illustrate some macro themes you're playing?
Lynch: One isEagle Materials ( EXP ), 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 like that.
IBD: Do you lean away from cyclicals because you prefer long-term holdings?
Lynch: We prefer companies that have more stability and more annuity-like revenues streams than cyclicals.
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.
IBD: Executive Board and Advisory Board target different areas, right?
Lynch: Yes, Advisory Board focuses only on health-care companies. Executive Board focuses on companies outside health care.
IBD: 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 market?
Lynch: 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!
IBD: 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?
Lynch: 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.
IBD: Name a holding that's been a big contributor, please.
Lynch: One we bought late last year wasFirst Solar ( FSLR ). 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.
IBD: In addition to this fund, you run or co-run large-cap and midcap portfolios. Do they all use the same investment philosophy?
Lynch: 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).
IBD: Earnings per share ofOasis Petroleum ( OAS ) have grown 65%, 63% and 123% the past three quarters. Why have you been trimming in recent quarters?
Lynch: 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 price itself.
IBD: Krispy Kreme Doughnut's (KKD) three- and five-year annual earnings growth rates are each 134%. How's this comeback happening?
Lynch: 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.
IBD: Medidata Solutions' (MDSO) EPS jumped 59% in their most recent report, after having shrunk three quarters in a row. What's changed?
Lynch: 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.
IBD: CoStar Group (CSGP) is up more than 50% in the past 52 weeks. Is this a real-estate recovery story?
Lynch: 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.
IBD: You've been building your stake inFiesta Restaurant (FRGI). What do you like?
Lynch: 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.